2012

Preliminary Evaluation of Home Insurance Product

[Type the author name]

5/7/2012

1. Executive summary
The purpose of this study is to investigate the appropriateness of the existing uniform pricing scheme. Hypothesis tests are performed to test the mean difference in claim rates between insured properties that are located at different states (NSW or QLD), belong to a different housing type (HOUSE or UNIT) or made up of different materials (BRICK or OTHER). The mean differences in claim sizes are also tested in the same fashion. From the results, it is concluded that the uniform pricing scheme is inappropriate and adjustments are required to improve the performance of the insurance product. Recommended improvements include the adjustments to the policy pricing according to the location of the insured properties and the housing type of the properties. Important factors in setting up the internal model are also considered and they include the modelling of claim rate of storm claims separately from other claims.

2. Purpose of this report

The objective of this study is to perform a preliminary investigation on the appropriateness of the uniform pricing scheme in our existing home insurance product. Another main objective of this report is to identify the important factors that need to be considered in developing the internal model that can be used for this home insurance product.

3. Data analysis
3.1 Claim rates
Claim rate equals to the proportion of the number of claims out of the number of contracts. A hypothesis testing is carried out to test whether there is a significant difference between the claim rate in NSW and the claim rate in QLD. Several assumptions were made during the test. The claim rate is assumed to follow a binomial distribution and each claim is independent and identically distributed. While these assumptions are valid for claim rates of the claims other than storm claims (OTHER claims), it might not hold true for STORM claims as the data suggests that most storm claims seem to happen only one a few dates. Therefore it was decided to exclude STORM claims in the analysis. Similar methods and assumptions are used to test the difference in claim rates between the properties that fall into the categories BRICK and OTHER, and HOUSE and UNIT.

3.2 Claim sizes

Hypothesis tests are used to test if there is a significant difference between the size of an average claim in NSW and the size of an average claim in QLD. The assumptions used are that each claim is

independent of each other and is identically distributed. The variances of the claims data in each group are also assumed to be different and this can be verified by the available data. Same methods are applied to test the difference in average claim size between the properties that belong to the categories BRICK and OTHER, and HOUSE and UNIT.

4. Results of analysis
4.1 Claim rates
There is no observed difference between the claim rates of OTHER claims in NSW and the claim rates in QLD. Similarly, there is no evidence suggesting that there exists a difference when comparing the claim rates of OTHER claims in properties which are built of BRICKS and properties which are built of OTHER materials. There is also no difference observed between the claim rates of a HOUSE and a UNIT. Overall, no significant relationship is observed between the claim rates of an OTHER claim and the different characteristics of an insured property.

4.2 Claim sizes

It is observed that the claim size of an average claim in NSW is larger than the claim size of an average claim in QLD. Also, the claim size of an average claim in a HOUSE is observed to be larger than that in an UNIT. Possible explanations of these results are the fact that housing prices in NSW are generally higher than QLD, therefore the value of potential loss is also higher. Houses also have a higher price than units in general. However, there is no observed difference in claim size of claims between properties which are built of BRICKS and the ones built of OTHER materials. Overall, the average claim size is observed to be higher in NSW comparing to QLD. And the average claim size of a HOUSE is observed to be higher than the average claim size of an UNIT.

5. Recommendations
5.1 Improvements to pricing scheme
There are strong evidence showing that the claim size has some correlation with the location of the insured property and the housing type of the insured property. This suggests that the existing uniform pricing scheme is inappropriate. Several adjustments to the pricing scheme are suggested: The pricing of the policy should be adjusted according to the location of the insured property. As shown in the data analysis section, the average claim size in NSW is higher than in QLD, therefore the premium charged on customers in NSW should be on average higher in order to cover the higher costs brought by the higher claim sizes. Extra costs will be

incurred as more technical analysis; marketing and administrative procedures will be required for a non-uniform pricing scheme. However they are most likely to be offset by the extra profit that will be generated by differentiating the pricing of policy according to their location. This is suggested by the huge difference between the average claim size in NSW and in QLD. The numerical figures are shown in the Appendix section. Apart from the location of the insured property, the pricing of policy should probably be adjusted according to the housing type of the property as well. However the financial feasibility will need to be confirmed using more in-depth analysis. Even though the claim size of a HOUSE is shown to be greater on average than the claim size of a UNIT, the numerical figures suggest that the difference is not substantially large. As mentioned previously, changing the pricing system of policies usually incur most costs on technical analysis, as well as the marketing and administrative procedures. Some cost-benefits analysis will be required to evaluate whether the extra profit generated by adjusting policy price according to housing type would offset those extra costs incurred.

5.2 Development of the internal model

To improve the accuracy and the uses of the internal model, some important factors should be carefully considered. They include: Modelling claim rate of other claims: as mentioned in the data analysis section, there are no observed relationships between the claim rates and the characteristics of the insured properties. It suggests that there is no need to model the claim rates of other claims separately. Modelling claim rate of storm claims separately: storm claims occur in the event of natural disasters which is rarer than the occurrence of other claims. Although a storm claim has a smaller chance of occurring, the claim size tends to be large and therefore enough reserve capitals should be set aside to prepare for these situations. More data will be required however to have a good fit of distribution to model the claim rate of storm claims. Consider characteristics of properties when modelling claim sizes: Being able to forecast the total claim sizes can help decide the amount of reserve capital required, hence minimising the costs incurred by reserving capital. It can also minimise the chance of default. To ensure accuracy, the relationship between the claim sizes and the characteristics of the insured properties need to be incorporated in the models.

6. Conclusion
After several hypothesis testings, the uniform pricing scheme is determined to be inappropriate. In order to improve the performance of the home insurance product, the pricing scheme needs to be improved by adjusting the policy price according to the location. There are also observed difference in average claims sizes in properties of different housing types. The development of an internal model is also highly important as it projects the future cash flows and tells us information on the minimum required level of reserve capitals.

Appendix
Table 1 Test statistics of OTH claims sizes of NSW vs QLD

NSW Mean Variance Observations Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail

QLD

38235.38 11267.79 2.94E+09 1.21E+08 540 0 607 11.20232 6.59E-27 1.647368 1.32E-26 1.96388 341

Table 2 Test statistics of OTH claims sizes of HOUSE vs UNIT

HOUSE Mean Variance Observations Hypothesized Mean Difference df t Stat P(T<=t) one-tail t Critical one-tail P(T<=t) two-tail t Critical two-tail

UNIT

28978.51 21994.35 2.21E+09 1.06E+09 732 0 290 2.195149 0.014473 1.650125 0.028945 1.968178 149

Comments on peer reviews

Positive feedbacks are received regarding the structure and use of language in the report. Sections including executive summary, purpose of the report are well accepted in general by the peers and therefore no changes will be made. It was pointed out that the technical analysis may be too typical and this is consistent with the self-review as well. However considering this is only a preliminary investigation, the depth of analysis should be sufficient and therefore no changes are made. One of the biggest advices that were taken from the peer reviews is to consider the incentive problems created within the different department in the corporation. Also recommendations were slightly over-simplified and too certain. To address these issues, some changes were made in the recommendation section mainly to mention the needs to consider extra costs incurred by other departments when a non-uniform pricing scheme is implemented. Another big advice taken was the use of appendix. It is suggested that the inclusion of appendix would increase the credibility of the analysis and makes it appear more convincing. To address this issue, an appendix section is included. Other specific advices taken include the change of title in the cover page.

Self reflection
What Ive learnt in this assignment
During the process of doing this assignment, I have learnt a lot on how to apply the skills Ive learnt in the actuarial studies course to real life application in the work field. This assignment good requires critical thinking skill as the problem encountered in the assignment is not as straight forward as a typical tutorial question. There are no definite solutions to the problems. It is more about finding a good solution and understands the advantages, disadvantages and implications of it. In the process of finding the solution, good technical skills are important as it directly affects the accuracy and reliability of the results. Interpretation of results is also highly important as I need to relate numerical results into real life applications. However, finding the solution is only one aspect. The biggest thing I have learnt is how to communicate your ideas to the audience. Different audiences have different knowledge and background. Therefore it is highly important to adjust the choice of words and languages specifically to different groups of audience. During the peer review process, I have again learnt the important of communication skill. Its important to know how to evaluate someones work so that it is beneficial for them. It is often difficult to make criticism to people but keep them encouraged at the same time. I have learnt how to balance positive feedbacks with constructive criticism so that my colleagues can further improve their work.

What I need to improve

After realising the important of communication skill during this assignment, I need to improve my communication skill especially in terms of writing. Often I have struggled to find the right words to describe what really is in my mind. I need to expand my vocabularies so that I can be informative but at the same time keep the audience interested. The hypothesis tests that were performed were also too typical. More critical thinking process will be better so different kinds of hypothesis testings can be carried out. For the peer review process, I need to improve my attention to details especially when looking for positive features in the reports. I may have a tendency to focus too much on picking up mistakes and this might discourage the person I am reviewing.

What I will do next time

I will do more research on home insurance product to get some insight on their pricing policy. More research will also be carried out on how insurance company market their insurance products. This extra information will help in making recommendations. For peer reviews, I will be more considerate about the feeling of the person being reviewed. I will pay more attention and make more comments on the positive features in their report but at the same time keeping my criticism constructive. My language used might have been too blunt in occasions especially when criticising someones work. I will consider using more friendly languages next time so I dont run the risks of demoralise the person being reviewed.