Discuss how Risk Classification is designed to generate a “mathematically fair” price and how it potentially fails to achieve this objective.
When insurance companies sell insurance to customers, they do not have the possible means of knowing the exact risk associated with an individual or a business. This is the reason why they attempt to look various demographic data and create classification of customers where they assume the risk to be of similar level. This is mainly because there are various aspects of the risk and it is practically not possible to note down all the risks of an entity. This is why risk classification is made. For example, consider life insurances sold by the companies. A person who smokes will be deemed a higher risk compared to a person who does not smoke. However, a person who does not smoke may have a family history of poor health and thus should be at higher risk. This is where the risk classification fails to achieve its objective.
Taking the above example, we can see that the insurance premium for the non-smoker should be higher because his risk of dying is more than the smoker. But in most cases, insurance companies will follow this strict classification of risk and thus will charge higher premium to the smoker. This is how the classification system potentially fails in many cases.
Discuss how Risk Classification is designed to generate a “mathematically fair” price and how it potentially...
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