Risk Based Pricing
From Open Risk Manual
Definition
Risk Based Pricing denotes a practice (and associated methodologies) of financial firms engaging in Risk Underwriting (that is, insure risk) as part of their core business model (whether insurance coverage, lending etc.) It primarily involves individually adjusted terms of contracts (such as interest rates, premia etc) which are broadly reflecting the firm's view on the risks embedded in the product.
Methodology
- A financial product will in general involve a number of distinct risks (from the point of view of the product provider) and in the first instance risk based pricing aims to isolate and assess the risk factors contributing to risk. For example a loan product might be analysed and be found subject to interest rate risk, credit risk and prepayment risk.
- Financial risks underwritten by the firm must ultimately be backed by risk capital and hence carry measurable costs. It is a matter of regulation, market practice and/or business model whether and how those risks are reflected in contracts individually or in bulk.
- When some or all risk factors are not reflected in individual contracts one is talking about a form of risk sharing. For example a riskier product (hence more costly from a capital perspective) might be subsidized while the firm enters a new market. Or relatively less risky borrowers might subsidize riskier borrowers if the terms of the lending product do not differentiate between risk levels.
Issues and Challenges
Practices around risk based pricing vary significantly by region and market segment. The extend of risk based pricing in retail markets is typically regulated.
