Economic Effects of Risk Classification Bans

Abstract

Risk classification refers to the use of observable characteristics by insurers to group individuals with similar expected claims, to compute the corresponding premiums, and thereby to reduce asymmetric information. Permitting risk classification may reduce informational asymmetry-induced adverse selection and improve insurance market efficiency. It may also have undesirable equity consequences and undermine the implicit insurance against reclassification risk which legislated restrictions on risk classification could provide. We use a canonical insurance market screening model to survey and to extend the risk classification literature. We provide a unified framework for analyzing the economic consequences of legalized vs. banned risk classification, both in static-information environments and in environments in which additional information can be learned, by either side of the market, through potentially costly tests.

Keywords: Adverse selection, Classification risk, Classification bans, Equity, Efficiency.

JEL Classification: D82, I13, I14, I18, I38, G22.