Actuarial Standard of Practice No. 12
Risk Classification (for All Practice Areas)
STANDARD OF PRACTICE
TO: Members of the American Academy of Actuaries and Other Persons Interested in Risk Classification (for All Practice Areas)
FROM: Actuarial Standards Board (ASB)
SUBJ: Actuarial Standard of Practice (ASOP) No. 12
This booklet contains the final version of a revision of ASOP No. 12, now titled Risk Classification (for All Practice Areas).
In 1989, the Actuarial Standards Board adopted the original ASOP No. 12, then titled Concerning Risk Classification. The original ASOP No. 12 was developed as the need for more formal guidance on risk classification increased as the selection process became more complex and more subject to public scrutiny. In light of the evolution in practice since then, as well as the adoption of a new format for standards, the ASB believed it was appropriate to revise this standard in order to reflect current generally accepted actuarial practice.
The exposure draft of this ASOP was approved for exposure in September 2004 with a comment deadline of March 15, 2005. Twenty-two comment letters were received and considered in developing the final standard. A summary of the substantive issues contained in the exposure draft comment letters and the responses are provided in appendix 2.
The most significant changes from the exposure draft were as follows:
1. The task force clarified language relating to the interaction of applicable law and this standard.
2. The task force revised the definition of “adverse selection.”
3. The task force reworded the definition of “financial or personal security system” and included examples.
4. The words “equitable” and “fair” were added in section 3.2.1 but defined in a very limited context that is applicable only to rates.
5. With respect to the operation of the standard, the task force added language that clarifies that this standard in all respects applies only to professional services with respect to designing, reviewing, or changing risk classification systems.
6. Sections 4.1 and 4.2 were combined into a new section 4.1, Communications and Disclosures, which was revised for clarity. The placement of communication requirements throughout the proposed standard was examined, and a sentence regarding disclosure was removed from section 3.3.3 and incorporated into section 4.1. A similar change was made by adding a new sentence in section 4.1 to correspond to the guidance in section 3.4.1.
In addition, the disclosure requirement in section 4 for the actuary to consider providing quantitative analyses was removed and replaced by a new section 3.4.4, which guides the actuary to consider performing such analyses, depending on the purpose, nature, and scope of the assignment.
The task force thanks everyone who took the time to contribute comments on the exposure draft.
The ASB voted in December 2005 to adopt this standard.
Task Force to Revise ASOP No. 12
Mark E. Litow, Chairperson
David J. Christianson Charles L. McClenahan
Arnold A. Dicke Donna C. Novak
Paul R. Fleischacker Ronnie Susan Thierman
Joan E. Herman Kevin B. Thompson
Barbara J. Lautzenheiser
General Committee of the ASB
W .H. Odell, Chairperson
Charles A. Bryan Mark E. Litow
Thomas K. Custis Chester J. Szczepanski
Burton D. Jay Ronnie Susan Thierman
Actuarial Standards Board
Michael A. LaMonica, Chairperson
Cecil D. Bykerk William A. Reimert
William C. Cutlip Lawrence J. Sher
Lew H. Nathan Karen F. Terry
Godfrey Perrot William C. Weller
Section 1. Purpose, Scope, Cross References, and Effective Date
This actuarial standard of practice (ASOP) provides guidance to actuaries when performing professional services with respect to designing, reviewing, or changing risk classification systems.
This standard applies to all actuaries when performing professional services with respect to designing, reviewing, or changing risk classification systems used in connection with financial or personal security systems, as defined in section 2.4, regarding the classification of individuals or entities into groups intended to reflect the relative likelihood of expected outcomes. Such professional services may include expert testimony, regulatory activities, legislative activities, or statements concerning public policy, to the extent these activities involve designing, reviewing, or changing a risk classification system used in connection with a specific financial or personal security system.
Throughout this standard, any reference to performing professional services with respect to designing, reviewing, or changing a risk classification system also includes giving advice with respect to that risk classification system.
Risk classification can affect and be affected by many actuarial activities, such as the setting of rates, contributions, reserves, benefits, dividends, or experience refunds; the analysis or projection of quantitative or qualitative experience or results; underwriting actions; and developing assumptions, for example, for pension valuations or optional forms of benefits. This standard applies to actuaries when performing such activities to the extent such activities directly or indirectly involve designing, reviewing, or changing a risk classification system. This standard also applies to actuaries when performing such activities to the extent that such activities directly or indirectly are likely to have a material effect, in the actuary’s professional judgment, on the intended purpose or expected outcome of the risk classification system.
If the actuary departs from the guidance set forth in this standard in order to comply with applicable law (statutes, regulations, and other legally binding authority), or for any other reason the actuary deems appropriate, the actuary should refer to section 4.
1.3 Cross References
When this standard refers to the provisions of other documents, the reference includes the referenced documents as they may be amended or restated in the future, and any successor to them, by whatever name called. If any amended or restated document differs materially from the originally referenced document, the actuary should consider the guidance in this standard to the extent it is applicable and appropriate.
1.4 Effective Date
This standard will be effective for any professional service commenced on or after May 1, 2006.
Section 2. Definitions
The terms below are defined for use in this actuarial standard of practice.
An actuary’s communication or other work product in oral, written, or electronic form setting forth the actuary’s professional opinion or recommendations concerning work that falls within the scope of this standard.
2.2 Adverse Selection
Actions taken by one party using risk characteristics or other information known to or suspected by that party that cause a financial disadvantage to the financial or personal security system (sometimes referred to as antiselection).
A measure of the predictive value in a given application that the actuary attaches to a particular body of data (predictive is used here in the statistical sense and not in the sense of predicting the future).
2.4 Financial or Personal Security System
A private or governmental entity or program that is intended to mitigate the impact of unfavorable outcomes of contingent events. Examples of financial or personal security systems include auto insurance, homeowners insurance, life insurance, and pension plans, where the mitigation primarily takes the form of financial payments; prepaid health plans and continuing care retirement communities, where the mitigation primarily takes the form of direct service to the individual; and other systems, where the mitigation may be a combination of financial payments and direct services.
The degree to which the expected outcomes within a risk class have comparable value.
Realistic in approach, given the purpose, nature, and scope of the assignment and any constraints, including cost and time considerations.
Individuals or entities covered by financial or personal security systems.
2.8 Risk Characteristics
Measurable or observable factors or characteristics that are used to assign each risk to one of the risk classes of a risk classification system.
2.9 Risk Class
A set of risks grouped together under a risk classification system.
2.10 Risk Classification System
A system used to assign risks to groups based upon the expected cost or benefit of the coverage or services provided.
Section 3. Analysis of Issues and Recommended Practices
This section provides guidance for actuaries when performing professional services with respect to designing, reviewing, or changing a risk classification system. Approaches to risk classification can vary significantly and it is appropriate for the actuary to exercise considerable professional judgment when providing such services, including making appropriate use of statistical tools. Sections 3 and 4 are intended to provide guidance to assist the actuary in exercising professional judgment when applying various acceptable approaches.
3.2 Considerations in the Selection of Risk Characteristics
Risk characteristics are important structural components of a risk classification system. When selecting which risk characteristics to use in a risk classification system, the actuary should consider the following:
3.2.1 Relationship of Risk Characteristics and Expected Outcomes
The actuary should select risk characteristics that are related to expected outcomes. A relationship between a risk characteristic and an expected outcome, such as cost, is demonstrated if it can be shown that the variation in actual or reasonably anticipated experience correlates to the risk characteristic. In demonstrating a relationship, the actuary may use relevant information from any reliable source, including statistical or other mathematical analysis of available data. The actuary may also use clinical experience and expert opinion.
Rates within a risk classification system would be considered equitable if differences in rates reflect material differences in expected cost for risk characteristics. In the context of rates, the word fair is often used in place of the word equitable.
The actuary should consider the interdependence of risk characteristics. To the extent the actuary expects the interdependence to have a material impact on the operation of the risk classification system, the actuary should make appropriate adjustments.
Sometimes it is appropriate for the actuary to make inferences without specific demonstration. For example, it might not be necessary to demonstrate that persons with seriously impaired, uncorrected vision would represent higher risks as operators of motor vehicles.
While the actuary should select risk characteristics that are related to expected outcomes, it is not necessary for the actuary to establish a cause and effect relationship between the risk characteristic and expected outcome in order to use a specific risk characteristic.
The actuary should select risk characteristics that are capable of being objectively determined. A risk characteristic is objectively determinable if it is based on readily verifiable observable facts that cannot be easily manipulated. For example, a risk classification of “blindness” is not objective, whereas a risk classification of “vision corrected to no better than 20/100” is objective.
The actuary’s selection of a risk characteristic should reflect the tradeoffs between practical and other relevant considerations. Practical considerations that may be relevant include, but are not limited to, the cost, time, and effort needed to evaluate the risk characteristic, the ongoing cost of administration, the acceptability of the usage of the characteristic, and the potential usage of different characteristics that would produce equivalent results.
3.2.5 Applicable Law
The actuary should consider whether compliance with applicable law creates significant limitations on the choice of risk characteristics.
3.2.6 Industry Practices
When selecting risk characteristics, the actuary should consider usual and customary risk classification practices for the type of financial or personal security system under consideration.
3.2.7 Business Practices
When selecting risk characteristics, the actuary should consider limitations created by business practices related to the financial or personal security system as known to the actuary and consider whether such limitations are likely to have a significant impact on the risk classification system.
3.3 Considerations in Establishing Risk Classes
A risk classification system assigns each risk to a risk class based on the results of measuring or observing its risk characteristics. When establishing risk classes for a financial or personal security system, the actuary should consider and document any known significant choices or judgments made, whether by the actuary or by others, with respect to the following:
3.3.1 Intended Use
The actuary should select a risk classification system that is appropriate for the intended use. Different sets of risk classes may be appropriate for different purposes. For example, when setting reserves for an insurance coverage, the actuary may choose to subdivide or combine some of the risk classes used as a basis for rates.
3.3.2 Actuarial Considerations
When establishing risk classes, the actuary should consider the following, which are often interrelated:
a. Adverse Selection: If the variation in expected outcomes within a risk class is too great, adverse selection is likely to occur. To the extent practical, the actuary should establish risk classes such that each has sufficient homogeneity with respect to expected outcomes to satisfy the purpose for which the risk classification system is intended.
b. Credibility: It is desirable that risk classes in a risk classification system be large enough to allow credible statistical inferences regarding expected outcomes. When the available data are not sufficient for this purpose, the actuary should balance considerations of predictability with considerations of homogeneity. The actuary should use professional judgment in achieving this balance.
c. Practicality: The actuary should use professional judgment in balancing the potentially conflicting objectives of accuracy and efficiency, as well as in minimizing the potential effects of adverse selection. The cost, time, and effort needed to assign risks to appropriate risk classes will increase with the number of risk classes.
3.3.3 Other Considerations
When establishing risk classes, the actuary should (a) comply with applicable law; (b) consider industry practices for that type of financial or personal security system as known to the actuary; and (c) consider limitations created by business practices of the financial or personal security system as known to the actuary.
3.3.4 Reasonableness of Results
When establishing risk classes, the actuary should consider the reasonableness of the results that proceed from the intended use of the risk classes (for example, the consistency of the patterns of rates, values, or factors among risk classes).
3.4 Testing the Risk Classification System
Upon the establishment of the risk classification system and upon subsequent review, the actuary should, if appropriate, test the long-term viability of the financial or personal security system. When performing such tests subsequent to the establishment of the risk classification system, the actuary should evaluate emerging experience and determine whether there is any significant need for change.
3.4.1 Effect of Adverse Selection
Adverse selection can potentially threaten the long-term viability of a financial or personal security system. The actuary should assess the potential effects of adverse selection that may result or have resulted from the design or implementation of the risk classification system. Whenever the effects of adverse selection are expected to be material, the actuary should, when practical, estimate the potential impact and recommend appropriate measures to mitigate the impact.
3.4.2 Risk Classes Used for Testing
The actuary should consider using a different set of risk classes for testing long-term viability than was used as the basis for determining the assigned values if this is likely to improve the meaningfulness of the tests. For example, if a risk classification system is gender-neutral, the actuary might separate the classes based on gender when performing a test of long-term viability.
3.4.3 Effect of Changes
If the risk classification system has changed, or if business or industry practices have changed, the actuary should consider testing the effects of such changes in accordance with the guidance of this standard.
3.4.4 Quantitative Analyses
Depending on the purpose, nature, and scope of the assignment, the actuary should consider performing quantitative analyses of the impact of the following to the extent they are generally known and reasonably available to the actuary:
a. significant limitations due to compliance with applicable law;
b. significant departures from industry practices;
c. significant limitations created by business practices of the financial or personal security system;
d. any changes in the risk classes or the assigned values based upon the actuary’s determination that experience indicates a significant need for a change; and
e. any expected material effects of adverse selection.
3.5 Reliance on Data or Other Information Supplied by Others
When relying on data or other information supplied by others, the actuary should refer to ASOP No. 23, Data Quality, for guidance.
The actuary should document the assumptions and methodologies used in designing, reviewing, or changing a risk classification system in compliance with the requirements of ASOP No. 41, Actuarial Communications. The actuary should also prepare and retain documentation to demonstrate compliance with the disclosure requirements of section 4.1.
Section 4. Communications and Disclosures
4.1 Communications and Disclosures
When issuing actuarial communications under this standard, the actuary should comply with ASOP Nos. 23 and 41. In addition, the actuarial communications should disclose any known significant impact resulting from the following to the extent they are generally known and reasonably available to the actuary:
a. significant limitations due to compliance with applicable law;
b. significant departures from industry practices;
c. significant limitations created by business practices related to the financial or personal security system;
d. a determination by the actuary that experience indicates a significant need for change, such as changes in the risk classes or the assigned values; and
e. expected material effects of adverse selection;
f. the disclosure in ASOP No. 41, section 4.2, if any material assumption or method was prescribed by applicable law (statutes, regulations, and other legally binding authority);
g. the disclosure in ASOP No. 41, section 4.3, if the actuary states reliance on other sources and thereby disclaims responsibility for any material assumption or method selected by a party other than the actuary; and
h. the disclosure in ASOP No. 41, section 4.4, if, in the actuary’s professional judgment, the actuary has otherwise deviated materially from the guidance of this ASOP.
The actuarial communications should also disclose any recommendations developed by the actuary to mitigate the potential impact of adverse selection.
Appendix 1- Background and Current Practices
Note: The following appendix is provided for informational purposes but is not part of the standard of practice.
Risk classification has been a fundamental part of actuarial practice since the beginning of the profession. The financial distress and inequity that can result from ignoring the impact of differences in risk characteristics was dramatically illustrated by the failure of the nineteenth-century assessment societies, where life insurance was provided at rates that disregarded age. Failure to adhere to actuarial principles regarding risk classification for voluntary coverages can result in underutilization of the financial or personal security system by, and thus lack of coverage for, lower risk individuals, and can result in coverage at insufficient rates for higher risk individuals, which threatens the viability of the entire system.
Adverse selection may result from the design of the classification system or may be the result of externally mandated constraints on risk classification. Classes that are overly broad may produce unexpected changes in the distribution of risk characteristics. For example, if an insurer chooses not to screen for a specific risk characteristic, or a jurisdiction precludes screening for that characteristic, this may result in individuals with the characteristic applying for coverage in greater numbers and/or amounts, leading to increased overall costs.
Risk classification is generally used to treat participants with similar risk characteristics in a consistent manner, to permit economic incentives to operate and thereby encourage widespread availability of coverage, and to protect the soundness of the system.
The following actuarial literature provides additional background and context with respect to risk classification:
1. In 1957, the Society of Actuaries published Selection of Risks by Pearce Shepherd and Andrew Webster, which educated several generations of actuaries and is still a useful reference.
2. In 1980, the American Academy of Actuaries published the Risk Classification Statement of Principles, which has enjoyed widespread acceptance in the actuarial profession. At the time of this revision of ASOP No. 12, the American Academy of Actuaries was developing a white paper regarding risk classification principles.
3. In 1992, the Committee on Actuarial Principles of the Society of Actuaries published “Principles of Actuarial Science,” which discusses risk classification in the context of the principles on which actuarial science is based.
Over the years, a multitude of risk classification systems have been designed, put into use, and modified as a result of experience. Advances in medical science, economics, and other disciplines, as well as in actuarial science itself, are likely to result in continued evolution of these systems. While future developments cannot be foreseen with accuracy, practicing actuaries can take reasonable steps to keep abreast of emerging and current practices. These practices may vary significantly by area of practice. For example, the risk classes for voluntary life insurance may be subdivided to reflect the applicant’s state of health, smoking habits, and occupation, while these factors are usually not considered in pension systems.
Innovations in risk classification systems may engender considerable controversy. The potential use of genetic tests to classify risks for life and health insurance is a current example. In some cases, such controversy results in legislation or regulation. The use of postal codes, for example, has been outlawed for some types of coverage. For the most part, however, the legal test for risk classification has remained unchanged for several decades; risk classification is allowed so long as it is “based on sound actuarial principles” and “related to actual or reasonably anticipated experience.”
Risk classification issues in some instances may pose a dilemma for an actuary working in the public policy arena when political considerations support a system that contradicts to some degree practices called for in this ASOP. Also, when designing, reviewing, or changing a risk classification system, actuaries may perform professional services related to a designated set of specific assumptions that place certain restraints on the risk classification system.
In such situations, it is important for those requesting such professional services to have the benefit of professional actuarial advice.
This ASOP is not intended to prevent the actuary from performing professional services in the situations described above. In such situations, the communication and disclosure guidance in section 4.1 will be particularly pertinent, and current section 4.1(e), which requires disclosure of any known significant impact resulting from expected material effects of adverse deviation, may well apply. Section 4.1(a), which relates to applicable law, and section 4.1(b), which relates to industry practices, may also be pertinent.
Appendix 2 – Comments on the Exposure Draft and Responses
The exposure draft of this revision of ASOP No. 12, Risk Classification for All Practice Areas, was issued in September 2004 with a comment deadline of March 15, 2005. Twenty-two comment letters were received, some of which were submitted on behalf of multiple commentators, such as by firms or committees. For purposes of this appendix, the term “commentator” may refer to more than one person associated with a particular comment letter. The task force carefully considered all comments received.
Click here to view Appendix 2 in its entirety.