Abstract
Restrictions on insurance risk classification may induce adverse selection, which is usually perceived as a bad outcome. We suggest a counter-argument to this perception in circumstances where modest levels of adverse selection lead to an increase in ‘loss coverage’, defined as expected losses compensated by insurance for the whole population. This happens if the shift in coverage towards higher risks under adverse selection more than offsets the fall in number of individuals insured. The possibility of this outcome depends on insurance demand elasticities for higher and lower risks. We state elasticity conditions which ensure that for any downward-sloping insurance demand functions, loss coverage when all risks are pooled at a common price is higher than under fully risk-differentiated prices. Empirical evidence suggests that these conditions may be realistic for some insurance markets.
Highlights
Restrictions on insurance risk classification are common in life and health insurance markets
Loss coverage is defined as the expected population losses compensated by insurance at market equilibrium
We suggest that if the social purpose of insurance is to compensate the population’s losses, loss coverage may be an intuitively appealing metric for evaluation of different risk classification schemes
Summary
Restrictions on insurance risk classification are common in life and health insurance markets. If the shift in coverage is large enough, it can more than offset the fall in numbers insured In these circumstances, despite fewer risks being insured under pooling, expected losses compensated by insurance – a quantity we term ‘loss coverage’ – can be higher. Whether the shift in coverage towards higher risks when risk classification is restricted is large enough to offset the fall in numbers insured depends on the response of higher and lower risks to changes in the prices they face: the demand elasticities of higher and lower risks. For a sequence of increasingly general demand specifications and any number of risk-groups, the elasticity conditions which ensure that loss coverage will be higher when all risks are pooled at a common price than under fully risk-differentiated premiums.
Sign-in/Register to view highlights & summary Sign-in/Register to access full text options 
Free) 
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call
