Risk Classification in Insuiance

Contiacting
Georges Dionne
3000,CoteSteCatherine,room4454
Montreal(Qc)Canada,H3T2A7
Ph.514.340.6596
Fax514.340.5019
georges.dionne@hec.ca
Casey G. Rothschild
PendletonHallEast,Rm.414
WellesleyCollege
106CollegeSt.
Wellesley,MA02481
Ph.781.283.3026
Fax781.283.2177
crothsch@wellesley.edu
24April2012
Abstract
Riskclassificationreferstotheuseofobservablecharacteristicsbyinsurerstogroupindividualswith
similarexpectedclaims,computethecorrespondingpremiums,andtherebyreduceasymmetric
information.Riskclassificationcanbeusedtomitigateadverseselectionandimproveinsurancemarket
efficiency,butitmayhaveundesirableequityorefficiencyconsequences.Weemployacanonical
screeningmodelofinsurancecontractingtostudythesetradeoffsinarangeofinformational
environments,andtounderstandwhenefficiencyorequityconcernsarelikelytobeparticularly
important.Wealsoreviewempiricalstudiesonriskclassificationandresidualasymmetricinformation.
Keywords:
Adverseselection,Classificationrisk,Diagnostictest,Empiricaltestofasymmetricinformation,Financial
equity,Insurancerating,Insurancepricing,Moralhazard,Riskclassification,Riskcharacteristic,Risk
pooling,Riskseparation,Socialequity.
1

1. Introduction

Riskclassificationreferstotheuseofobservablecharacteristicssuchasgender,race,behavior,orthe
outcomeofgeneticteststopriceorstructureinsurancepolicies.Riskclassificationhelpsinsurersclassify
selectedriskswhenunderwriting.Itallowsthemtogroupindividualriskswithsimilarexpectedmedical
costs,computethecorrespondinginsurancepremiums,andreduceadverseselection(andpotential
moralhazard).Onlyriskcharacteristicscorrelatedwithexpectedclaimcostsareusefulforunderwriting.
Informationonindividualriskisseldomusedtodetermineindividualparticipationinemployeror
governmentsponsoredplans,butisoftenobservedinvoluntaryplansandinlongterminsurance
markets,whereitservestodefineaccessibility,classifypolicyholdersinhomogenousriskclasses,and
setthepremiumsofeachriskclass.
IntheU.S.,thestandardsofriskclassificationintheinsurerunderwritingpolicyareidentifiedinthe
ActuarialStandardsofPractice12(ASOP12).Thechoiceofratingvariablesconsistsofthreesteps:1)
selectionofobjectiveriskcharacteristicscorrelatedtomedicalexpenses(acausalrelationshipisnot
necessary);2)useofacceptabledataandstatisticalmethodsthatmay,however,besubjecttothe
actuarysjudgment;and3)considerationofneworadditionalcharacteristics,takingintoaccountthe
benefitsandcostsofdoingmoredetailedanalysis(AmericanAcademyofActuaries,2001).
Anefficientriskclassificationsystem,usingactuarialrulesandprinciples,shouldgenerateanactuarial
premiumthatreflectstheexpectedcostassociatedwithagivenriskcharacteristic.Twoclientswiththe
samerisklevelshouldpaythesamepremium.Thisisknownasthefinancialequitycriteriainthe
actuarialliterature(Baker,2011).Inhealthinsurance,premiumsaremostcommonlydeterminedby
age,sex,andsmokingbehavior.Currentmedicalconditions(highcholesterol,diabetes,etc.)and
medicalhistoriesofolderclientsareoftenaddedascriteriabecausetheycanaffectthemedical
expensescoveredbytheinsuranceplan.Informationonlifestyle,diet,andexercisecanalsobeadded.
Riskclassificationmaytakeintoaccountadvancesindiagnosticsandtreatments.However,thispractice
islimitedbyregulationinmanycountrieswheresomecharacteristicsortestscannotbeusedto
evaluateeligibilityandestablishpremiums.Opinionsdifferabouttheuseofsophisticateddiagnostic
tests,suchasgenetictests(Chiappori,2006;HoyandWitt,2007).Althoughthesetestsclearlyprovide
usefulinformation,theyreducehighriskindividualsaccesstomedicaltreatments.Often,theyreveal
medicalconditionsthatareexogenoustotheindividuals,andconsideringthemforinsurance
2

accessibilityraisesequityconcerns.(Thisissometimesreferredtoasclassificationrisk.)Thisexplains
thepresenceoflegalconstraintsontheapplicationofcertaintestsforinsuranceclassificationand
pricing.ThenewPatientProtectionandAffordableCareAct(PPACA),introducedintheU.S.in2010,
forbidspricingonanycharacteristicsotherthanage,familystatus,geographicorratingarea,and
tobaccouse.TheActrestrictseventheuseofthesecharacteristics(Baker,2011;Harrington,2010a,
2010b),andprohibitsthepricingofinsurancebasedonindividualhealthstatus.
Moregenerally,selectionandpricingactivitybasedonindividualcharacteristicsissubjecttoconcerns
aboutsocialfairness(orequity)andpotentialdiscrimination.Thisisparticularlytrueinthemedicaland
disabilityinsurancemarkets.Thepolicydecisiontorestricttheuseofriskclassificationthusoften
involvesatradeoffbetweenfinancialandsocialequity.Lessobviously,italsoofteninvolvesatradeoff
betweensocialequityandefficiencyprovisionofinsurance.
Forexample,riskpoolingarisingfromlegalrestrictionsonriskclassificationmayleadtoasituationin
whichlowerriskindividualspayhigherpremiumsthanthosecorrespondingtotheirtruerisk,while
higherriskindividualspaylowerpremiums.Ontheonehand,thesefinancialinequities(may)reduce
classificationriskandthepotentialfordiscrimination,andimprovesocialequity.Ontheotherhand,
whentheproportionofhighriskindividualsissignificant,premiumsmayriseconsiderablybecauselow
riskindividualswillleavetheinsurer.Thenetresultcanbethathigherriskindividualsarenobetteroff
asaresultofthelegalrestrictions,andlowerriskindividuals,whonolongeravailthemselvesof
insuranceopportunities,aremadestrictlyworseoff.
Thissituationcorrespondstoapureadverseselectiondeathspiralproblem.Onewaytoreducethis
sortofpremiumspiralistooffermenusofcontractswithintheriskclasses.Forexample,thenewActin
theU.S.permitsthesaleofdeductiblestopeopleunder30,whichwillprobablycreateaseparationof
riskswithinthisgroup.Compulsoryinsuranceisanotherwaytomitigateadverseselectionandtheneed
forriskclassification.
Inarecentpaper,EinavandFinkelstein(2011)developagraphicalmethodthatcanbeadaptedtostudy
thecostsandbenefitsofriskclassification.Theirapproachusesaveryspecificdeadweightlossnotion
ofefficiencyanddoesnotdirectlyaddressdistributionalconcerns.Italsoabstractsfromexplicitly
modelingthenatureofinsurancemarketcontracting,and,inparticular,thescreeningmodelsthathave
beenthehallmarkoftheinsurancemarketliteraturesinceRothschildandStiglitz(1976).Inthispaper,
wesurveyandelaborateonthisscreeningliterature.Weshowhowcanonicalinsurancecontracting
3

frameworkscanbeusedtoillustrateexplicitlythetradeoffsbetweenefficiencyanddistributional
concerns,and,moreover,canbeusedtoidentifysettingsinwhichtheequity(distributional)or
efficiencyconsequencesaretheoreticallymostlikelytobeparticularlyimportant.Thesetheoretical
modelsandconsequencesarethefocusofsections27.Section8relatesthesemodelstoempirical
studiesonasymmetricinformationandriskclassification.
2. The Canonical Modeling Framework

2.1BasicFramework
Ourformalanalysisofriskclassificationemploysastandardadverseselectionmodelofinsurance
markets.WealsoconsidersomemoralhazardextensionsinSection7.Individualsinthismodelare
endowedwithalumpsumofmoneywandfaceariskofamonetarylossofsize.Individualsdifferin
theirprobabilityofexperiencingthisloss.Anytwoindividualswiththesamelossprobabilityaresaidto
havethesamerisktype.ThereissomesetI ofpossiblerisktypes,andp

isthelossprobabilityof
typeieI.Forexample,I = {E, I],withp
H
> p
L
(ahighrisktypeEandalowrisktypeI)inthe
canonicalmodelofRothschildandStiglitz(1976).
Insurancecontractsareofferedbyriskneutralinsurers.ContractsconsistofapremiumRpaidbythe
insuredandanindemnityHwhichispaidiftheinsuredsuffersaloss.Anindividualwhopurchasessuch
acontractthushasnetwealthC
1
= w - Ravailableforconsumptionifshedoesnotexperiencealoss
andC
2
= w - + H - Rifshedoesexperiencealoss.Itisfrequentlymoreconvenienttodescribe
contractsdirectlyintermsoftheinducedconsumptionallocations(C
1
, C
2
)ratherthanpremium
indemnitypairs;wefollowthisconventionhere.
Toillustratetheconnectionbetweenthepremiumindemnityandtheinducedconsumption
descriptionsofinsurancecontracts,Figure1belowdepictsarepresentativeinsurancecontract(C
1

, C
2

)
inconsumptionspace.ThisintheconsumptioninducedbythepremiumRandthenetindemnityH - R
Thiscontract(C
1

, C
2

) liesbelowthe4S

line,indicatingthattheindemnityH islessthantheloss.
Thiscanbeinterpretedasacontractwithapositivedeductible.Acontractwithapositivedeductibleis
saidtoprovidelessthanfullinsurance.Afullinsurancecontracthasnodeductible,andisassociated
withaconsumptionpoint(C
1

, C
2

)thatliesonthe4S

line.(Consumptionallocationsabovethe4S

line
resultfromcontractsprovidingoverinsurance.)
4

<Figure1abouthere>
Aninsurerearnsprofits:

(C
1
, C
2
, p

) = [(1 - p

)w + p

(w - ) - [(1 - p

)C
1
+ p

C
2

= R - p

H
(1)
fromsellingacontract(R, H)whichinducesconsumption(C
1
, C
2
)toatypeiindividual.Curvesof
constantprofit(isoprofitcurves)arethuslineswithconstantslope (1 - p

)p

whendrawnin
consumptionspace.
Individualareexpectedutilitymaximizers,withpreferencesgivenby:
I(C
1
, C
2
, p

) = (1 - p

)u(C
1
) + p

u(C
2
), (2)
whereu
i
(C) > uandu
ii
(C) < u.
Indifferencecurveshaveslope (1 - p

)u
i
(C
1
)p

u
i
(C
2
).Sinceu
ii
< u,thismeansthattheyare
bowedtowardstheorigin(inconsumptionspace),andtheyaretangenttoisoprofitlinesat(andonly
at)pointsonthefullinsuranceline.
2.2InformationalEnvironment
Informationaboutrisktypecanbesymmetricorasymmetric.Ifitissymmetrici.e.,ifinsurershavethe
sameinformationaboutanygivenindividualsrisktypeastheindividualdoesthen,withoutlossof
generality,wecanassumeeachindividualknowsherownrisktypeandthatinsurersperfectlyobserve
therisktypeofeachpotentialcustomer.(Thisisbecausepreferencesandprofitsarelinearin
probabilities:amodelwithsymmetricallyknownbutuncertainrisksp

isanalyticallyidenticaltoa
modelwithsymmetricallyknownandcertainrisksp

= E(p

).)
Wewillfocusattentiononasymmetricinformationenvironments(orimperfectriskclassificationbased
onobservablecharacteristics)inwhichtheinsurerislessinformedthananygivenindividualsabout
accidentriskinsideriskclasses.(SeeVilleneuve,2005,forananalysisofmarketsinwhichtheinsureris
moreinformedthantheinsured.)Moreover,weassume,withoutlossofgenerality,thatindividualsare
fullyinformedabouttheirrisktype.Ifinsurershavenoinformationaboutindividualsrisk,thenall
individualsareindistinguishablefromanexpectedriskperspectivetoinsurers:theyknownothing
5

morethanthatanygivenindividualisdrawnfromthepopulationdistributionofrisktypes.Weuse(i)
todenotethispopulationdistribution.Alternatively,insurersmaybepartiallyinformed:partially
informedinsurersobserveaninformativesignaloeabouteachindividualsrisktype.Thesignalis
informativeinsofarastheconditionalprobabilitydistribution(i|o)overrisktypesdiffersfrom
(i). Signalsarealsoreferredtointheliteratureasgroups,categoriesorclasses.
WhentherearetworisktypesEandI,wecantake(E) = zand(I) = 1 - zsothatzmeasures
thepopulationfractionofhighrisktypes.Similarly,whentherearetwogroupsoe{A, B]saymalesand
femaleswecantake(E|A) = z
A
and(E|B) = z
B
> z
A
.ThisyieldsthemodelstudiedbyHoy
(1982)andCrockerandSnow(1986),whichplaysacentralroleinouranalysis.Inthiscase,groupA
individuals(e.g.,men)arelesslikelytobehighriskindividuals,butifz
A
> u,therearenevertheless
somehighriskindividualsingroupA.Similarly,groupBindividuals(e.g.,women)aremorelikelytobe
highrisktypes,butifz
B
< 1,therearestilllowrisktypesingroupB.
2.3MarketOutcomes
Ofparticularinterestistheprofileofconsumptionallocations(C
1

, C
2

)whicheachrisktypeiobtainsina
givenmarketenvironment.Thesearefrequently(butnotexclusively)referredtoasequilibrium
outcomesintheliterature,buttheliteratureissomewhatinconsistentintheformalunderpinningsof
variousequilibriumconcepts(seeHellwig,1987,foradiscussion)andwethereforeemploythemore
generaltermmarketoutcomeshere.
Themarketoutcomewhichobtainsinagivenmarketenvironmentnaturallydependsonthe
informationalandtheinstitutionalfeaturesofthatenvironment.Wefocusontwotypesofinstitution,
bothofwhicharecompetitiveandbothofwhichinvolveexclusivecontracting.Werefertothesetwo
typesasthefixedcontractsandscreeningcases.
Inthefixedcontractscase,firmscompeteonprice(premium)toprovideanexogenouslyfixedtypeof
contract.Thisisausefulstylizedmodelforexaminingsettingsinwhich,bylaworbycustom,insurance
contractarestandardized,inthesensethatcoverage(i.e.,thelossescoveredandtheindemnities
providedforthoselosses)isuniformacrossinsuranceproviders.Ourfocalexampleofthefixed
contractscaseinvolvesfullinsurancecontractsi.e.,contractsfullyindemnifytheloss.Weassume
thatthemarketoutcomesinthiscasearegivenbytheNashequilibriumofagameinwhich(alarge
numberoffirms)firmsfirstsetcontractpricespotentiallydifferingforindividualswithdifferentrisk
6

typesorindifferentgroupsandindividualsthenchoosethelowestpricedcontractavailabletotheir
risktypeand/orgroup.
Inthescreeningcase,firmscompeteontwodimensions:onpriceandonthetypeorlevelofcoverage
provided.Thisadditionalflexibilityallowsfirmstooffermenusofcontractsdesignedtodifferentially
appealtodifferentrisktypes.Asinglefirmmight,forexample,offerbothahighdeductiblelow
premiumcontractandalowdeductiblehighpremiumcontractinthehopesofinducingindividualsto
revealtheirrisktypeviatheircontractchoices.Suchascreeningstrategyispotentiallyusefulwhenfirms
cannotobserverisktypeorfaceregulatoryrestrictionsonofferingtypespecificcontracts.
ThecanonicalmarketoutcomeinthescreeningcaseistheRothschildStiglitz(1976)equilibrium,
depictedinFigure2foramarketwithtworisktypesandunobservableprivateinformation.Thismarket
outcomeallocatesthecontractC

H
toEtypesandC

L
toItypes.Theformerliesattheintersectionof
the4S
o
lineandtheEtypeszeroprofitline(thelinethroughthenoinsuranceconsumptionpoint
(w, w - )withslope-(1 - p
H
)p
H
).Thatis,itprovidesfullinsuranceatanactuariallyfairrate.The
ItypescontractC

L
liesattheintersectionoftheItypeszeroprofitlineandtheEtypes
indifferencecurvethroughC

H
.Itthusprovidesactuariallyfairbutincompleteinsuranceforthelower
riskItypes.Specifically,Itypesgetasmuchinsuranceaspossibleattheiractuallyfairratewithout
inducingEtypestoswitchtothecontractdesignedforItypes.Screeningofdifferentrisktypesis
achievedinthismarketoutcomebecausethelowerriskItypesstrictlypreferC

L
toC

H
(asshownby
theirindifferencecurve,labeledI
L
,throughC

L
)andarewillingtosacrificefullinsurancetocredibly
signalthattheyarelowerrisksandtherebyreceivelowerpremiums.
RothschildandStiglitz(1976)showthatthemarketoutcome(C

H
, C

L
)depictedinFigure2istheonly
possibleNashequilibriumofagameinwhichmultiplefirmssimultaneouslyofferindividualcontracts
andthenindividualschoosetheirpreferredcontractfromthesetofcontractsoffered.Theyalsoshow
thatthereisnoequilibriumofthegamewhenthefractionzofhighrisktypesissufficientlylow.This
lackofequilibriumoccursbecausewhenzislow,aportionofthepooledactuariallyfairline(i.e.,the
zeroprofitlineforanindividualwithrisktypep = zp
H
+ (1 - z)p
L
)liesabovetheItypes
indifferencecurve.Whenthisisthecase,afirmcoulddeviatefromtheRothschildStiglitzcandidate
equilibriumbyofferingasinglecontractprovidingconsumptionbetweenthepooledfairlineandtheI
typeindifferencecurve.Thiswouldbeaprofitabledeviationsinceitwouldattractbothrisktypes;the
RothschildStiglizequilibriumcandidateisthusnot,infact,aNashequilibriuminthiscase.
7

<Figure2abouthere>
Theliteraturehasprimarilyemployedthreedistinctalternativeequilibriumconceptstoresolvethisnon
existenceproblem.Eachofthethreeconceptspredictsauniqueequilibriumoutcomeforanysetof
parameters,buttheydonotalwayscoincide,andthereisnoconsensusaboutwhichone(ifany)isright
(seeHellwig,1987).TheRiley(1979)reactiveequilibriumpredictsthattheRothschildStiglitzcandidate
equilibriumwillbethemarketequilibrium,evenwhentheproportionofhighrisktypesislow.The
Wilson(1977)(E2)foresightequilibriumcoincideswiththeRothschildStiglitzequilibriumwheneverthe
latterexists,andotherwiseisapoolingequilibriuminwhichbothrisktypesreceivethecontractonthe
pooledzeroprofitlinewhichismostpreferredbytheItype.
TheMiyazaki(1977)Wilson(1976)Spence(1978)(henceforth,MWS)involvesasimilarforesight
conceptandrecognizesthatattheRothschildStiglitzcandidateequilibrium,theremaybescopefor
ParetoimprovingcrosssubsidiesfromtheItypestotheEtypes.Thecontractpair(C

H
, C

L
)inFigure
3illustratesanexampleofsuchacrosssubsidy.TheItypecontractC

L
liesstrictlybelowtheItypes
zeroprofitline,whiletheEtypecontractC

H
liesstrictlyabovetheEtypeszeroprofitline.Thepair
thusinvolvescrosssubsidies.SincethepointC

H
stillprovidesfullinsurance,itisobviouslystrictly
betterfortheEtypesthantheRothschildStiglitzcandidatecontract,labeledC

H#
.Asdrawn,theItype
contractC

L
alsoliesonahigherindifferencecurve(labeledI
L
)thanItypeswouldbeoninthe
RothschildStiglizcandidateequilibrium(thedashedindifferencecurvebelowI
L
).Thisispossible
becausethecrosssubsidytoEtypesmakesEtypeslessinterestedinswitchingtotheItypes
contract.ThisallowsthemarkettoprovidemoreinsurancetoItypes.Paretoimprovingcrosssubsidies
existwheneverthebenefitstoItypesofthisadditionalinsurancearemorethanenoughtooutweigh
thecostsofprovidingthecrosssubsidy.
<Figure3abouthere>
IntheMWSequilibrium,themarkettakesadvantageoftheseParetoimprovingcrosssubsidies
whenevertheyexist.Specifically,theMWSequilibriumisthememberoftheclassofconstrained
efficientseparatingallocationswhichmaximizestheexpectedutilityofItypessubjecttoEtypesbeing
atleastaswelloffastheywouldbewiththeirfullinsuranceactuariallyfaircontract.Forsufficientlyhigh
valuesofz,itagaincoincideswiththeRothschildStiglitzequilibrium.Forlowervaluesofz,itinvolves
crosssubsidiesfromlowriskstohighrisks.AsintheRothschildStiglitzcandidateequilibrium,Etypes
8

stillreceivefullinsurance,butnowatpotentiallybetterthanactuariallyfairrates.Similarly,Itypes
remainunderinsuredalbeitlesssobutpaygreaterthanactuariallyfairpremiums.(SeeDubeyand
Geanakoplos,2002,Martin,2007,NetzerandScheuer,2008,andPicard,2009formoderndiscussionsof
thejustificationsoftheRothschildStiglitzandMWSconcepts.)
Analternativeapproachtomodelingmarketoutcomesintheinsuranceliteratureistofocusonefficient
outcomes(see,e.g.,CrockerandSnow,2000)ratherthanequilibriumoutcomespersealthoughthe
twocancoincide,sincetheMWSequilibriumisconstrainedefficient(forafixedproportionofhighrisk
types;seeCrockerandSnow,1985a).Afirstbestefficientmarketoutcomemaximizesaggregate
profits:

(i)n(C

, p

)
cI

(3)
subjectto

I(C

, p

) I

(4)
forallrisktypesieI,whereI

isaminimumutilityconstraintfortheitype.Itisstraightforwardtoshow
thatanallocationisfirstbestefficientforsomesetofminimumutilitiesifandonlyifC
1

= C
2

foreachi.
Asocialplannerwhoobserveseachindividualsrisktypesandcandictatetheirrequiredinsurance
contractscould,inprinciple,implementanyfirstbestefficientmarketoutcomewithnonnegative
aggregateprofits.Sincewetypicallyassumethatthesocialplannerisinterestedinthewellbeingof
individualsandnotfirmsperse,wefocusonthefirstbestefficientmarketoutcomeswithexactlyzero
profits.(Indeed,thetermfirstbestefficientfrequentlyincorporatesthiszeroprofitassumption,asin
CrockerandSnow,2000.)
Whenindividualsareprivatelyinformedaboutrisktypeandthesocialplanneriscompletelyuninformed
aboutanindividualsrisktypeasecondbestefficiencyproblemforthesocialplannerisappropriate.
Inthissecondbest(orconstrained)efficientproblem,thesocialplannerfacestheadditionalincentive
compatibilityconstraints:

I(C

, p

) I(C

]
, p

) i, ]. (5)
9

Theseconstraintsreflectthefactthatthesocialplannercannotdirectlyidentifyanindividualstype,and
thuscannotforceanindividualtoselectacontractwhichhefindsstrictlyworsethansomeother
contractwhichisavailable.
Whenthesocialplannerispartiallyinformedaboutindividualrisktypesviaapartiallyinformativesignal
o,itcanconditioncontractsonthesignal,sotheincentivecompatibilityconstraintsfortheconstrained
efficientproblemareinstead:

I(C

,c
, p

) I(C

],c
, p

) i, ], o such that (i|o) > u, (i|o) > u (6)

Ourapproachtostudyingtheeffectsofriskclassificationonmarketoutcomeswillbetocompare
marketoutcomesinthepresenceofriskclassificationtomarketoutcomesinitsabsence.
Itisworthnotingthatwedonotconsidersomeothermodelsofmarketoutcomeswhichariseinthe
literature.Forexample,wedonotexplicitlyconsidermodelswithamonopolyinsuranceprovider(e.g.,
Stiglitz,1977)oroligopolisticmarkets(e.g.,BuzzacchiandValletti,2005).Nordoweconsiderlinear
pricingequilibrium,whichareoftenusedinmarketswherecontractingisnonexclusiveandindividuals
canbuysmallamountofcoveragefrommultipleproviderssimultaneously(e.g.,Pauly,1974,Hoyand
Polborn,2000,andVilleneuve,2003).
3. Risk Classification can have Purely Distributional Consequences

Policydiscussionsaboutriskclassificationfrequentlyemphasizetheperceiveddistributionalbenefitsof
restrictingfirmsfromemployingriskclassificationanddownplayorignorethepotentialefficiencycosts
ofsuchrestrictions.Wefirstconsidera(ratherrestrictive)settinginwhichriskclassificationdoesnot
haveanyefficiencyconsequencesandthisemphasisisappropriate.
Thissettingischaracterizedbythefollowingassumptions:
(i) therearetworisktypes,EandI,withp
H
> p
L
,andafractionzofEtypes;
(ii) thereissymmetricinformation,soinsuranceproviderscanreadilyidentifytherisktypeof
anyindividual;
(iii) insurancecontractsarefixedfullinsurancecontracts,sofirmscompeteonlyonprice;
10

(iv) thereisamandatorypurchaserequirement:eachindividualmustbuyone(andonlyone)
insurancecontract.
Figure4depictsthemarketoutcomes.Wheninsuranceprovidersclassifybasedonobservablerisktype,
eachtypeie{E, I]paysitstypefairpremiumR

= p

inexchangeforfullindemnificationoftheloss
.TheassociatedconsumptionallocationsarelabeledC

.Wheninsuranceprovidersdonotemploy
riskclassificationbasedonrisktype,bothtypesofindividualspaythepooledfairpremiumR

=
(zp
H
+ (1 - z)p
L
) p,withresultsinconsumptionC

P
.Thisistheuniqueequilibriumoutcomeof
thegameinwhichfirmsfirstpostprices(whicharetypespecificifriskclassificationisemployed)and
individualsthenchoosefromthecontractsavailabletothem.
<Figure4abouthere>
Riskclassificationclearlyhasdistributionalconsequencesinthissetting:itimprovesthewellbeingof
theItypesattheexpenseofthewellbeingofEtypes.Becausebothmarketoutcomesarefirstbest
efficient,riskclassificationhasnoefficiencyconsequences.
Wheneverriskclassificationispermitted,itwillbeusedbythemarket.Thisisbecause,attheno
classificationequilibrium(C

P
inFigure4)adeviatingfirmcouldmakepositiveprofitsofferingaslightly
lessexpensivecontract(justupandtotherightfromC

P
)whichisavailableonlytoItypes.Thiswill
attractallItypes,leavingonlytheEtypesbuyingC

P
andrenderingthatcontractunprofitable.As
such,thenoclassificationmarketoutcomeisonlylikelytoariseinthepresenceofexplicitlegal
restrictionsontheuseofriskclassification.Theconsequencesofriskclassificationarethereforebest
interpretedastheconsequencesoflegalizingversusbanningriskclassificationhere.
Inthissimplesetting,legalrestrictionsonpricingbasedonriskrelatedcategoricalaffiliationslikegender
canbeimposedwithoutadverseefficiencyconsequences.Thisdoesnotmeanipsofactothatsuch
restrictionswhichtransferresourcesfromlowriskindividualstohighriskindividualsaredesirable,
however.Fromaninterimperspective,whenrisktypesaretakenasgivenandknown,thedesirabilityof
suchbansdependsondistributionalpreferences.Anobjectiveobserverspreferenceislikelytodepend
onwhyindividualshavedifferentrisktypes.Forexample,iftheriskinessofagivenindividualisthe
resultofprevioushealthinvestmentdecisionssuchasdietorexercise,thenarestrictionontheuseof
observablecorrelatesofthispastbehaviorinpricingpolicieswillhavetheperverseeffectofpunishing
11

goodpastdecisionsandrewardingbadones.Anobjectiveobservermightreasonablyregardthisas
inequitable.
Evenwhenrisktypeiscompletelyoutsideofindividualcontrol,howeverforexamplewhentypeis
determinedbygeneticpredispositionstowardsillhealthopinionsaboutthedesirabilityofthe
distributionalconsequencesofbanningriskclassificationmaydiffer.Lowriskindividualsarelikelyto
objecttotheredistributionthatresultsfromsuchaban,andmightreasonablywonderwhytheyshould
beforcedtoeffectivelysubsidizeotherindividualsinsurancepremiums.Autilitariansocialplanner,on
theotherhand,willalwayspreferthemarketoutcomewithabanonriskcategorization.AsHoy(2006)
pointsout,utilitariansocialwelfarepreferencesareanaturalchoice:theyfollowdirectlyfrom
Harsanyis(1953,1955)veilofignoranceapproachsincetheycoincidewiththeexantepreferencesof
anindividualwhodoesnotyetknowwhichrisktypeshewillendupbeing.
Theassumptions(i)(iv)underlyingthisanalysisareobviouslyquiterestrictive.Itisstraightforwardto
showthatassumptions(i)and(ii)canberelaxed,though:thesamebasicresultwouldholdiftherewere
morerisktypes,orifinsurerscouldobserveanimperfectsignalofindividualsprivatelyknownrisktype.
Ontheotherhand,althoughthefullinsurancepartcanberelaxed,thefixedcontractpartofassumption
(iii)isessential.Aswediscussinthefollowingsection,ifcontractsarenotfixed,therewilltypicallybe
negativeefficiencyconsequencesofimposinglegalrestrictionsonriskclassificationinscreening
settings.
Themandatorypurchaseassumption(iv)mayormaynotbeessential,dependingonspecificsof
individualpreferencesandonthedistributionofrisktypes.Figure4depictsasituationinwhichitisnot
essential.Asdrawn,thepointC

P
liesstrictlyabovetheautarkicindifferencecurves(labeledI
H
and
I
L
)thatpassthroughthenoinsuranceconsumptionpoint(w, w - ).Thismeansthat,ifrisk
classificationwerebanned,bothindividualswouldstillvoluntarilychoosetopurchasethecontractC

insteadofforegoinginsurance.Ontheotherhand,ifI(C

P
, p
L
) < I(w, w - , p
L
)sothattheItype
indifferencecurveinsteadhitthe4S

lineaboveC

P
,thenassumption(iv)isessential.Wediscussthis
voluntarypurchasecaseinthefollowingsection.
4. Risk Classification Bans can be Purely Efficiency Reducing

12

Theexampleabovemaybewhatsomepolicymakershaveinmindwhencontemplatingabanonrisk
classification:theyimaginethattheonlyresultoftheimpositionofabanwillbeashifttopooledprices
andtheyviewthisasdistributionallydesirable.Inmanysettings,thisisanunreasonableexpectation.
Considertheconsequencesofrelaxingthemandatedpurchaseassumption(iv)inthefixedcontracts
settingoftheprecedingsection,forexample.Withoutthismandate,abanonriskclassificationcan
reduceefficiencyandhavenobeneficialdistributionalconsequencesatall:Ifthefractionzofhighrisk
typesissufficientlyhigh,thenI(C

P
, p
L
) < I(w, w - , p
L
).IncontrastwithFigure4,thismeansthat
theItypeindifferencecurvethroughthenoinsurancepoint(w, w - )willhitthe4S

lineabove
C

P
.Ifriskclassificationisbannedinsuchanenvironment,thenanypremiumatwhichItypeswillbuy
insurancewillbestrictlyunprofitablewhenitisalsosoldtoEtypes.SuchabanwillthereforeleadI
typestoexittheinsurancemarket;theywillbestrictlyworseoffasaresult.Moreover,onceItypesare
drivenoutofthemarket,EtypeswillendupwiththecontractyieldingconsumptionC

H
,exactlyas
theywouldifriskclassificationwerelegal.Banningriskclassificationinsuchanenvironmentistherefore
purelyefficiencyreducing:ithurtsItypeswithoutbenefittingEtypes.
Infact,thenegativeefficiencyconsequencesofabanonriskclassificationinafixedcontractvoluntary
purchaseenvironmentcanbequitedire.Suppose,forexample,thatthefixedcontractprovidesfull
insurance,andthatthereisacontinuumofrisktypeswithriskprobabilitiesp

uniformlydistributedon
|u,1].ForanygivenpremiumR < (i.e.,anypolicyactuallyofferinganyinsurance),onlyindividuals
with

q(R) =
u(w) - u(w - R)
u(w) - u(w - )
(7)
willvoluntarilychoosetopurchaseinsurance.Thebreakevenpremiumtoselltothissetofindividualsis
(1 + q(R))2.When
(1+q(R))
2
> RthepremiumRisstrictlylowerthanpremiumrequiredtobreak
evenonthesetofindividualswhovoluntarilypurchaseinsurancecontractsatpremiumR,andoffering
contractsatapremiumRwillleadtolosses.Itiseasytofindexamplesofutilityfunctionsu()withthe
propertythat
(1+q(R))
2
> RforeveryR < . (E.g.,u(x) = x - kx
2
withk <
1
2w
.)Inthiscasethereis
nopremiumR < atwhichfirmsarewillingtosellcontracts.Theuniquemarketoutcometherefore
involvesnoinsuranceatall.
13

Thisperniciousoutcomecanbeunderstoodintuitivelyasfollows:iffirmsnaivelypricedinsuranceatthe
pooledfairpremium(R = u.S),thelowestriskindividualswouldchoosenottopurchaseandthe
insurancepoolwouldendupbeingtooriskyforthatpremium.Insurerswouldbeforcedtoraise
premiums,inducingsomeoftheleastriskyremainingindividualstodroptheirinsurance,forcingfirms
tofurtherraisepremiums,andsoforth.Dependingonthepreferencesandthedistributionoftypes,this
canleadtoacompleteunravelingofthemarket.ThisunravelingwasfirstdescribedformallybyAkerlof
(1970),andisknownasanadverseselectiondeathspiral.(See,forexample,CutlerandReber(1998)
andStrohmengerandWambach(2000).)
Whencontractsarenotfixed,firmscantypicallyusescreeningmechanismstopreventacomplete
collapseofthemarketforinsurance.Bansonriskclassificationcanstillbepurelyefficiencyreducing
evenwhenfirmsemployscreening,however.Suppose,forexample,thattherearetworisktypes,that
informationissymmetric,andthatmarketoutcomesaredescribedbytheRileyequilibrium(i.e.,the
RothschildStiglitzcandidateequilibrium).Thenwhenriskclassificationispermitted,individualswill
purchasetheirtypespecificfullinsuranceactuariallyfaircontractsC

asinFigure4.Whenitisbanned,
theywillinsteadpurchasethecontractsC

depictedinFigure2.Eventhoughbothtypesstillcontinue
toactivelyparticipateintheinsurancemarket,thebanispurelyefficiencyreducing:Etypesare
unaffectedbytheban,butItypesnowpurchaseacontractprovidingstrictlylessinsurancethanbefore
andarestrictlyworseoff.
BuchmuellerandDiNardo(2002)lookempiricallyattheconsequencesofcommunityrating(abanon
riskclassification)inthesmallgroupandindividualhealthinsurancemarketinNewYorkState.They
provideevidencethatsuggestsexactlythissortofaneffect:theyfindnoevidenceofasignificant
reductioninthefractionofindividualswithinsurance,buttheydofindevidenceofasignificantshiftin
towardslessgenerousinsurancecoverage.
5. Risk Classification Can Involve Tradeoffs between Efficiency and
Distributional Equity

5.1EfficiencyandDistributionalEffectswithMWSMarketOutcomes
14

Theconsequencesofriskclassificationinscreeningenvironmentsarelessclearcutunderothertypesof
marketoutcomes.WeusetheMWSmarketoutcomesconcepttoillustratethatbansonrisk
classificationcanhavenegativeefficiencyconsequencesandbeneficialdistributionalconsequences.
Figure3canbeusedtoanalyzethetwotype,symmetricinformationcase.Withriskclassification,
individualswouldreceivefullinsuranceattheiractuariallyfairfullinsurancepremium,resultinginthe
consumptionsC

#
.ThecontractsC

denotetheMWSoutcomeswithoutriskclassification.Asdrawn,
thismarketoutcomeinvolvescrosssubsidiesfromtheItypestotheEtypes.Becauseofthesecross
subsidies,Etypesarestrictlybetteroffthantheywouldbewiththeiractuariallyfairfullinsurance
contract.Itypesarebetteroffthantheywouldbewithoutthecrosssubsidiesi.e.,inaRothschild
Stiglitzequilibriumbutstrictlyworseoffthantheywouldbeinthemarketoutcomewiththecontract
C

L#
thattheywouldreceivewithriskclassification.
ForasocialplannerwhowouldliketoredistributefromItypestoEtypes,banningriskclassification
andmovingthemarketoutcomesfromC

#
toC

hasdesirabledistributionalconsequences.Suchaban
hasunambiguouslynegativeefficiencyconsequences,however:itmovestheeconomyfromafirstbest
efficientallocationtoonewhichisnotfirstbestefficient.Indeed,theallocationC

isParetodominated
bythepair[C

H
, C

L
depictedinFigure3.Thepair[C

H
, C

L
yieldsaggregateprofitsofzero,and,since
informationissymmetricandrisktypeisobservable,itisinformationallyfeasible.Asocialplannercould,
inprinciple,directlyimplementthatstrictlypreferableoutcome.Alternatively,byimposingaproperly
calibratedtax/subsidyoncontractssoldtoIEtypes,itcouldinduceadecentralizedmarketwith
legalizedriskclassficationtoofferthem..
CrockerandSnow(1986)showthatthesameconclusionsgeneralizewhenriskclassificationisonly
partiallyinformative.Theyconsiderthesettingwithtworisktypes,andtwopartiallyinformativesignals
(groupsorcategories)AandB,wheresignalB(respectively,A)isassociatedwithagreater
(respectively,lower)probabilityofbeingahighrisk.Formally(E|A) = z
A
and(E|B) = z
B
> z > z
A
,
withz
B
< 1andz
A
> u.ItiseasiesttoseehowtheresultsgeneralizebyexaminingtheMWSequilibria
withandwithoutriskclassification.Withoutriskclassification,themarketoutcome(C

H
, C

L
)issimply
theMWSoutcomeforatworisktypeeconomywithafractionofhighrisks.Withriskclassification,
themarketoutcomeprovidesindividualsingroupo(oe{A, B])withtheconsumptions (C

H,c
, C

L,c
)
associatedwiththeMWSoutcomeforatworisktypeeconomywiththegroupspecificfractionz
c
of
highrisks.Therearethreepossibilities(exhaustive,becauseifanMWSoutcomeinvolvespositivecross
15

subsidieswithsomefractionofhighrisks,theMWSoutcomeinamarketwithasmallerfractionofhigh
riskswillaswell):
(1) TheAgroupmarketoutcomes(C

H,A
, C

L,A
)donotinvolvecrosssubsidiesfromlowrisksto
highrisks.
(2) TheAgroupmarketoutcomes(C

H,A
, C

L,A
)involvecrosssubsidies,whilethenorisk
classificationmarketoutcomes(C

H
, C

L
)donotinvolvecrosssubsidies.
(3) Thenoriskclassificationmarketoutcomes(C

H
, C

L
)involvecrosssubsidies.
Incase(1),marketoutcomescoincidewiththeRothschildStiglitzequilibriumconsumptionsbothwith
andwithoutriskclassification.Inthiscase,banningriskclassificationhasneitherefficiencynor
distributionalconsequencesindeed,ithasnoeffectsatall.
Incase(2),themarketoutcomewithriskclassificationParetodominatesthemarketoutcomewithout
riskclassification:CategoryBindividualsreceivethesame(RothschildStiglitz)contractswithand
withoutriskclassification,whilebothrisktypesinCategoryAarestrictlybetteroff.Inthiscase,risk
classificationhasonly(beneficial)efficiencyconsequences.
Case(3)isillustratedinFigure5.TrianglesdenotethecategoryandtypespecificcontractsC

,c
when
riskclassificationislegal,andcirclesdenotethetypespecificcontractsC

,c
whenclassificationis
banned.Asitshows,riskclassificationmakescategoryAindividualsbetteroff(movesthemtothe
higherdashedindifferencecurves)andcategoryBindividualsworseoff(movesthemtothelower
dashedindifferencecurves).
Riskclassificationalsohasefficiencyconsequencesincase(3)becausethemarketoutcomewithoutrisk
classificationisnotsecondbestefficientinthiscase.TheMWSequilibriumistheconstrainedefficient
outcomewhichmaximizesthewellbeingofItypes.Whenthisequilibriuminvolvescrosssubsidies,the
magnitudeofthesecrosssubsidiesischosentobalancethebenefitofeasingtheincentiveconstraint
withthecostofreducedresources.Loweringthefractionofhighrisktypeslowerstheresourcecostof
anygivenamountofincentiveconstrainteasing,andthustiltsthebalancetowardsadditionalcross
subsidies.Thismeansthatat(C

H
, C

L
)inFigure5,additionalcrosssubsidieswouldbePareto
improvingwithincategoryA.Thatis,thereisthereforeanalternativeallocationthatcouldbeofferedin
anincentivecompatiblewaytothecategoryAindividualsthatwouldincreasethewellbeingofboth
categoryAtypesatthesamenetactuarialcostforthecategory.(ItisnotillustratedinFigure5,butinit
16

theEtypecontractwouldlieonthefullinsurancelineaboveandtotherightofC

H
,andtheItype
contractwouldlieupandtotheleftofC

L
.)ItisthereforefeasibletomakethecategoryAindividuals
strictlybetteroffwithoutchangingtheallocationstocategoryBindividuals.
<Figure5abouthere>

5.2WelfareAnalysiswithDistributionalandEfficiencyEffects
Therearethreegeneralapproachestowelfareanalysiswhentherearebothefficiencyanddistributional
consequences.Oneapproachistoadoptanexplicitsocialwelfarefunctionwhichassignswelfare
weightstothedifferenttypes,asinHoy(2006).Thisapproachcanbeviewedasimposingatacittrade
offbetweenthedistributionalbenefitsandtheefficiencycosts.Asecondapproachistoexplicitlyand
separatelyquantifytheefficiencyanddistributionalconsequences;thisapproachisusefulwhen
differentpolicyanalystsdifferintheirperceptionabouttheoptimaltradeoffbetweendistributionand
efficiencyconcerns(vizFinkelsteinetal.,2009,whoapplythisapproachtotheanalysisofgender
classificationintheU.K.compulsoryannuitymarket).
Athirdapproachistoarguethatpolicymakersshouldfocusexclusivelyontheefficiencyconsequences.
Consider,forexample,themarketoutcome(C

H
, C

L
)whichobtainsunderabanonriskclassification,
asdepictedinFigure5.Thefactthatthisisinefficientmeansthatthereissomealternativeallocation
whichasocialplannerfacedwiththesameinformationalconstraintsasthemarketcouldPareto
improveuponit.Drawingonearlierwork(CrockerandSnow,1985b),CrockerandSnow(1986)show,
moreover,thatthissortofParetoimprovementcanbedecentralizedbyimposingasetofcontract
(andcategory)specifictaxeswhilelegalizingriskclassification.Hence,althoughdistributionalconcerns
implythatitispossibleforasocialplannertopreferthenoriskclassificationoutcome(C

H
, C

L
)tothe
marketoutcomes(C

H,A
, C

L,A
)and(C

H,B
, C

L,B
)whichobtainwithlegalizedriskclassification,sucha
socialplannerwillalwaysstrictlyprefertolegalizeriskclassificationwhileimposinganappropriatesetof
taxes.
Rothschild(2011)discussesanalternativewaytodecentralizethisParetoimprovement:theprovision
ofpartialsocialinsurance.Figure6illustrateshisargument.TheMWSoutcomewithbanned
categorizationprovidesconsumptionC

toitypes;asillustrated,theseinvolvecrosssubsidiesfromI
17

riskstoErisks,soriskclassificationhasbothdistributionalandefficiencyconsequencesi.e.,the
marketoutcomefallsundercase(3),asdescribedabove.
NowsupposethegovernmentimplementsasocialinsurancepolicyprovidinganindemnityofH
S
anda
(mandatory)premiumR
S
illustratedinFigure6.Thispolicyisthepooledfairpolicythattransfersthe
sameresourcesfromItypestoEtypesastheMWSoutcomewould.Inthepresenceofsuchasocial
insurancepolicy,individualswouldhaveaneffectivewealthofw

= w - R
S
andwouldfacean
effectivelossof

= - H
S
.TheMWSoutcomewithbannedriskclassificationandthiseffective
endowmentlosspairleadstothesameconsumptionsC

asbefore.Inotherwords,inthepresenceofa
banonriskclassification,thepartialsocialinsurancepolicyhasnoeffectonthemarketoutcome(when
describedintermsofrealizedconsumptions).Butwiththepartialsocialinsurancepolicyinplace,these
marketoutcomesarenowimplementedwithoutmarketdrivencrosssubsidiesfromIriskstoErisks.
Thatis,theMWSequilibriumnowfallsincase2andintroducingriskclassificationispurelyefficiency
improving.
<Figure6abouthere>
Thisargumentboilsdowntoasimpleobservation:removingbansonriskclassificationispotentially
problematiconlyinsofarasitundoescrosssubsidiesprovidedbythemarketbetweenthedifferent
categories.Socializingthecrosssubsidy(e.g.,viapartialsocialinsuranceprovision)mootsthese
concerns.Theargumentisthereforequitegeneral.Forexample,itisnotdependentontheassumption
thatmarketoutcomesaredescribedbytheMWSequilibrium,anditappliesevenwhenrisk
classificationiscostlyforfirmstoimplement,forexamplebecauseverifyinganindividualsriskclass
involvesperformingacostlytest.
Thismeansthatevenwhentheredistributivebenefitsofbanningriskclassificationmakeaban
potentiallydesirable,imposingabanisneveranoptimalwaytoachieveredistributivegoals.Thisargues
forevaluatingriskclassificationexclusivelyonefficiencygroundsatleastwhenevermoreefficient
waysofachievingthoseredistributivegoalsare,infact,available.
6. Endogenous Informational Environments

18

Intheprecedinganalysis,wemodeledindividualsashavingperfectinformationabouttheirownrisk
type.Thisisnotessential:whatisessentialforthatanalysisisthatindividualshaveafixedsetof
informationabouttheirrisktype,andthatitisatleastasgoodastheinformationinsurershave.
Inmanyapplications,however,theassumptionofstaticinformationisunrealistic.Individualsmaybe
abletolearnmoreinformationabouttheirownrisktypesthroughascreeningtestormedical
examination,forexample.Withtheadventanddevelopmentofgeneticscreening,analysisofinsurance
purchasesinthesesortsofdynamicinformationalenvironmentsisincreasinglyimportant.
Dynamicinformationalenvironmentsaremorechallengingtoanalyzebecauseoftheinteraction
betweentestingavailability,decisions,andinsuranceopportunities.Inparticular,anindividualsdecision
tolearnmoreaboutherrisktypewilllikelytodependonhowthatinformationwillaffectones
insuranceoptions,andthoseinsuranceoptionswillinturndependonindividualsincentivestolearn
information.Forexample,anindividualmightreasonablyworrythattakingagenetictestexposesthem
toclassificationrisk:theymightworrythatabadtestoutcomewillmakethemuninsurableorinsurable
onlywithadramaticallyincreasedpremium.Thiscouldbeproblematiceveniffirmscannotgetaccessto
testoutcomeinformationwithoutpermissionfromthecustomer:sinceindividualswithgoodtest
outcomeswillhaveanincentivetovoluntarilyrevealthatoutcometoinsurers,insurersmaybeableto
inferbadoutcomesfromtheomissionofgoodtestresults.
DohertyandThistle(1996)andDionneetal.(2000)provideacomprehensiveanalysisoftheseissues
(seealsoCrockerandSnow,1992).Wefollowtheirbasicanalysishere,butmodifyitintwoways:first,
weconsidertheimplicationsofriskclassificationinthiscontextmoreexplicitly.Second,weemploythe
MWSmarketoutcomeconceptinsteadoftheRothschildStiglitzconcept,andtherebyresolvesomeof
thenonexistenceproblemsthatariseintheiranalyses.
Thebasicframeworkissimple:therearetworisktypesEandI,asabove.Therearetwopossible
informationalstatesforindividuals:informedindividualsknowtheirrisktypeanduninformed
individuals(utypes)donot.Letdenotethefractionofindividualswhoareinformed;sinceindividuals
canchoosewhetherornottobecomeinformed,
0
isanendogenousquantityhere,where
0
> u
isthe(exogenous)initialfractionofinformedindividuals.Thefractionofinformedindividualswhoare
Etypes,denotedagainbyz,isindependentof.Finally,thereisafixedutilitycost uforindividuals
totakethetest.

utypesareuncertainabouttheirtruerisktype,butiftheyremainuninformedthey
behaveexactlyaswouldanindividualwithrisktypep
0
= zp
H
+ (1 - z)p
L
.
19

Therearefourcasestoconsider,whichdifferintheavailabilityofteststatusinformationtoinsurers(or
toanotionalsocialplanner).DescribetheMWSmarketoutcomesinthesecasesfacilitatestheanalysis
ofthewelfareconsequencesofbanningriskclassificationinthisenvironment.
6.1Symmetricinformation
Ifinformationiscompletelysymmetric,themarketoutcomesaresimple(andarethesameunderMWS
andRothschildStiglitzconcepts):eachtypei(i = E, I, u)receivesatypespecificactuariallyfairfull
insurancecontractC

#
(i.e.,theactuariallyfaircontractforanindividualwithriskp

).Sincebecoming
informeddoesnotchangetheexpectedvalueofutypesconsumption.Sinceitintroducewelfare
reducinguncertaintyinthepriceofthecontractreceivedutypeshavenoincentivetobecome
informed,and =
0
.
6.2Privatetestresults,publicinformationstatus
Figure7depictsthemarketoutcomeifinsurancefirmscanobservewhetheranindividualhasbeen
testedornotandcanconditiontheircontractsonthisobservationbutdonotobservetheoutcome
ofthattest.Inthiscase,utypesagaingettheirfullinsuranceactuariallyfaircontractC

0#
.EandI
typesgetthecontractsC

H
andC

L
associatedwiththeMWSmarketoutcomeforatworisktype
economy,whichinvolvecrosssubsidies(asdrawn).
Asinthesymmetricinformationcase,uninformedindividualsagaindonothaveanincentivetobecome
informedinthismarketoutcome.
Ifinformationstatusisknownandtestresultsareprivatebutverifiable,thenItypeswillthenhavean
incentivetoverifiablyrevealtheirtestresultsandreceivetheirfullinsuranceactuariallyfaircontract
C

L#
.Moreover,firmswilltheninferthatinformedtypeswhodidnotrevealtheirrisktypesareEtypes;
theywillthereforereceivetheirfullinsuranceactuariallyfaircontractC

H#
.Thiscaseisthuseffectively
thesameasthesymmetricinformationcase.
<Figure7abouthere>
6.3Privateinformationstatus,verifiabletestoutcomes
Iftypeandinformationalstatusareprivate,butteststatusisverifiable,thenItypeswillagainreveal
theirtypeandreceivefullfairinsurance.WewillsolveforthemarketoutcomefortheuandEtypesin
20

twosteps.First,weconsiderthemarketoutcometakingthefractionofinformedtypesasgiven.
Second,weconsidertheincentivestobecomeinformedtoidentifythepossibleequilibriumvalues.
Foranygivenu < < 1,themarketwillimplementastandardMWSoutcome,withutypesplayingthe
roleusuallyplayedbyItypes.DenotebyC

$
()thecontractreceivedbyitypes(i = u, I).Sincethe
ratioofItoutypesisz(1 - ),higherreducesthescopeforutilityimprovingcrosssubsidies
fromtheutotheItypes.Consequently,I(C

0$
(), p
0
)isnonincreasingin.Moreover,thereis
somesuchthattherearezerocrosssubsidieswhen (whentheMWSoutcomecoincideswith
theRothschildStiglitzequilibrium)andpositivecrosssubsidieswhen < .Inthelattercase,
I(C

0$
(), p
0
) isstrictlydecreasingin;intheformer,itisindependentof.
Thevalueofinformationtoutypesis:

I() = z|I(C

H$
(), p
H
) - I(C

0$
(), p
H
)] + (1 - z)|I(C

L#
, p
L
) - I(C

0$
(), p
L
)]. (8)
Sincethefirsttermiszero(bythebindingincentivecompatibilityconstraintintheMWSoutcome):

I() = (1 - z)|I(C

L#
, p
L
) - I(C

0$
(), p
L
)]. (9)
Figure8plotsI(),whichjumpsupdiscretelyat = 1sincethemarketwilloffernocontractto(non
existent)utypesthere,andchoosingtoremainuninformedwouldforceutypesintocontractC

H#
.
<Figure8abouthere>
Theequilibriumvaluesofcanbefoundforvarioustestcosts(weassumethat
0
< ).When
< I(
0
) < I(1),allindividualswanttogettestednomatterwhatotherindividualsdo.Themarket
outcomethereforeinvolvesallindividualsgettingtestedandreceivingtheirtypespecificactuariallyfair
fullinsurancecontracts.WhenI(1) < ,nobodywantstogettestedandtheuniqueequilibriumhas
=
0
.Forintermediatevaluesoftherearemultipleequilibriumvaluesof.Thismultiplicityarises
fromofacoordinationproblem:asFigure8illustrates,theincentivetobecomeinformedincreasesas
moreandmoreindividualsbecomeinformed.WhenI() < I(1),therearetwoequilbria:eitherall
individualscoordinateonremaininguniformed(sothat =
0
)ortheycoordinateonbecoming
informedand = 1.WhenI(
0
) < I(),thereis,additionally,athird(unstable)equilibrium:the
uniqueintermediatevaluesatisfyingI() = .Whenevertherearemultipleequilibria,theycanbe
Paretoranked,withlowerequilibriabeing(generically)strictlybetterthanhigherequilibria.
21

6.4PurelyPrivateinformation
Wheninformationispurelyprivate,themarketoutcomecanbefoundbyfirstconsideringthemarket
outcomeforanygiven
0
andthenlookingforequilibriumvaluesof.
Whenu < < 1,thereareeffectivelythreeunobservablydistincttypes.Figure9providesaqualitative
depictionoftheMWSmarketoutcome(C

L
|
(), C

0
|
(), C

H
|
()).InthisoutcomeEtypesreceivefull
insurance,andtherearetwobindingincentivecompatibilityconstraints:

I(C

H
|
(), p
H
) = I(C

0i
(), p
H
)
I(C

0i
(), p
0
) = I(C

Li
(), p
0
).
(10)
UnliketheRothschildStiglitzequilibriumcandidateoutcomes,however,theMWSoutcomemayinvolve
crosssubsidies.Figure9depictsthecasewhereItypesprovidecrosssubsidiestotheutypes(i.e.,I
typesliebelowtheiractuariallyfairlineandutypeslieabovetheirs).
<Figure9abouthere>
Thevalueofinformationtoanutypeisstrictlypositiveinanymarketoutcomewithu < < 1.Towit:

(1 - z)|I(C

L
|
, p
L
) - I(C

0
|
, p
L
)] + z|I(C

H
|
, p
H
) - I(C

0
|
, p
H
)]
= (1 - z)|I(C

L
|
, p
L
) - I(C

0
|
, p
L
)] > u.
(11)
Thatis,uninformedindividualsareindifferenttobecominginformediftheyturnouttobeEtypes,but
strictlypreferbecominginformediftheyturnouttobeItypes.Denotethevalueofinformationatthe
marketoutcomeassociatedwithaninformedfractionbyI().Incontrastwiththeprivate,verifiable
informationcasediscussedabove,itisnotstraightforwardtosignI
i
().Butitiseasytoshowthat
I(1) = uandthatI() iscontinuous.Itfollowsthatwhenever > I(
0
),thereisanequilibriumat
0
in
whichno(additional)individualswillchoosetotakethetestandthattheuniqueequilibriumwhen
= uandtestingiscostlesshas = 1.
Forintermediatevaluesofe(u, I(
0
)),neitheroftheseoutcomesisanequilibrium:ifnoindividuals
gottested,thenallwouldwantto,andifallindividualsgottested,noonewouldwantto.Incontrast
withDohertyandThistle(1996),however,thereisanequilibriumwithsomeintermediatefraction
(
0
, 1)ofindividualstakingthetest.ThisvaluesatisfiesI() = ,whichholdsforsomebythe
22

continuityofI().Hence,forany > u,themarketoutcomeisathreerisktypeMWSmarketoutcome

liketheonedepictedinFigure9.
6.5TheInefficiencyofRiskClassificationBanswithEndogenousInformation
Riskclassificationisonlyrelevantwhenfirmspotentiallyhaveaccesstosomeinformationwhichthey
canuseforclassificatione.g.,intheinformationalenvironmentsofsections6.1,6.2,and6.3.Banning
riskclassificationineachofthesesettingseffectivelymakesinformationpurelyprivate,asinsection6.4.
Wenowshowthatsuchabanleadstoinefficienciesineachofthethreesettings.Todoso,weexplicitly
constructanincentiveandinformationcompatiblecontractmenuthatcould,inprinciple,beofferedby
asocialplannerwithnomoreinformationthaninsurancefirmsandthatwouldParetoimproveonthe
marketoutcomethatobtainswithoutriskclassification.
Supposefirstthatwhenriskclassificationisbanned,themarketoutcomeinvolves < 1,sothereare
someinformedindividuals.Themarketoutcome(C

L
|
, C

0
|
, C

H
|
)isdepictedinFigure10.(Figure10
remainsagnosticaboutthecrosssubsidies.)Figure10alsodepictsanalternativemenuofcontracts
(C

s
L
|
, C

s
0
|
, C

s
H
|
).Thismenuisconstructedinthreesteps:
1. C
s,1
H
|
= C
s,2
H
|
= C
1
H
|
+ e = C
1
H
|
+ e,soEtypesareofferedslightlymoregenerousfullinsurance
coverage.
2. I(C

s
0
|
, p
H
) = I(C

s
H
|
, p
H
)andn(C

s
0
|
, p
0
) = n(C

0
|
, p
0
),sothatEtypesremainindifferentto
theircontractandtheutypescontract,andutypesgetadditionalinsurance,andthe
additionalinsuranceispricedattheiractuariallyfairrate.
3. I(C

s
L
|
, p
L
) - I(C

s
0i
, p
L
) = I(C

L
|
, p
L
) - I(C

0
|
, p
L
)andC
s,1
L
|
= C
s,2
L
|
,sothatItypesareoffered
fullinsurance,andthebenefittoautypeofbecominginformedandlearningthatsheisanI
typeisunchanged.
<Figure10abouthere>
Theallocation(C

s
L
|
, C

s
0
|
, C

s
H
|
)isincentiveandinformationcompatiblewheneverIisobservableor
verifiable.Moreover,bysteps2and3,thevalueofinformationtoutypesisunchanged;ittherefore
remainsanequilibriumforthesamefractionofindividualstobeinformed.
23

Sincen(C

0
L
|
, p
L
) > n(C

L
|
, p
L
), themenu(C

s
L
|
, C

s
0
|
, C

s
H
|
)thereforeearnsnonnegativeprofitsfor
sufficientlysmalle.Themenu(C

s
L
|
, C

s
0
|
, C

s
H
|
)couldthereforebeimplementedbyasocialplannerno
moreinformedthanthemarket.SinceitParetodominatesthebannedriskclassificationmarket
outcome(C

L
|
, C

0
|
, C

H
|
),riskclassificationisinefficientwheneverIisobservableorverifiablei.e.,in
theinformationalenvironmentsofsections6.1and6.3.Wheninformationstatusbutnotrisktypeis
observable,asinsection6.2,asimilarconstructioncanbeusedtoshowthat(C

L
|
, C

0
|
, C

H
|
)is
inefficient.
Supposenextthatthemarketoutcomewhenriskclassificationisbannedinvolves = 1.Themarket
outcomewillthereforebetheMWSoutcome(C

L
, C

H
)foratwotypeeconomy.Thisisinefficientin
theinformationalenvironmentsofsection6.1and6.3,sinceasocialplannercanfeasiblyimplementthe
contractpair(C

L
, C

H
),whereC

L
isthefullinsurancecontractwithn(C

L
, p
L
) = n(C

L
, p
L
).Itis
alsoinefficientintheinformationalenvironmentofsection6.2.Inthiscase,asocialplannercaninstead
offerthemenu(C

L
, C

0
, C

H
),whereC

0
isthefullinsurancecontractsatisfyingn(C

0
, p
0
) =
zn(C

H
, p
H
) + (1 - z)n(C

L
, p
L
).UninformedtypeswillstrictlypreferC

0
tobecominginformedand
facingalottery(withthesameexpectedvalue)overtheothertwocontracts,andmoreoverwillnot
havetobearthecostofgettingtested.
Weconcludethattheoutcomeswithoutriskclassificationareinefficientineachofthethree
informationenvironmentsinwhichriskclassificationcouldpotentiallybeused.
6.6DistributionalConsequencesofRiskClassification
Riskclassificationmayhavedistributionalaswellasefficiencyconsequences.Forexample,Etypesmay
receivepositivecrosssubsidiesinthepureprivateinformationmarketoutcomedepictedinFigure9.
Whenitdoes,banningriskclassificationwillincreasethewellbeingofEtypesrelativetothesymmetric
informationmarketoutcomesC

#
(vizFigure7).
Thewelfareconsequencesofriskclassificationwithendogenousprivateinformationarethus
qualitativelyquitesimilartotheconsequenceswithfixedprivateinformationdiscussedinsection4.A
banonriskclassificationmayleadtoamarketoutcomewhichispreferableondistributional
groundstothemarketoutcomewhichobtainswhenriskclassificationispermitted,butimposingaban
24

isneveranoptimalwaytoachieveredistributivegoals:thefactthattheyareinefficientmeansthat
thereisalwaysbeafeasiblethoughperhapsnotpracticalmenuofParetodominantcontracts.
6.7RiskClassificationwhenTestingIsIntrinsicallyBeneficial
Theprecedinganalysisfocusedonasituationinwhichtherearenointrinsicbenefitsoftesting;the
privatebenefitsoftesting,ifany,arisefromtheinformationalasymmetriesandtheassociatedsortingof
individualsintoinsurancecontracts.Inpractice,ofcourse,testingmayhavedirectbenefits.Itmight
facilitatebettertreatment,forexample.Asimplewayofincorporatingthissortofbenefitistoallowthe
costoftestingtobenegative.Whilethiscanchangethemarketoutcomesdiscussedinsections5.1
and5.2(sinceindividualscouldnowchoosetogettested),itdoesnotsubstantivelyaffecttheanalysisof
riskclassificationintheseenvironments.Hoeletal.(2006)reachasimilarconclusioninamodelwith
heterogeneityinthebenefitsoftesting.(AlsoseeDohertyandPosey,1998,andHoelandIversen,2000
whobuildonHoys1989modelofselfprotectiontoconsidertheconsequencesofgenetictestingina
marketwithasymmetricinformation.)
7. Endogenous Risk Classification

Wehavefocusedonthepureadverseselectioncaseintheprecedingsections,andabstractedfrom
moralhazard.Moralhazardreferstoasituationinwhichanindividualsriskinessp

dependsonsome
choicexshemakes,andthischoiceisinturninfluencedbyherinsurancecoverage.Forexample,diet
andexerciseinfluencehealthandhencehealthrisk,andthepresenceofinsurancecoverageforstatins,
betablockers,andmoreinvasiveandexpensiveinterventionslikecardiacbypasssurgerymaylead
individualstobelessattentivetotheirdietandexerciseregimens.
Thetheoreticalliteratureonriskclassificationinmoralhazardcontextsisthin.BondandCrocker(1991)
isanexception.Theyconsideraspecialcaseofamoralhazardframeworkwhereindividual
preferencesaregivenby

(C
1
, C
2
, x) = [1 - p

(x) u(C
1
) + p

(x)u(C
2
) + 0

0(x). (12)
Anindividualsriskthusdependsonsomedecisionx,andthedecisionxhasadirecteffectonindividual
wellbeingviathestrictlyconcaveandincreasingfunction0(x).Theparameter0

capturesthetastefor
25

x,whichhasunitcostc.Theaccidentriskp

(x) ofthetwotypesi = E, Ipotentiallydifferfortwo

reasons.First,foranygivenx,itmaybethatp
H
(x) > p
L
(x).Second,differenttastes0
H
> 0
L
maylead
differenttypestomakedifferentxchoices.Forexpositionalsimplicity,wefocushereonthesecond
effectbytakingp
H
(x) = p
L
(x) p(x).
Thechoicevariablexcould,forexample,representtheextenttowhichanindividualisoverweight,
whichis(atleastinpart)aresultofindividualchoices.Etypeshaveastrongertasteforbeing
overweight,eitherbecausetheyenjoyweightpromotingactivitieslikeeatingrichfoodsmorethanI
types,orbecausetheircostofmaintaininglowerweightishigher(e.g.,theydislikeweightreducing
activities,orhaveametabolismwhichmakesitharderforthemtolowertheirweight).Thesimplifying
assumptionthatp
H
(x) = p
L
(x) p(x)meansthatindividualsareotherwiseidentical:iftheychose
thesameweight,thentheywouldfacethesamestatisticalriskofaloss.
Riskclassificationinvolvespricingpoliciesbasedontheobservabledecisionsx.Thisiscalled
endogenousriskclassificationbecausetheriskclassificationdependsnotonanexogenously
determinedvariablelikegender,butratherontheendogenouschoiceofx.FollowingBondandCrocker
(1991),itisstraightforwardtoshowthatendogenousriskclassificationleadstoafirstbestefficient
marketoutcome:AfirstbestallocationmaximizesI

(C
1

, C
2

, x

)subjecttoaresourceconstraint
|p(x)C
2

+ (1 - p(x)C
1

+ cx] - |p(x)(w - ) + (1 - p(x))w]

(13)
foreachiandforsometypespecificresourcelevels

(e.g.,zeroforafirstbestallocationwhichis
breakevenfortypei).Lettingz

betheLagrangemultiplierontheresourceconstraint,thefirstorder
necessaryconditionsforC
1

andC
2

atafirstbestallocationare:
(1 - p(x))u
i
(C
1

) = z(1 - p(x)), (14)

and
p(x)u
i
(C
1

) = zp(x), (15)
fromwhichitfollowsimmediatelythatC
1

= C
2

andz = u
i
(C

)inanyfirstbestallocation.The
firstordernecessaryconditionforx

is
p
i
(x)|u(C
1

) - u(C
2

)] + 0

0(x) = z|c + p
i
(x) + p(x)(C
2

- C
1

)], (16)
26

or
0

0(x

)
u(C

)
= c + p
i
(x

).
(17)
<Figure11abouthere>
Figure11plotsthefirstbest(x

, C

)pairsfori = E, I.associatedwith
L
=
H
= u.Becausep(x)is
thesameforbothtypes,thezeroprofitlinelabeledn = uisthesameforbothtypes.(Itisnonlinear
becauseofthexdependenceofp(x).)Thefirstbestallocationsoccuratthetangencypointsofthe
indifferencecurves(labeledI
H
andI
L
),andthetangencypointforEtypeshasx
H
> x
L
because
0
H
> 0
L
.ItisclearfromFigure11thatthisallocationisincentivecompatible.Itisthereforetheunique
NashequilibriumoftheRothschildStiglitzstylegameinwhichmanyprofitmaximizingfirms
simultaneouslyoffercontractsandindividualsthenchoosetheiroptimalcontract.Thismeansthat
endogenousclassificationherecapturedbythefactthatfirmsareofferingdifferentcontractsto
individualswhomakedifferentchoicesofxleadstoafirstbestefficientoutcome.Thisconclusionis
robusttosmalldifferencesbetweenp
H
()andp
L
(),whichmanifestthemselvesinFigure11asvertical
differencesbetweenthebreakevenconstraintsofthetwotypes.
Ifclassificationisbanned,sothatcontractsarenotallowedtoconditiononx,ontheotherhand,nofirst
bestallocationisfeasible.Toseethis,notethatutilityanindividualgetsfromchoosingxandacontract
providinganindemnityHatapremiumRis:
u

(x) p(x)u(w - R - - cx - H) + (1 - p(x))u(w - R - cx) + 0

0(x). (18)
Atafirstbestallocation,C
1
= w - R - - cx - H = w - R - cx = C
2
= C

,andEquation(17)can
beusedtosignthederivativeofu

(x):
u

i
(x

) = 0

0
i
(x) - cu
i
(C

) = u
i
(C

)|p
i
(x

)] > u. (19)
Thismeansthatatanyfirstbestallocationeachindividualshaveanincentivetochooseahigherx.As
such,nofirstbestefficientallocationisimplementablewhenfirmscannotemployendogenousrisk
classificationandtheircontractsonx.Banningendogenousriskclassificationisthereforeinefficientin
thissimplesetting.Thisinefficiencyisintuitive:banningtheuseofxinpricingpolicieseffectivelymakes
xunobservableandintroducesanentirelystandardmoralhazardproblem.

27

8. Risk Classification and Residual Asymmetric Information in Insurance

Markets

Theobjectiveofthissectionistoproposedifferenttestsforthepresenceofresidualasymmetric
informationininsurancemarkets.Fromtheprecedingsections,weknowthatthepotentialpresenceof
asymmetricinformationbetweenclientsandinsurersregardingindividualrisksmotivatesrisk
classification.Fullefficiencyinriskclassificationshouldseparateindividualrisksandgeneratedifferent
actuarialinsurancepremiumsthatreflecttheserisks.Thismeansthereshouldnotbeanyresidual
asymmetricinformationbetweentheinsurerandtheinsuredinsidetheriskclasses.Withactuarial
premiums,fullinsuranceshouldbetheoptimalcontractandthereshouldnotbeanycorrelation
betweeninsurancecoverageandindividualrisk.Butinthereallifeofhealthinsurancecontracting,
therearenumerousconstraintsthatlimitefficiencyinriskclassification.Incentivecontractingbecomes
importantandtheempiricalquestionistowhatextenttheseconstraintslimittheefficiencyofrisk
classification.Inthefollowingsections,wepresentthestatisticalmethodologydevelopedoverthe
recentyearstoverifyifthereremainsresidualasymmetricinformationinobservedriskclasses.
Informationproblemsarecommonininsurancemarkets.Usually,andasassumedinsections27above,
theinsuredarebetterinformedabouttheirowncharacteristicsoractionsthanaretheirinsurer.The
twobestknowninformationproblemsdiscussedintheeconomicsliteraturearemoralhazardand
adverseselection(Arrow,1963).Asymmetriclearningisanotherinformationproblemthatcan
degenerateintoadverseselectionovertime.(SeeCohen,2005;Dionneetal,2010.)Symmetriclearning,
incontrast,canfostercreateafullinformationsituationbetweentheparties.Doingstatisticaltestson
thelinkbetweenriskclassificationandthepresenceofagivenasymmetricinformationproblemis
thereforeverycomplicated,becausethesamecorrelationbetweenacontractcharacteristicandan
observedriskcanbeattributedtomorethanoneinformationproblem.Itmayalsobeattributedto
othercharacteristicsthatarenotwellcontrolledinthestatisticaltest.Thetheoreticalpredictionsmust
becarefullyestablishedinatheoreticalmodel(Dionneetal.,2010)todistinguishtheeffectofeach
informationproblem.
Manytheoreticalcontributionswerepublishedinthe1970stoaccountforstylizedfactsobservedin
insurancemarkets.Theoneperiodorstaticmodelsdiscussedabovewerefirstdeveloped.Partial
insurance,suchasdeductibleandcoinsurancecontracts,canbejustifiedbyasymmetricinformation.
However,adeductiblecanbeoptimalformoralhazard,adverseselection,orproportional
28

administrativecosts.Riskclassificationbasedonobservablecharacteristicsisanothermechanism
associatedwiththepresenceofasymmetricinformation.Aseparatingequilibriumisaformofrisk
classificationinwhichdifferentriskschoosedifferentcontracts.Asdocumentedabove,insuredswho
acceptahigherdeductibleagainstalowerpremiumchoosetobeinadifferentriskclassthanthe
higherriskindividualsintheportfolio.
Therefore,acrucialempiricalquestionis:Doweneedadditionalriskseparationschemeswhenan
efficientriskclassificationsystemexists?Inotherwords,doesaninsurerthatappliesriskclassification
techniquesbasedonobservablecharacteristicsinitsunderwritingpolicyneedtosearchforoptimal
contractformswithintheriskclasses?Theanswerisnoinstaticoroneperiodcontracts,providedthere
isnoresidualasymmetricinformationwithintheriskclasses.Yettherealityismuchmorecomplicated
becausecontractdurationbetweenthepartiescancovermanyperiods,andovertime,thetruerisks
maybecomeknowntobothparties.
Thefirstgoalofempiricalresearchoninformationproblemsinmarketsistodeterminewhetherresidual
asymmetricinformationremainsinthesemarkets.Theempiricalquestionininsurancecanbe
summarizedasfollows:Isthereanyresidualcorrelationbetweenchoseninsurancecoverageandrisk
withinriskclasses?Thesecondgoalistoidentifywhichinformationproblemremainswhenthefirsttest
rejectsthenullhypothesisthatthereisnoresidualinformationproblem.Thisstepisimportantforthe
insurerbecauseitmustimplementtheappropriateinstrumentstoimproveresourceallocation.A
deductibleefficientlyreducesexantemoralhazard,butnotnecessarilyexpostmoralhazardbecause
often,theaccidenthasalreadyoccurredwhentheactionistaken.Ahighdeductiblecanevenhavean
adverseeffectandencourageaccidentcostbuilding(DionneandGagn,2001).Asiswellknowninthe
empiricalliterature,apositivecorrelationbetweeninsurancecoverageandriskisanecessarycondition
forthepresenceofasymmetricresidualinformation,butitdoesnotshedlightonthenatureofthe
informationproblem.Thethirdgoalistofindwaystoimprovethecontractsandreducethenegative
impactofasymmetricinformationonresourceallocation.Theseresourceallocationobjectivesmust
takeintoaccountotherissuessuchasriskaversion,fairness,andaccessibilityofservices.Thislastissue
isparticularlyimportantinhealthcaremarkets.Adecreaseininsurancecoveragemayreduceexante
moralhazardbecauseitexposestheinsuredpersontorisk,butitalsosignificantlyreducesaccessibility
tohealthservicesforsickpeoplewhoarenotresponsiblefortheircondition.
Ininsurancemarkets,thedistinctionbetweenmoralhazardandadverseselectionboilsdowntoa
questionofcausality(Chiappori,2000).Thetheoreticalliteratureonmoralhazardstatesthat
29

unobservedactionsoftheinsuredresultfromtheformsofcontracts.Forexample,ageneroushealth
insuranceplancanreducetheincentivesforpreventionandincreasetheriskofbecomingsick.With
adverseselection,thenatureoftheriskalreadyexists,butthenatureofthecontractschosenisa
functionoftherisks.Thereisthereforeareversecausalitybetweentheriskandthecontractwhenwe
considereachproblemseparately,althoughthecorrelationbetweeninsurancecoverageandthelevel
ofriskispositiveinbothcases.
Econometriciansanalyzetwotypesofinformationwhenstudyinginsurersdata(Gouriroux,1999;
PuelzandSnow,1994;Dionneetal.,2006;Richaudeau,1999).Thefirsttypecontainsvariablesthatare
observablebybothpartiestotheinsurancecontract.Riskclassificationvariablesareoneexample.
Econometricians/insurerscombinethesevariablestocreateriskclasseswhenestimatingaccident
distributions.Theycanbeusedtomakeestimatesconditionalontheriskclassesorinsidetherisk
classes.Thesecondtypeisrelatedtowhatisnotobservedbytheinsurerortheeconometricianduring
contractnegotiations,butcanexplaintheinsuredschoiceofcontractsoractions.Ifwelimitour
interpretationtoasymmetricinformation(eithermoralhazardoradverseselection),wecantestthe
conditionalresidualpresenceofasymmetricinformationinaninsurersportfoliobytestingfora
correlationbetweenthecontractcoverageandtherealizationoftheriskvariableduringacontract
period.Twotypesoftestshavebeenproposedintheliterature(ChiapporiandSalani,2000;Dionneet
al.,2001;seeChiappori,2000;andChiapporiandSalani,2003fordetailedanalyses).Oneparametric
testestimatesthefollowingrelationship:
y

= o + [X

+ yJ

+ oE(J

|X

) + e

, (20)
wherey

isthecontractchoicebyindividuali(levelofdeductible,forexample),X
i
isavectorofcontrol
variablessuchastheobservablecharacteristicsusedinriskclassificationandcontrolvariablesforrisk
aversion,[isavectorofparameterstobeestimated,J

istherealizationoftherandomvariable
observedattheendofthecontractperiod(accidentornot,forexample),E(J

|X

)istheconditional
expectedvalueoftherandomvariableobtainedfromtheestimationoftheaccidentdistribution,ande

istheresidualoftheregression.Apositivesignisusuallyanticipatedforthecoefficientofd
i
when
residualasymmetricinformationremains(highercoverageorlowerdeductibleisrelatedtomore
accidentsorhigherrisk).TheseminaltheoriesofRothschildandStiglitz(1976)andWilson(1977)
stronglypredictthatsuchacorrelationshouldbeobservedinthedatainthepresenceofadverse
selection,whileHolmstron(1979)andShavell(1979)stronglypredictthatthecorrelationisdueto
moralhazard.NotethatthedependentvariableintheaboveregressioncanbetheriskvariableJ

while
30

thecoveragey

isanindependentvariable.ThissymmetryisdiscussedindetailinDionneetal.(2006).
ThepresenceofthevariableJ

isnotnecessarilyexogenousinequation(20).Itisoftenbetterto
instrumentthisvariable(SeeDionneetal.,2009,formoredetails).
ThepresenceofE(J

|X

)isnecessarytocontrolforspecificationerrors(missingvariables)orfor
potentialnonlinearitynotmodeledintheequation.Withoutthiscontrol,thecoefficientofJ

canbe
significantforreasonsotherthanthepresenceofresidualasymmetricinformationintheriskclasses.
IfthecoefficientofJ

isnotsignificant,onecanrejectthepresenceofresidualasymmetricinformation
intheriskclasseswhenallotherfactorsarewellcontrolled.Thisdoesnotmeanthatthereisno
asymmetricinformationinthismarket;rather,itmeansthattheinsurersriskclassificationsystem
eliminatesasymmetricinformationefficiently,andthatthereisnoresidualasymmetricinformation
withintheriskclasses.Inotherwords,whenriskclassificationisdoneproperly,itisnotnecessaryto
choosethecontractformwithintheriskclassestoreduceasymmetricinformation.
AnequivalentmodelwasproposedbyChiapporiandSalani(2000).Here,twoequationsareestimated
simultaneously,oneforcontractchoiceandtheotherforaccidentdistribution.Anexampleisthe
bivariateprobitmodel:
y

= (X

, [) + e

(21)
J

= g(X

, [) + p

(22)
Thetestconsistsinverifyingwhetherthereisdependencebetweentheresidualsofthetwoequations.
Anabsenceofconditionalcorrelationisinterpretedasanabsenceofresidualasymmetricinformationin
thedata.Theauthorspresentanadditionalnonparametrictestthatisindependentonthefunctional
formsoftheabovemodels.ItisbasedonaChisquaretestofindependence.
Toseparatemoralhazardfromadverseselection,econometriciansneedasupplementarystep.An
additionalmarketrelationshipcanbeestimatedtolookforadverseselection(conditionalonthefact
thatthenullhypothesisofnoasymmetricinformationwasrejected),asDionneetal.(2009)didfor
auctions.Ininsurancemarkets,dynamicdataareoftenavailable.Timeaddsanadditionaldegreeof
freedomtotestforasymmetricinformation(DionneandDoherty,1994;HendelandLizzeri,2003).This
informationcanbeusedinmanyinsurancemarketswherepastexperienceisimportant.Experience
ratingworksattwolevelsininsurance.Pastaccidentsimplicitlyreflectunobservablecharacteristicsof
theinsured(adverseselection)andintroduceadditionalincentivesforprevention(moralhazard).
31

Experienceratingcanthereforedirectlymitigateproblemsofadverseselectionandmoralhazard,which
oftenhinderriskallocationintheinsurancemarket.
Experienceratingnotonlyprovidesadditionalinformationonrisk,butmayalsoplayanimportantrole
inthedynamicrelationshipbetweenpolicyholdersinsuranceclaimsandcontractchoice.The
theoreticalliteratureonrepeatedinsurancecontractingovertimeclearlyindicatesthatthesefeatures
mayhelpovercomeproblemsofmoralhazardwhenrisksknowntothepolicyholder(endogenous)are
unobservablebytheinsurer(Winter,2000)orwhenexogenouscharacteristicsareunobservable
(Dionneetal.2000).Contractchoiceisinfluencedbytheevolutionofthepremium,whichisclosely
linkedtotheinsuredsriskorpastexperience.Becauseincreasedinsurancecoveragetendstolowerthe
expectedcostofaccidentsfortheinsured,incentivesforsafebehaviourareweakenedforallrisks.
Underexperiencerating,thesubsequentriseinaccidentsincreasesthemarginalcostsoffuture
accidents.Experienceratingmaythereforeoffsetthedisincentiveeffectcreatedbysingleperiod
insurancecoverage.
However,theabovetestsareconductedinastaticframework,whichfailstorecognizethedynamics
thatexperienceratingintroducesincontractualrelationships.ChiapporiandSalani(2000)discussin
detailhowtheomissionoftheexperienceratingvariable,evenintestswithoneperioddata,must
plausiblyexplainthefailuretodetectasymmetricinformation.Dionneetal.(2010)testedthis
conjecturebyaddingabonusmalusvariableinequationssimilartothosepresentedabove.They
affirmedthatthebonusmaluscoefficientwasindeednegativelyrelatedtothelevelofinsurance
coverage(throughfluctuationsinthepremium)andpositivelycorrelatedtoclaims(potentiallythrough
unobservedheterogeneity).Thecoefficientsthusappeartohidethelinkbetweenclaimsandcontract
choice,whichisexactlywhatChiapporiandSalani(2000)argue.Thisisapparentintraditionalcross
sectionaltests,aswellasinextrapolationsusinglongitudinaldatamodelsthatsimplypoolrepeated
observationsorpermitthecorrelationofunobservedindependentfactorswitheachcontractobserved
overtime.Theadditionaltimefactorthusimprovesthepowerofthetesttodetectasymmetric
information.
Abbringetal.(2003a,2003b)applyamultiperiodincentivemechanismbyfocusingonthedynamicsof
claims,butnotonthedynamicsofcontractchoice(becauseofdatalimitations).Applyingspecific
assumptionsaboutthewealtheffectsofaccidentstopolicyholderswhodifferonlyintheirclaimrecords
(thustheirexperiencerating),theirmodelpredictsthatsubjectswiththeworstclaimsrecordsshould
tryhardertoincreasesafety,andthereby,ceterisparibus,filefewerclaimsinthefuture.However,their
32

datadonotsupportthepresenceofmoralhazard.Dionneetal.(2011)extendtheirmodelanddonot
rejectthepresenceofmoralhazard,usingadifferentdataset.Thepotentialpresenceofadverse
selectionintheirdatawasnotarealproblembecausealldriversmustbeinsured(seealsoAbbringet
al.,2008foranothertestofmoralhazard).
Dionne,Michaud,andDachour(2010)showthatfailuretodetectresidualasymmetricinformation,and
morespecifically,moralhazardandadverseselectionininsurancedata,isduetothefailureofprevious
econometricapproachestomodelthedynamicrelationshipbetweencontractchoiceandclaims
adequatelyandsimultaneouslywhenlookingatexperiencerating.Intuitively,becausethereareatleast
twopotentialinformationproblemsinthedata,anadditionalrelationshiptothecorrelationbetween
riskandinsurancecoverageisnecessarytotestforthecausalitybetweenriskandinsurancecoverage.
UsingauniquelongitudinalsurveyofpolicyholdersfromFrance,theyproposeamethodologyto
disentanglethehistoricalpathwaysinclaimsandpremiums.Theyshowhowcausalitytestscanbeused
todifferentiatemoralhazardfromasymmetriclearning(andeventuallyadverseselection).Theydonot
rejectmoralhazardforagivengroupofpolicyholders,anddonotrejectasymmetriclearningfor
youngerdrivers.
CohenandSiegelman(2010)presentasurveyofadverseselectionininsurancemarkets.Theyreview
theempiricalstudiesindifferentinsurancemarkets,includinghealthinsuranceandlongtermcare
insurance.Theyarguethatthecoverageriskcorrelationisparticulartoeachmarket.Accordingly,the
presenceofasignificantcoverageriskcorrelationhasdifferentmeaningsindifferentmarkets,andeven
indifferentriskpoolsinagivenmarket,dependingonthetypeoftheinsuredservice,theparticipants
characteristics,institutionalfactors,andregulation.Thismeansthatwhentestingforthepresenceof
residualasymmetricinformation,onemustcontrolforthesefactorsaswell.
Forexample,onereasonfornotobservingasignificantcorrelationbetweencoverageandriskisthe
absenceofinsuredprivateinformationontheinsuredshealthstatus.AssuggestedbyCohenand
Siegleman(2010),thestatisticaltestshouldbedonewithintheriskclasses,eveniftheemployerdoes
notusesomeobservablevariablesasariskclassificationvariable.Anotherreasonforthelackofrisk
coveragecorrelation,whichmayalsoapplytohealthinsurance,ispolicyholdersfailuretousetheir
privateinformationtonegotiatetheirinsurancecoverageandpremium.Paulyetal.(2003),forexample,
showthatthedemandforlifeinsuranceisnotsensitivetoinsurancepriceandrisk.
33

Riskaversionisaprivateinformationfactorthatreducestheempiricallinkbetweeninsurancecoverage
andrisk(FinkelsteinandMcGarry,2006;Fangetal,2008).Cutler,Finkelstein,andMcGarry(2008)
provideadditionalevidenceforthiseffect.Theyverifyhowinsurancecoverage,risk,andriskaversion
areinterrelatedinfivemarketsincludinglife,health,andlongtermcare.Theyaffirmthatindividuals
participatinginriskyactivities(lessriskaverse)arelesslikelytobuyinsurance.However,these
individualsdonotrepresentlowerexpectedclaimpayments.Apossibleextensionofthisresearchisto
usethenewproposedcrosssectionaltestsbyChiapporietal.(2006)basedonprofitmaximizationin
competitivemarketsthatarerobusttoheterogeneityinpreferences.
AsdocumentedbyFinkelsteinandPorteba(2006),however,insuranceconsumptiondependson
institutions.Moreover,riskclassificationinthehealthcaremarketisregulatedinmanycountries.
Therefore,theempiricalpredictionsbasedontheimplicitassumptionofcompetitivemarketsmaynot
beappropriateformanymarkets,includinghealthinsurance.Forfurtherdiscussiononparticularities
otherthanefficientriskclassificationthatmaygenerateanabsenceofcorrelationbetweeninsurance
coverageandrisk,seeCohenandSingleman(2010).
9. Conclusion

Inthisarticlewehaveproposedaneconomicanalysisofriskclassificationininsurancemarkets.We
havestudiedindetailthecanonicalmodelingframeworkstoillustratethepossibletradeoffsbetween
efficientinsuranceprovisionandsocialequityassociatedwiththeuseofriskclassification.Wehavealso
analyseddifferentmodelsofriskseparationwhenthereareresidualinformationalasymmetrieswithin
riskclasses.Theseinformationalasymmetriescaneitherbefundamental,orcanarisefromregulatory
restrictionsontheuseofriskrelevantcharacteristicsinpricinginsurancepolicies.Suchrestrictionsare
oftenobservedinhealthinsurancebecausesomecharacteristicsortestsarebannedfrombeingusedby
insurerstoevaluatedifferentrisks.Finally,wehavestudiedtheempiricalefficiencyofriskclassification
bypresentingdifferentempiricaltestsforthepresenceofresidualasymmetricinformationindifferent
insurancemarkets.
34

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Figure1:Ba asicFramework
40

Figure2:Ro othschildStiglitz zEquilibriumCa andidate

41

Figure3:MiyazakiWilsonS SpenceEquilibriumwithCross
42
Subsidies

Figure4:Ris skClassification ncanhavePurelyDistributional

43
lConsequences

Figure5:Ris skClassification ncanhavebothEfficiencyandD

44
DistributionalCoonsequences

Figure6:Pa artialSocialInsuranceProvision nisPreferableto

45
oaBanonRiskCClassification

Figure7:MarketOutcomes swithPrivateTe estResultsand

46
PublicInformattionStatus

Figure8:Th heValueofInfor rmationwhenT TestsareUnobse

47
ervablebutVeri

ifiable

Figure9:An nMWSMarketO OutcomewithT ThreeTypes

48

Figure10:T TheInefficiencyofBanningRisk kClassificationw

49
withEndogenousInformation

Figure11:F

FirstBestBreak EvenAllocation nswithEndogen

50
nousRiskClassiffication