Frequency and severity are fundamental metrics in the insurance industry. Many traditional actuarial models depend on these assumptions to build pricing models. However, relying solely on frequency and severity can be misleading, and a deeper understanding is required to accurately assess risk.
The Homeowners Insurance Example
Take, for instance, the fire risk in homeowners insurance. Frequency, which refers to the number of claims, may appear stable over a long period but can show significant volatility year to year. Conversely, severity, which refers to the average cost per claim, is expected to increase with inflation. An insurance company analyzing its fire exposure might adjust its program if it notices a rise in frequency due to changes in construction types or other hazards. In such cases, it is prudent to separately evaluate frequency and severity components to develop more accurate pricing models.
Vehicle Service Contracts (VSCs)
For F&I (Finance and Insurance) contracts, the correlation between frequency and severity is much stronger. Consider a Vehicle Service Contract (VSC) sold on a new vehicle. Initially, the frequency of claims is zero while the vehicle is under the manufacturer’s warranty. As the bumper-to-bumper warranty expires, frequency increases moderately, and a more significant increase is observed when the powertrain warranty ends. Severity also varies with the type of claims. For instance, if an administrator introduces a new benefit like towing, which has low severity but high frequency, the overall frequency of service contracts increases while severity decreases as smaller claims dominate the data.
GAP Insurance Dynamics
GAP Insurance provides another example of the complexities involved. A GAP claim can only occur when there is negative equity in the vehicle. Over time, as vehicles gain positive equity, the potential for GAP claims diminishes. For a group of GAP contracts initiated simultaneously, one would expect stable frequency and decreasing severity until positive equity is achieved. At that point, the frequency of claims would drop, but the severity might increase as only larger claims remain.
High-Mileage Vehicle Contracts
When administrators sell service contracts on high-mileage vehicles, these contracts typically have higher costs. However, the frequency of claims might be lower since such coverage often only includes components required to keep the vehicle operational like transmissions. Thus, frequency may decline while severity rises, increasing the pure premium. This example highlights how focusing solely on frequency and severity can obscure the true cost dynamics.
