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Legislators and regulators increasingly are attempting to improve the availability and affordability of insurance -- whether life, health, auto or home -- by restricting how insurance companies can classify risks. However, those who attempt to reform insurance markets by restricting risk classification need to be very careful, for when they undermine the fundamental principles of risk-based insurance, they usually end up doing more harm than good.
Insurance and risk. Purchasing insurance is different than purchasing any other good or service. It more closely resembles an option, a financial instrument used to hedge against a loss that might occur. The risk of future loss is why insurance exists; but for insurance to be a viable choice, consumers must be able to determine that it is in their economic self-interest to transfer their risk to an insurer. That is why it is crucial that premiums be based on a policyholder's risk potential, and why risk classification is an essential component of a private insurance market.
The workings and benefits of risk classification. Risk classification is the process of dividing individuals into groups with similar anticipated claims. For example, within a large group of automobile insurance policyholders, some drivers may have good driving records and some bad. When insurers sort and group the different types of drivers into risk pools of similarly situated individuals, they can estimate expected costs. For a low-risk group, expected costs are low and the insurance company can charge an appropriately low premium. For a high-risk group, the premium is larger because there is greater chance that more claims will be filed, which increases insurers' expected costs.
But that is a very simple example. Risk classification is more than just looking at a driving record. It is also based on other demographic variables such as age, gender and the value of the car insured, all of which can effect future outcomes. By analyzing these variables and driving characteristics of a large population over time, insurers can better predict risk and reduce uncertainty over prospective claims. This in turn helps consumers by ensuring more fairness and accuracy in the premiums they pay.
Risk classification benefits consumers. Since risk classification will always be part science and part art, each risk pool is bound to include policyholders that represent less risk than others in their pool. Responding to the competitive pressures of the marketplace, insurance companies will develop or utilize different methods to improve their identification and categorization of such people, thus enabling companies to offer those policyholders a lower premium and attract them away from their current insurers.
Risk spreading. The opposite of risk classification (also known as risk pooling) is risk spreading. Risk spreading occurs when the varying risks of individual policyholders are combined and spread among all policyholders of a given population. A good example of risk spreading is known as "community rating." This type of health care reform, popular in some quarters, mandates that premiums be assessed according to a community's demographics, not individual risk, with the result being that low-risk groups are unfairly charged higher premiums so that high-risk groups can pay lower premiums.
Negative impact on consumers. Even worse, because the new premiums mandated by community rating represent an underpriced bargain for high-risk individuals, low-risk individuals find little value in the now overpriced insurance, and often decide to opt out of the market. Insurers are left with the high-risk policyholders taking advantage of the artificially low rates. In order to hold down rates for this subsidized group, insurers must continue to raise prices on those low-risk subscribers who choose to stay in the market, which further increases the dropout rate. Ultimately, fewer and fewer people can afford insurance -- with relatively healthy, low-income individuals and families being especially impacted. Moreover, insurance companies often find that the funds collected from premiums cannot cover increasing claims costs. Rather than face eventual insolvency, many insurance companies leave the market.
|Family, age 30*|| |
|Male, age 30|| |
|Female, age 30|| |
|Family, age 45*|| |
|Male, age 45|| |
|Female, age 45|| |
|Family, age 60*|| |
|Male, age 60|| |
|Female, age 60|| |
|* head of household age|
|Source: New York State Insurance Department.|
For example, in 1993 New York State instituted community rating for individuals and employers with three to 50 workers (small group policies). As the chart to the right illustrates, individuals of different age and risk were charged the same premiums, as were families. Consequently, premium costs for young people doubled or tripled, nine insurance companies left the New York market, and more New Yorkers were uninsured than before the reforms were instituted.1 Similar reforms in Kentucky produced similar results -- 45 of 47 companies withdrew from the state's individual health insurance market, causing the insurance commissioner to determine that the "health insurance market is unstable and cannot sustain itself over the long term."2
Risky business. Reforms that limit risk classification can actually drive up premiums for low-risk groups, reduce the incentive for those groups to insure themselves, and force insurance companies to leave the market. All risk groups are left with fewer insurance options and higher premiums. In the final analysis, limiting insurers' ability to classify risk is itself a risky business -- one that ultimately does damage to insurance consumers and the companies that provide them services.
1John Merline, "Insurance Reform Can Backfire," Consumers' Research Magazine, May 1996, p. 10; M. Stanton Evans, "'Simple' Reforms Could Damage Health Care," Consumers' Research Magazine, April 1995, p. 14.
2Joe Niedzielski, "Kentucky Department Calls State's Health Insurance Market 'Unstable,'" National Underwriter: Life & Health Edition, April 28, 1997, p. 3; Michael Quinlan, "Task Forces Differ on Ways to Fix Health Coverage," The (Louisville, KY) Courier Journal, June 5, 1997, p. 1B.