What is Actuarial Risk
Actuarial risks are the risks that the assumptions that actuaries implement into a model to price a specific insurance policy may turn out wrong or somewhat inaccurate. Possible assumptions include the frequency of losses, severity of losses and the correlation of losses between contracts. Actuarial risk is also known as "insurance risk."
BREAKING DOWN Actuarial Risk
The level of actuarial risk is directly proportional to the reliability of assumptions implemented in pricing models used by insurance companies to set premiums.
Life, in general, carries many risks. For example, a homeowner faces a large potential for variation associated with the possibility of economic loss caused by a house fire. A driver faces a potential economic loss if his car is damaged. A larger possible economic risk exists with respect to potential damages a driver might have to pay if he injures a third party in a car accident for which he is responsible. A major part of an actuary's job is to predict the
frequency and severity of these risks as they relate to the financial liability for risks taken on by an insurer in an insurance contract.
Actuaries use various types of prediction models to estimate risk levels. These prediction models are based on assumptions, and ensuring those assumptions in a model actually reflect real life is vital for the pricing of all types of insurance. Flaws in a model's assumptions could lead to premium mispricing. In the worst case scenario, an actuary may underestimate the frequency of an event. The unaccounted incidents will cause an increase in the frequency of payouts, which could bankrupt an insurer.
Actuarial Risk and Life Tables
One of the most common risk assessment models – and thus actuarial risk – are life tables, which are used to price life insurance policies. Life tables seek to predict the probability of an individual passing away before his next birthday occurs. Actuarial science relies on the following two chief types of life tables:
- Period life table: This table shows mortality rates of a specific population of individuals, during a given period of time.
- Cohort life table: This table shows the overall rates of mortality for a specific population’s total lifetime. Sometimes called a “generation life table”, this device relies on the fact that a population of individuals were all born during the same interval of time. Cohort life tables are used most often, because they can predict future mortality rate changes in a given population, and can analyze mortality rate patterns over time.
Life tables may be based historical records, however, said records often under-calculate infant mortality, compares with regions that have superior records.