Actuarial Risk: What it Means, How it Works

What Is Actuarial Risk?

Actuarial risk refers to the risk that the assumptions actuaries implement into models used to price specific insurance policies may prove to be inaccurate or wrong. Possible assumptions include the frequency of losses, the severity of losses, and the correlation of losses between contracts. Actuarial risk is also known as "insurance risk."

Understanding 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 carries many risks. A homeowner faces the 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. He faces even larger damages if he injures a third party in a car accident for which he is responsible. A major element of an actuary's job involves predicting 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.

Various Prediction Models

Actuaries use various types of prediction models to estimate risk levels. These prediction models are based on assumptions that aim to reflect real life, which is vital for the pricing of all types of insurance. Flaws in a model's assumptions may 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 conceivably bankrupt an insurer.

Actuarial Risk and Life Tables

Life tables are among the most common risk assessment models used. These devices are customarily employed for the purposes of pricing life insurance policies. Life tables strive to forecast the probability of an individual dying before his or her next birthday. The following two types of life tables dominate actuarial sciences:

• Period life table: This table demonstrates the mortality rates of a given population of individuals during a specific and narrow time period.
• Cohort life table: This table displays the overall mortality rates for a specific population’s total lifetime. Sometimes called a “generation life table,” this tool assumes that individuals in a given population are all born during the same time interval. These tables are used the most frequently because they can predict future mortality rate changes in a given population, and they can analyze mortality rate patterns over time.