Hello, I am hoping that someone can clear up the confusion on the following issue for me. A repeated topic that I've seen come up over the course of my revision for SP8 (and also SA3) is whether we should consider pooling of risk to be an advantage or disadvantage. On one hand, pooling of risk is one of the core principles underlying the birth of the modern insurance market (Lloyd's marine insurance) with the aim being to pay a premium knowing that sometimes your premium will be used to cover someone else's loss, while in other cases other people's premiums will be covering your loss, but you end up paying less overall than having to cover the cost of every loss yourself. However, I have seen many situations throughout questions (ASET, X assignments and end of chapter) in which, when discussing something like charging a fixed or maximum premium to all customers, there are points listed for both: Advantage - this contributes towards the pooling of risk principle Disadvantage - customers with a lower risk will be paying more to subsidise customers with a higher risk It seems to me that these are diametrically opposing points of view. In which case, which one is the correct answer? Thanks, T
There isn’t a correct answer here, it’s not black and white. It’s both an advantage of insurance that some people subsidise others and also a disadvantage. I can think of analogies with taxation - it’s both a good thing that those better off subsidise others in more need and it’s unfair that some people pay less tax and get the same benefits. The concepts of risk based pricing and risk pooling are somewhat at odds with one another and in practice should be balanced. It’s actually sometimes a contentious topic, e.g. charging health insurance based on data collected from user wearables might improve risk based pricing, but you might then become completely uncompetitive for people who have worse health metrics (a commercial consideration) and also (an ethical consideration) do we want only the healthiest people to afford insurance? Some amount of differentiated pricing seems fair, but perhaps not too much! Hope that helps, I’m not sure if I’ve addressed your question.
Thanks for your answer, you raise some interesting points. I've highlighted the main part, which is also actually the motivation behind my original question. I suppose that the main thing I can't fully grasp is why, ignoring the ethical and social considerations, any insurer would want to willingly take on high-risk customers, especially when they end up charging a premium that doesn't actually reflect the riskiness of those customers - will this not be a loss-making venture in the long term?
You will make a lower margin from those customers, but not necessarily a loss. (Also even if you make an underwriting loss you can make some investment returns on the premiums and make an insurance profit overall.) Charging higher premiums to these customers might mean they go somewhere else entirely, whereas at the moment you can make a healthy profit from them, albeit at a lower margin than the very lowest risk customers. You’re right that anti-selection could become an issue though, as if you don’t do risk based pricing at all you’ll attract all the worst risks because they’re getting subsidised.
