Section 7 Physical Environment
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Objectives
- Describe aspects of the physical environment.
- Describe how the physical environment may affect actuarial work.
Definition and exmaples
- Physical environment includes both hazards and technology.
- Hazards can be subdivided into natural and man-made.
- Health hazards are natural hazards that tend to primarily affect health and life actuaries.
- Natural environmental hazards and man-made hazards can influence health, life, casualty, finance and investment actuaries.
- Technology is subdivided into computer-related and health-related technologies.
- Changes in global weather patterns have produced an increased number of hurricanes and other natural disasters. The disasters have produced substantial losses for the property insurance business and increased uncertainty in pricing for property insurance.
- Better catastrophe models are needed to estimate potential losses resulting from the perils, particularly hurricanes and earthquakes. These actuarial models often require the use of other fields, such as engineering and climatology, as well as traditional actuarial analysis. Actuaries practicing in these areas must be familiar with these models, work to update and improve the models and use them in their pricing work.
- Man-made catastrophes such as terrorism must now be factored into the rates unless coverage for this hazard is excluded. The pricing of terrorism coverage is very difficult due to the lack of reliable data, the constantly changing nature of the threat and the potential severity of possible terrorist events. Many actuaries believe that terrorism is not an insurable peril.
- Other examples of man-made catastrophes include adverse judicial/legislative decisions. Adverse judicial decisions include mandated expansion of coverage to areas or perils that were never contemplated when the coverage was priced. Examples include mold damage, concurrent causation and construction defects. It can also include events such as bad-faith awards and large jury awards against large corporations. It is difficult to include a specific rating element for these uncertain events. One solution is the inclusion of a contingency margin in developing actuarially sound prices.
- Health hazards often create financial problems that call for actuarial solutions such as private or public health insurance. They also affect the design of solutions in other practice areas such as the cost of life insurance. An example of a health hazard that created significant problems is the influenza outbreak in 1918. Read “Influenza Pandemics: Are We Ready for the Next One? What Actuaries Can Learn From 1918” (m2s7-01_RM0407.pdf). Here the author discussed how tail mortality risk has received more attention and he specifically explains how influenza influenced mortality experience during the epidemic. Tail mortality risk refers to the extreme areas of the mortality distribution that define a risk. Some groups have defined the tail as being the portion of the distribution that is two or more standard deviations from the mean. Traditionally, much analyses has focused on the mean of the distribution with less attention at the extremes. We can infer from Rudolph’s article that life insurance companies can be at great risk from such future epidemics if design and pricing of the products did not consider these extreme scenarios.
- Estimating the transmission rates and reach of new diseases can be difficult. In 2004, Risk Management Solutions (RMS) conducted an extensive study of potential catastrophic risk. Read the RMS press announcement (m2s7-02_RMS Announcement.pdf) to obtain a brief overview. “Catastrophe, Injury, and Insurance: The Impact of Catastrophes on Workers’ Compensation, Life, and Heath Insurance”, the RMS summary document (m2s7-03_CasualtyStudySummary.pdf). Finally, read Chapter 8, “Infectious Diseases” in this final report: “Catastrophe, Injury, and Insurance: The Impact of Catastrophes on Workers Compensation, Life, and Health Insurance" (m2s7-04_CasualtyStudy_Final-Chapter 8.pdf).
- From readings: Historical records have indicated that the average time between pandemics is approximately 25 years. The RMS study estimates the costs of another influenza pandemic to health insurers would be $30 billion to $41 billion, and life insurers $9 billion. These readings addressed the issue of transmission rates for AIDS, SARS and influenza. AIDS and SARS both surprised experts by how fast and extensively the diseases spread. Influenza pandemics in 1918, 1957 and 1968 affected a very large number of Americans. The 1918 pandemic alone killed 0.67 percent of the entire U.S. population and higher levels elsewhere. The authors defined a hypothetical scenario describing how the health insurance industry would bear huge losses, while the life insurance industry would also be adversely affected by the excess mortality, but less so because of gains on annuities.
- Examples of environmental hazards include natural disasters such as hurricanes, tsunamis and tidal waves, heat waves, earthquakes, tornados, wildfires and winter storms. These hazards create a need for casualty solutions and may affect the design of solutions in the life insurance and health practice areas. The effect of these catastrophes is not only a function of the severity of the disaster, but also of the concentration of population exposure and the insurance coverage. This is discussed in Chapter 2 of the RMS study (m2s7-05_CasualtyStudy_Final-Chapters 2.pdf). Additionally, read this short article discussing the cost to insurers of the 2011 Japanese earthquake.
- From the readings: The Risk Management Solutions (RMS) study identified the following as “perils of greatest concern": Earthquake, industrial accident, influenza pandemic, terrorist attack.
- Another type of hazard is of the man-made variety. The Risk Management Solutions study described terrorism and war as examples of man-made hazards. Losses from these types of hazards have been well publicized. Man-made hazards often create significant problems for actuaries because they are unpredictable. Read the Academy of Actuaries paper on terrorism and the impact to the insurance markets (terrorism_may02.pdf) to learn more.
- Advances in computer technology have had a significant effect on the work of actuaries. Available technology often influences the way in which the actuary performs an analysis as well as the range of viable solutions. For example, actuaries are trained in the development and use of mathematical models to develop solutions to problems involving contingencies. As technology improves, the complexity and power of the models can increase. This enables actuaries to better define the problems and develop better solutions. At the same time the increased communication due to the Internet has placed more pressure on insurance companies and pension plans to be competitive.
- Read The Role of Technology in Risk Management (Link broken) for an overview about the relative roles of technology and human ingenuity in risk management.
- According to the article, the following are the main reasons why technologically excellent models fail:
- Model outputs are believed without being challenged.
- Incorrect assumptions are used.
- Poor quality data is used.
- Medical advances affect life, health and pension actuaries. For example, life actuaries are primarily concerned with the effects of increased longevity on insurance and annuities. Pension actuaries must consider increased longevity when designing, costing and funding various retirement plans. Health actuaries must consider how medical advances affect utilization rates and claim costs. Read Health Technology and How It Affects Actuaries (m2s7-09_HealthTechAffect.pdf).
- Decreases in mortality rates from medical advances would decrease the cost of life insurance. However, the effect on the lifetime cost for health and long term care insurance can go either way. If mortality rates decline, but people are less healthy, then costs for health and long term care insurance are likely to be increased. On the other hand, if the new medical technology leads to healthier lives or lower cost treatments in the future, then health and long term care insurance costs may decline.
- If insurance companies are not permitted to use genetic testing information and applicants have such information, they could select against the insurers by increasing their purchase of insurance that covers any increased risk of which they are aware. For example, if an individual has a genetic predisposition to Alzheimer’s, long term care insurance becomes more attractive, especially if the insurance company can’t charge a higher premium for the greater risk.