Is Rate Classification Profitable?

Abstract

Previous research on rate classification has failed to produce a clear answer to the profitability of rate classification to the innovating insurer. This paper adapts conventional models of oligopolistic behaviour to identify the potential rent to a rate discriminating insurer and to examine the market dynamics of such innovation. The profitability of rate innovation depends upon the reaction functions of competing insurers. The process of adverse selection against non discriminatory rate structures and the spread of the information contained in the rate innovation may be sufficiently vigorous to prevent profit taking by the innovating insurer. The regulation of the insurance industry is directed by several welfare objectives. Prominent amongst these in many national and state regulatory systems is the requirement that insurance rates effectively discriminate between different risk classes. With respect to this objective the need for regulations depends upon whether market processes will result in rate structures that effectively discriminate between different risk groups. In neo classical economic theory the driving force in the market is the profit motive; thus with this structure the market can only function adequately if innovations in rating promise to yield surplus profit to the innovating firms. Two papers appearing in the June 1980 edition of this Journial give contradictory views on whether it is profitable for an insurer to discriminate between risk groups in its premium structure. In the first paper, Doherty [3] argues that premium discrimination is profitable, though it is implicit in the analysis that demand curves of the constituent risk groups in the insurance portfolio are downwards sloping. This condition indicates some degree of market power for participating firms. In the second paper Tryfos [8] argues that a rating innovation which leads to a proliferation of risk classes is not profitable to the innovating insurer. This second conclusion is based upon the explicit assumption that risks within each classification system are charged a breakeven price and that the portfolio composition is unchanged by the choice of classification system. In spite of differences, the papers agree that a