How the losses of the few are spread among the many
European insurers pay out almost €3bn a day in claims to help businesses and individuals through difficult events and in benefits to long-term savers. They do this by collecting premiums in a pool, from which the losses are paid.
The premiums for each individual or business in the pool are calculated by weighting relevant risk factors depending on their likelihood. This is risk-based underwriting. Not matching pricing to risks could increase premiums for the many, thus disincentivising them from seeking cover, or threaten insurers’ solvency and their ability to meet their promises to pay claims.
Risk-based underwriting is currently in the spotlight due to discussions on a possible EU-wide “right to be forgotten” for cancer survivors as part of the European Commission’s “Beating Cancer Plan”. Insurance Europe is engaging in these discussions.
Q&A on risk-based underwriting and a right to be forgotten (RTBF)
What is risk-based underwriting?
It determines premiums and benefits based on relevant risk factors. The relevant risk factors are weighted depending on their chance of occurrence, with similar risk factors weighted in a similar way. This requires there to be no information asymmetry and prevents anti-selection.
Why is risk-based underwriting used to price private insurance?
Private insurance works by pooling the premiums paid by the many to create a reserve to pay for the claims of the few. It is generally accepted that risk-based underwriting is the fairest way to set each policyholder’s contribution to that pool.
What is the difference between risk-based underwriting and RTBF?
Taking the example of a person with a prior cancer diagnosis, risk-based underwriting would disregard that diagnosis if the risk of mortality is not higher than that of a person without such a diagnosis. Under a RTBF, a prior cancer diagnosis would be disregarded a fixed period after treatment ends, irrespective of whether there is still a heightened risk of mortality.
Why is an EU-wide RTBF inadvisable?
It would decouple the risk of mortality from the insurance premium charged for that risk. In the longer term, this would lead to higher premiums for all groups of insureds to cover the unpriced RTBF. Furthermore, EU-level action is inadvisable because there are real and significant variations in cancer treatment and outcomes between member states.
What is anti-selection?
Anti-selection occurs when higher risk individuals are more likely to take out insurance. An EU-wide RTBF could lead to this, with lower-risk policyholders feeling they are paying too much and ceasing to take out insurance, while higher-risk policyholders become overrepresented in the pool of insureds. In the longer term, this will be to the detriment of all policyholders, as products become more expensive to cover the risks insured or are withdrawn because the products become unfeasible.
What is information asymmetry?
Information asymmetry occurs when the policyholder and their insurer hold different risk-relevant information. If underwriting decisions are made on the basis of incomplete information, the insurer is unable to price the risk accurately and will not hold the required reserves to meet its promises to pay claims.
What obligations are insurers under to treat consumers fairly?
Insurers are subject to myriad rules to ensure the fair treatment of all consumers. These prevent discrimination on the basis of protected features (e.g. gender), set solvency and capital requirements to ensure the continued operation of insurers and require insurers to inform consumers clearly about the key features of products.