Actuaries are very smart mathematicians who make heavily educated guesses for future cash flows, based on decades-worth of historical data. None of us a crystal ball to foretell the future. The insurance company's defense against this unavoidable uncertainty is the third building block.
The Risk Adjustment for Non-Financial Risk: Think of an insurer issuing 1,000 auto insurance policies in one city only. Informed by historical evidence, the actuaries predict with confidence that claims will amount to exactly $1 million this year. What happens when a freak, once-in-a-century winter blizzard pelts the city, causing a massive pile-up on the highway and the claims go up to $1.5 million?
A manufacturing company knows the cost of a piece of steel to the last penny. However, when it comes to an insurance company, it is not so straightforward. The company essentially bears a huge amount of uncertainty on two things. One is the timing of the claim and the other is the quantum of claims. Due to the aversion of investors and regulators towards uncertainty, the company charges financial compensation for taking on this risk for the client.
This required compensation is called the Risk Adjustment for Non-Financial Risk.
A specific amount of money is set aside in the accounting measurement model to reflect a severe uncertainty of future cash flows. Consider it as the firm's premium to ensure a peaceful sleep. An engineer who constructs a bridge incorporates extra steel so that the bridge can bear weights much higher than the design capacity. In the same way, actuaries incorporate a Risk Adjustment to ensure the company has a buffer if claims are worse than anticipated.
How the Risk Adjustment Changes: The size of this building block depends entirely on the type of insurance being sold:
You must know that this block only applies to non-financial risk (natural disasters, mortality or accident, etc. - risk). It does not include financial risk such as a sudden drop in the worldwide stock market.
Our model is expanding. With our estimated cash flows, time adjustment and cushion for unpredicted events, we are all set. But this leaves a gigantic question hanging: Where's the actual profit that the shareholders get to keep? We will evaluate that in our last lesson.