Mathematics behind Insurance pricing

Recently there has been bit of hoo- ha between insurers and doctors on issues pertaining to integrated shield plans, panel of doctors etc. The Singapore government has stepped in by promising to set up a panel of experts to bring all stakeholders together for a proper discussion.


In this post I will share about the pricing mechanism behind insurers.


When faced with a potential customer/policyholder. The most important questions an insurer will ask are:

  1. what is the probability claims will be made

  2. what is the payout for each claim

When these two are combined, it becomes the expected payout (probability x outcome = Expectation) for each policyholder. Of course if your expected payout is $5000, it doesn't mean you specifically will be claiming $5000 in the coming year, it simply means that if there a large group of policyholders (grouped by health demographic), the average payout of each holder is $5000.


Insurers obtain clues on those two questions from a variety of sources, examples include:

  • their own historical data (worldwide and country specific)

  • specific individual medical/claims history

  • their own outlook for the coming year

So if your expected payout for the coming year is indeed $5000, insurers will charge you a premium of $5000 such that it's a fair deal for both parties where the loss ratio (claims/premiums) is one. Of course if the loss ratio is greater than 1, the insurer is incurring a loss on the policy.


But of course insurers are here to to earn profits and thus we have to take into account all other business expenses (marketing, HR, agent commission), hence the relevant factor to consider is actually the combined loss ratio (claims + all relevant expenses / premium).


So with an ageing population insurers naturally feel that odds and severity of claiming are higher, resulting in a higher expected payout and thus premiums should rise to compensate for their relevant risk exposure.


Correct or ethical of not, I have no direct answer but I will seek to shed more light on the dynamics of insurance policy and insurers in my subsequent post.


Best Regards,

Alvin


#acesaspire #acesmath