Risk Classification in Insurance Contracting

Abstract

Risk classification refers to the use of observable characteristics by insurers to group individuals with similar expected claims, compute the corresponding premiums, and thereby reduce asymmetric information. Risk classification can be used to mitigate adverse selection and improve insurance market efficiency, but it may have undesirable equity or efficiency consequences. We employ a canonical screening model of insurance contracting to study these trade-offs in a range of informational environments, and to understand when efficiency or equity concerns are likely to be particularly important. We also review empirical studies on risk classification and residual asymmetric information.

Keywords: Adverse selection, Classification risk, Diagnostic test, Empirical test of asymmetric information, Financial equity, Insurance rating, Insurance pricing, Moral hazard, Risk classification, Risk characteristic, Risk pooling, Risk separation, Social equity

JEL Classification: D80, D82, D86, G22, I11, I18