The Impact of Imperfectly Categorizing Risks on Income Inequality and Social Welfare

Abstract

The use of imperfect information to categorize risks is a pervasive (and controversial) phenomenon in the insurance industry. Although this activity reduces the 'average' extent of vertical price discrimination, it is shown in this paper that both highand low-risk types may prefer, ex ante to knowing the category to which they will be assigned, that such information be suppressed. Furthermore, for the Lorenz criterion it is shown that under certain restrictive demand conditions the imperfect categorization of risks leads to an increase in inequality. The paper employs the Wilson E2 equilibrium concept. L'impact d'une categorisation imparfaite des risques sur l'inegalite du revenu et le bien-etre social. L'utilisation de renseignements imparfaits pour categoriser les risques est un probleme important qui porte a controverses dans l'industrie de I'assurance. Meme si ce phenomene reduit le degre de discrimination verticale par les prix, en moyenne, I'auteur montre que a la fois les personnes dont le coefficient de risques est faible et elev6 (et ce avant de savoir a quelle categorie on va les assigner) peuvent fort bien preferer que cette information soit supprimee. De plus, 1'auteur montre que sous certaines conditions de demande restrictives, la categorisation imparfaite des risques conduit a un accroissement du degre d'inegalite mesure par le critere de Lorenz. Ce memoire utilise le concept d'equilibre dit de Wilson E2. If insurance firms are unable to distinguish between the risk types of their clients, but consumers know their own probability of loss (i.e., if asymmetric information persists), then the complication of adverse selection may arise. Adverse selection occurs when the class of risks (or set of classes) that purchases insurance differs 'adversely' from that anticipated by the firm. For example, if a firm offers a contract to low-risk types at their actuarially fair rate, then high-risk types will also purchase it, with the result that the firm will earn (expected) losses. Hence the problem of adverse selection restricts the ability of firms to offer efficient insurance contracts to low-risk types. It has been demonstrated by Rothschild and Stiglitz (1976) that, provided the proportion of high-risk types in the population is above some critical level, a This paper is a revised version of chapter 3 of the author's PHD thesis entitled 'The economics of risk classification in insurance.' London School of Economics and Political Science, 1982. I am indebted to my supervisor, Lucien Foldes, and an anonymous referee for useful comments. The author alone is responsible for any errors herein. Canadian Journal of Economics / Revue canadienne d'Economique, xvil, No. 3 August / aotlt 1984. Printed in Canada / Imprimd au Canada 0008-4085 / 84 / 557-568 $1.50 C) Canadian Economics Association This content downloaded from 157.55.39.215 on Wed, 31 Aug 2016 04:39:57 UTC All use subject to http://about.jstor.org/terms