Academic journal article Journal of Risk and Insurance

Loss Coverage as a Public Policy Objective for Risk Classification Schemes

Academic journal article Journal of Risk and Insurance

Loss Coverage as a Public Policy Objective for Risk Classification Schemes

Article excerpt

ABSTRACT

This article suggests that from a public policy perspective, some degree of adverse selection may be desirable in some insurance markets. The article suggests that a public policymaker should consider the criterion of "loss coverage," and that in some markets a policymaker may wish to regulate risk classification with a view to increasing loss coverage. Either too much or too little risk classification may reduce loss coverage. The concept is explored by means of examples and formulaic and graphical interpretations. An application to the UK life insurance market is considered.

INTRODUCTION

Much discussion of risk classification is concerned with the phenomenon of adverse selection or antiselection. The discussion is usually framed negatively: any degree of adverse selection is conceived as a problem that should be deprecated, avoided, or minimized. For many purposes, this perspective is useful. However, this perspective can be limiting if one is commenting on risk classification from a public policy viewpoint. Such comment often seems to retain the implicitly negative and deprecatory framing of adverse selection. This framing focuses on adverse selection as a possible obstacle to efficiency of contracting in insurance and implicitly assumes that promoting such efficiency should be the only or main focus of public policy. But from a public policy viewpoint, it is not clear that this exclusive focus is always appropriate, or that adverse selection is always adverse. From a public policy viewpoint, the restitution of some types of loss by insurance may be seen as a desirable objective, which policymakers often seek to promote (e.g., via tax relief on premiums). Some degree of adverse selection in some insurance markets may then be seen by a policymaker as desirable: it means that the right people, people more likely to suffer loss, will tend to buy (more) insurance. If the degree of adverse selection in an unregulated market is insufficient, a policymaker may wish to impose some restrictions on risk classification and so induce what has been called "regulatory adverse selection" (Polborn, Hoy, and Sadanand, 2006; Hoy, 2006). Some such restrictions are seen in many jurisdictions in practice.

The purposes of this article are to explore the idea that from a public policy perspective some degree of adverse selection may be desirable in some insurance markets, and to suggest the idea of loss coverage as a possible criterion for a desirable level of adverse selection. The remainder of this introduction outlines these ideas in general terms. The second section considers a simple example of how loss coverage may be increased by restrictions on risk classification and alternatively how it may not. The third section gives formulaic and graphical interpretations. The fourth section considers an application to the UK life insurance market. The final section gives conclusions and suggestions for further research. A more discursive treatment (but without the mathematical and graphical interpretations) was given in a recent review of risk classification (Thomas, 2007).

Throughout this article, I assume that the probability of a loss is independent of insurance coverage; that is, I ignore possible moral hazard. I also ignore the possibilities of government transfer payments toward higher risks or tax-and-subsidy schemes within the insurance market (Crocker and Snow, 1985) as remedies for perceived inequities arising from risk classification. I assume that all insurers are required to adopt similar risk classification regimes; that is, I ignore competition in risk classification of a "cream-skimming" nature. This assumption is not representative of extant markets with little or no regulation of risk classification, but in the context of policy restrictions on risk classification which are the focus of the article, it can easily be imposed by the policymaker. Finally, I assume that in all risk classification regimes insurers make zero profits in equilibrium. …

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