There are two methods of classification of risk. First, the judgement method and second, the numerical rating system.
1. The Judgement Method
Under this method the individual decisions of experienced persons, in the medical, actuarial, underwriting and other departments are combined.
These persons are qualified and permitted to take decision. Unlike the other method, no rigid rules and scales are prescribed and followed.
Personal judgement, therefore, plays vital part in the whole system of underwriting. Under this system the routine cases are processed with a minimum of consideration by assistants trained in the review of applications and doubtful or significant cases or border line cases are resolved by experts who take the decision on their experience and general impressions.
This method is still used in India by the Life Insurance Corporation.
The judgement method is generally used where a single factor is to be considered or where the decision for acceptance or rejection is to be taken.
The second use of this method is that where numerical rating fails to decide, this method comes to much assistance because the merit of each and every factor is personally considered.
The personal decision of the officers and experts may be quick and significant. The various difference in the reports, thorough inquiries is made and personal judgement is substituted by the other method.
The disadvantage of this method is that the personal direction may be biased by the whims and negligence of the officers. Inexperienced decision may harm the insurance business. The second criticism is that it is not very much scientific.
There is no basis except the personal experience, for taking correct decision.
To avoid the weaknesses of the judgement method, a method known as the numerical rating system was devised and is commonly used by the insurers.
2. Numerical Rating System
This system is based upon the principle that a large number of factors enter into the composition of a risk and that the impact of each of these factors on the longevity of the risk can be determined by a statistical study of lives possessing that factor.
It assumes that a standard risk has a rating of 100. Each factor has 100 if they are standard and no marks will be assigned. Information for each factor one by one is considered.
Favourable factors are assigned negative values called “credits” while unfavourable factors are assigned positive values called “debits”.
The particular percentages to be added or deducted for each factor will depend upon the degree of its variation from the situation assumed for the normal risk and the experience of each insurer.
The algebraic summation of the debits and credits added to the per value of 100 represents the numerical value of risk. In practice, value are generally assigned to the important factors such as build, physical condition, personal history, family history, occupation, residence, habits, moral and plan.
The value assigned to the various factors are on the basis of mortality.
For example, if the mortality experience of a group of insured lives with a particular medical history reflected a certain degree of overweight has been found to be 135 per cent of that among all standard risk, a debit (+) of 35 marks will be assigned to such medical history.
Similarly, the degree of risk on the basis of each factor is evaluated in terms of percentage.
If it is more than 100 i.e., if the risk is more than the standard the extra percentage will be debited (+) and if the degree of risk expressed in percentage is less than 100, the lesser percentage will be credited (-) up to the difference.
One example of numerical rating system will make it clear.
A married man having two children of the age 3.2 has good physical condition. He is over He is over-weight by 60 per cent. His expanded chest measurement is one inch less than the girth of his abdomen. He has no indication of adverse effect on longevity.
His family was from tuberculosis, insanity etc.
He was working as blacksmith. His habits and morals are good. He lives in a posh house in good surrounding.
The plan for insurance is twenty-year endowment.
According to the following table, he is given 60 marks in debit (+) side for overweight.
The family history is favourable which has been given him 15 marks in credit side.
The plan of insurance 20-year’s endowment would call for an additional credit of 10 marks.
The residence, habits, good behaviour, occupation and physical conditions have no credit marks, only debit marks are assigned to these.
If the rating is :
- below 76 – it is generally treated as super-standard
- between 75 and 125 – it is standard risk
- more than 125 and below 500 – it is sub-standard
- more than 500 – it is uninsurable.
The degree of rating for classification may vary from insurer to insurer.
The numerical rating system follows the same procedures as that is followed by those who judge a risk with only difference of allotting marks.
The same factors are considered and the final decision is based upon the relationship of the various favourable and unfavourable features of the risk.
The numerical method is objective standards which assists in the final valuation of risk and makes for greater consistence of decision.
The method expediates the handling of cases and holding done the expense of the selection process.
It enables to make decision on the medico-acturial investigation and reduces the operation of the subjective factor in the under-writing of risks to a minimum.
The basic ratings are continuously reviewed in the light of up-to-date trends in insurance.
Various criticisms have been levied on the system. The system is thought to be too arbitrary. There are many impairments concerning which knowledge is too limited to permit the assignment of numerical values.
The interrelated factors are non-additive. Too many minor debits and credits are taken into account in evaluating risk.
Rating have often to be modified by taking into account the interaction of various aspect of the risk and in particular, the probable influence on the risk of occupation, habits, mode of living, socio-economic status, moral hazard, etc.
Supporters of the system recognize its flaws but feel that it is still superior to any other method.
The numerical ratings arrived at can only be regarded as a guide, and the selection of risk depends to a considerable extent on the individual judgement and skill of the medical examiner, actuaries and underwriting officers of the life insurance business.