Efficiency and Fairness in Insurance Risk Classification
UVA Law Faculty Affiliations
The heart of any insurance system is its method of classifying risks and setting prices. Different methods of classification can produce different safety incentives, different risk distributions, and different protection against loss. Because Americans spend over $250 billion annually on private insurance, classification practices have enormous economic significance. These practices also have moral implications, because risk classification produces risk sharing. Yet the nature of risk classification and the economic and moral purposes it serves remain inadequately analyzed.
The result has been a series of unresolved and, in the view of some, unresolvable controversies concerning the risk classification practices of the insurance industry. On the one hand, if two purchasers of insurance coverage have different predicted losses or actual loss experiences, it is easy to conclude that the prices that each pay should reflect those differences. On the other hand, insurance may also be viewed as a method of risk sharing in which a group of insureds collectively bears the risk that a group member will suffer a loss. A particularly intense conflict may arise if losses vary according to the race, sex, or age of the insured, because classification on the basis of these characteristics is likely to be especially suspect.
In short, attitudes toward insurance always seem to be pulling in two directions-one that highlights the risk assessment, or efficiency-promoting features of insurance classification, and the other that stresses insurance's risk-distributional function. This article examines the ways to resolve this tension, by analyzing in detail the competing principles in this field.