TITLE:RISK CLASSIFICATION STANDARDSAUTHOR:

Mr. Michael A. Walters
Mr. Waiters iS Senlor Vice President and Actuary
for Insurance Services Office.
He received his
B. S. degree from Fordham University, his M. S.
degree from the University of Notre Dame a n d h l s
FCAS in 1972. Mike is Treasurer of the CAS andis on the CAS Board of Directors.
He has servedon the Education Co~nitree (Chairman), Finance Committee, Committee on Government Statistics and Joint
C o ~ i t t e e on Review of Education and Examination.
He has authored a paper entitled "Homeowners Insurance
Ratemaklng" which appeared in the 1974 PCAS. Mikeis also a member of the American Academy of Actuaries.

REVIEWER:

Mr. Robert A. Bailey
Mr. Bailey is an Actuary [or the National Association of Insurance Commissioners.
He has earned his
B.S, and M.S. degrees in Actuarial Science fromState University of Iowa. Bob received his FCAS
in 1955 and is a member of the American Academy ofActuaries.
Perhaps no one has authored more papers
or reviews of papers for the CAS than Mr. Bailey.
Over the years, he has written numerous articles
dealing primarily with insurance finance and pricing.
Bob has also served on many CAS co~nlctees including
the Board of Directors of both the CAS and the American Academy of Actuaries.

-

688

-

INTRODUCTION
The e s c a l a t i n g

inflation

more t h a n j u s t

overallo f t h e p a s t decade spawned c o m p l a i n t s a b o u t
insurance rate

products,

insurance costs

questionsof f a i r n e s shave naturally

confronted with four digit
digit

inflation.

increases.

U n l l k e most o t h e rdepend upon buyer c h a r a c t e r i s t i c s ,a r i s e n as some i n s u r e d s wereauto insurance prices"Affordability",soalon 8 with double"availability",

acceptability"

all became buzz-words

In particular,

regulators,

have focussed

increasingand "socialof the late seventies.
and other consumer advocateslegislators,

concern on the third requisite of virtually

every state's mandate on insurance

rates, that they "not be unfairly

discriminatory".

Some critics have claimed that insurance raring methods,

and classi-

ficationsspecifically,

perceptions

about what

is fair.

should be sensitive

to c o n s ~ e r

They suggest that classifications

qualitiesof reliability,

incentive

value.

causality,

controllability,

possess
separation

andSome of these proposals might be essential

to theinsurance process, while others may be merely sound businessadvice,and st ill others might only be

A search throughabundance

insurance and actuarialof historicalliteraturerhetoric.

literature does not find an

resource material relevant

language of, these current
reformers have,consumerisc

issues.

Some of the more persuasivein fact, coined new phrases and fashioned new

as the basis for change.

From a social standpoint,of the espoused changes may be genuine attempts
ability problems

to, or in thein whatis intended

the resulting mechanism violates

to be a "fair" manner,

the principles

not an insurance program.

Therefore,

jurisdiction

insuranceof a state's-

but ifof insurance,

it is

it might not be under the

regulation.

689 -

some

to solve afford-

A recentproblem.

insurance monographby Professor John Long elaborates

on theI"It is fashionable to be critical of insurance theory and toblame the ills of the insurance marketplace on the shortcomings
of insurance theory.
For example, one point of view is thatthe purpose of the insurance industry is to serve the needs ofthe public and that any inability of the industry to do someans that something is wrong with the underlying insurance
theory... This point of view is questionable, whatever concept
one holds about the nature of theory...
"A case in point has to do with exposure to flood loss... The
Congress has seen fit to provide a subsidy to eligible people
who participate in what is called the national flood insurance
program.
This program raises the question of how much 'nonfortuitous' transfer of funds can occur in a transaction
without causing the transaction to be something other thaninsurance... In the author's judgment, the federal flood
program exceeds such limit and, therefore, is a type of welfare
rather than a type of insurance.
This classification is not to
imply that because the flood program is not insurance it is'bad'. The only point being made is that the subsidy for allparticipants by the taxpayers as a whole is so large that thearrangement is not insurance.
Calling something insurance does
not necessarily imbue it with the characteristics associatedwith insurance."

It is important

therefore to distinguish

those qualities which somewould like to see an insurance classifiction
achieve alternativecient conditions,insurance.
standards

goals,

system possessfrom those which are necessary

or standards,

toand suffi-

which flow from the nature of

The purpose of this paper is to develop a set of thesefor insurance classifications,which have been implicitly

used, or should be used, to evaluate compliancewith insurance

statutes.

NATURE OF INSURANCE
The purpose of insurance
fortuitous

financial

ing the insured's

is to protect

loss.

an insured

from a large and

It is achieved by contractually

uncertainty

transferr-of loss to the insurer for the certainty

of a smaller payment called the premium.

This uncertainty

of loss

is called risk.
I

John D. Long, "Soft Spots in Insurance Theory",
Vol. 11, 1978, P. 444.
690 -lssues in Insurance,Since theinsurer

assumes t h e

individual

premium should be fundamentally
insured'sloss.

The expected

insured's

riskof l o s s ,thebased upon the expected value of theloss for an insured is the probabilityof

his having an accident or a claim times the average cost of that claim.
The premium should also include the expense of servicing
plus s margin

for profit and contingency

as a reward

the policy

for the risktaking.

The amount of this profit margin should depend upon two basic

factors,

the ability of the insurer to estimate the expected

average)loss of the individuals

overall reduction of uncertainty

Insurers are not, of course~

insured; 2 and, second,accomplishedonly the expectedindividual's

actual losses from his expectedpurchase of insurance,
individual

by the pooling process.

loss.

losses of

It is the variation of anloss that motivates hiswhile the variation of expected

to individual

the amount oftrying to predict the actual

each insured,(orthat motivates

losses frominsurers to price insureds

differently.

Althoughfrom an insured's

standpoint,

the essence of insurance

transfer of risk, a further value of insurance
reduction of overall
independently

risk or uncertainty

is thefor society is theby pooling many insureds

exposed to loss.

Now, these risks in the pool do not have to be exactly

the same typesof risks for insurance to work, as witnessed by the success of Lloyd'sof London, with a multiplicity
the same over the years.
different2of risks no two of whom may have been

And certainly,

insureds who are inherently

risks should not have to pay the same for the insurance

There is obviously more risk involved to the insurer than distinguishing one insured from another.
The uncertainty of next
year's inflation level, for example, affects the expected cost of
individuals, but more or less to the same degree.
-

691

-

p r o c e s s t o work.

But p o o l i n g works e s p e c l a l l ywell within a given lineof i n s u r a n c e , l i k e p r i v a t e passenger a u t o i n s u r a n c e , when enough i n d e pendent r i s k s

a r e p o o l e d such t h a t

itis virtually

they all will have accidents

i n t h e same y e a r .

t h a t are w r i t t e n ,reality

intuitively

the closer

In f a c t ,once each r i s kallows insurers

Its

combined o r pooled w i l l

combined e x p e c t e dl o s s e s a t t h e end o f t h e y e a r .

the actual

lossesas pooling ofThis latter term somehow may connote that everyone

share the costs equally.

andcome r e a s o n a b l y c l o s e t o t h eThis does not say that the pooling of risks is the s ~ eshouldInsurance can work just as well even if everyr i s k had a d i f f e r e n t

expected

estimate the expected

losses.

Likewise

first

This

t o have more c o n f i d e n c e

has been r e a s o n a b l y p r i c e d ,on a l l t h o s e r i s k slosses.

t h e more r i s k scornea t o t h e e x p e c t e d .

e x p r e s s e s t h e "law o f l a r g e n ~ b e r s " . 3

perhaps b e s t known a p p l i c a t i o nthat,

impossible thatloss,

as l o n g as you can r e a s o n a b l y

insurance does not require that each classificationmust belarge enough to stand on its ow~n. This fallacy says that individualclasses cannot share the risk afnong other classes. 4

It would also

deny the ability to summarize across classes to gain additional
formation about other classes,

such as pooling classification

formation within territory to determine
within state to determine
34

ststewide

inin-

territory rates, or territories

rate levels.

See D. B. Houston, "Risk, Insurance, and Sampling",
Risk and Insurance, XXXI No. 4, 526-530.

The Journal of

See Stanford Research Institute, The Role of Risk Classifications in
Property and Casualty Insurance, Final Report, May i976, p. 63:"confusion surrounding the term 'classification' stems also from anassociation with the concept of pooling of risks to reduce .theaggregate risk.
Many people feel that the essence of classification
lies in having large classes, the members of which share the total
risk of the class (and supposedly do not share the risk of any otherclass).
According to this incorrect view, classes must each have
many members to pool risks; classes with too few members are therefore
oot 'credible' and are assumed to violate the basic principle of risk
sharing."- 692 -

Furthermore,some may believe that insurance is an instrument ofsocial policy to compensate victims.

This view treats the premiums

as merely a means of accumulating

funds to pay out losses in ways

possibly fundamentally different

from the relative risk that each

insured presents to the pool.

But trying to do something noble via

the premium collect ion facilities of insurers does not make theresultant mechanism insurance,what(as earlier cited).

Insurance is

it is - the transfer and reduction of risk; it is not a tax toredistribute wealth.

Thus, the expected loss of the individual
pricing of insurance.

is important to theBut, being inherently unknowable, even by the

insured himself, how do insurers infer this vital quantity?

There

are three basic methods.

First, they may use wisdo~ and experience as an underwriter in
exercisinginformed judgment about the nature of the insured and theexposure to loss and attendant hazards.

This

is not the mostaccurate method but it is sometimes the only one available.

From aninsured's standpoint, with a complicated risk desired to be transferred, as long as both parties agree on a price, the insurance
mechenism is working.

The second method of inferring individual expected loss is toobserve the insured's actual losses over a long period of time.
This gains certain additional

information,

picking up more of thesubtleties of the risk that could not be obtained by logical,
informed judgment.

(This is analogous to experience rating versus

-

693

-

schedule rating.)
outdated,

However, once obtained this information may beas the risk to be insured next year may have changed

substantially.

Furthermore~ depending on the frequency of accidents,

it may take twenty to thirty years of observation to infer correctly,
given the dominance of randomness

in the accident occurrence process.

The third method of inferring expected losses is to observe theexperience of a group of similar risks over a much shorter and more
recent period of time.
classifications.

These groups of similar risks are called

Furthermore,

the group observation process also

involves the second use of the Law of Large Numbers.

The first use

was that if you know the expected losses in advance, then the actual
losses will teed to approximate the expected at the end of theyear for the insurance enterprise as a whole.

However, by observing a smaller number of similar risks over a shortperiod of time you have more confidence you have closely estimated the
expected losses of the individuals

in advance.

This is especially

important if the set of insureds can change from one year to thenext.

(This process of classifying

is analogous to using stratified

random sampling to gain more information when the size of the total
sample is limited. 5)

There are some who feel that group inference for an individual
member of a group is unfair per se, no matter how the groups aredefined.

This would seem to prohibit the use of any statistical

based knowledge throughout society, and is contradicted by ell
5

Houston, p. 534. Author's Note:
If the classes are fairly
stable over time, they do not even need to have similar expected
losses for the individuals within in order to gain a good estimateof the class average expected losses.
Merely the variance ofactual losses from the mean for each individual insured in theclass should be similar.
This results from the fact that insuranceclassificat ion reviews use all the risks insured in each calss.
- 694 -

insurance

statutes which allow,

fications.

or even mandate,the use of classi-

The SRI also clearly addressed this:"...the opinion that distinctions based o n sex, o r any othergroup variable, necessarily violate individual rights reflects
ignorance of the basic rules of logical inference in that it
would arbitrarily forbid the use of relevant information.
Itwould be equally fallacious to reject a classification s y s t e mbaaed on socially acceptable variables because the resultsappear discriminatory.
For example, a classification system
may be built on use of ear, mileage, merit rating, and othervariables, excluding sex.
However, when verifying the average
rates according to sex one may discover significant differences
between males and females.
Refusing to allow such differences
would be attempting6to distort reality by choosing to be
selectively blind."

C L A S S I F I C A T I O N STANDARDS

SO insurance classifications
many kinds of insurance,
enablingloss.

are seen as needed

insureds to pay in proportion

If there were no reflection

insurer,

it could risk insolvencychanged substantially.
a larger margin

to their relative hazard ofof these relative costs by an
if the distribution

At a minimum,for profit and contingency

to offset the much

results.

it is import ant to distinguishfrom risk selection.
(via marketing)

Risk selection

and a more specificof exposures

such an insurer will require

greater chance of adverse underwriting

At this point,in the pricing of

helping to reduce overall risk, as well as

risk classification

determines

both the general(via underwriting)set ofinsureds with whom the insurer decides to enter into a contractual
relationshipaccording7

and whom the classification

to its predetermined

SRI (1976),

system must pricecriteria.

p. 91.

In some lines and states, a shared (or so called involuntary)
market exists which requires participation by insurers in order towrite voluntary business.
This helps solve an availability
problem for those not "selected" by insurers under usual markets.
-

695 -

Given the preceding, the variables comprising a classification
system should be chosen so that a set of general standards orconditions are met (in addition, of course, to any expressed statutory
requirements regarding fair discrimination).

i)

Similar risks should be assigned to the same class withrespect to each variable; coversely, dissimilar risks
should be assigned to different classes,

so that there are

no clearly identifiable subsets with a significantly
different loss potential or expected loss in the sameclass. 82)

The common characteristics used to identify insureds as
similar should reasonably relate to the potential for, or
hazard of, loss. 9

Next, the classes should be exhaustive and mutually exclusive; that is, an individual should belong to at least
one, but only one class with respect to each rating variable.

4)

There should be clear and objective phraseology

in thedefinition of classes~ so that there exists no ambiguity as
to what class an individual

5)

insured belongs.

An insured should not be able to easily misrepresent ormanipulate his classification.

It is important to stress the words "clearly identifiable" when
dealing with t h e alleged overlap or heterogeneity of certainclasses.
This is different from, and yet related to, what some others
have used as the notion of causality, and will be covered in thes e c t i o n on Non-Standards.
- 696 -

6)

The cost of administering

a rating variable

should bereasonable in relation to the benefits received.

And finally,to the extent possible,

factors should be susceptible

the class rating

to measurementby actual

insurance data.

These seven standards
which can describe

actually

fall into three broader categories

a set of necessary

insurance classifications:and sufficienti.e., homogeneous,conditions

well-defined,

for

and

practical.

HomogeneousMore homogeneousclasses will take fewer risks to obtain reasonableestimates of expected costs,
competition

and will minimize the ability ofto skim off better than average risks thus changing

theultimate cost s.

The "reasonable

relationship"

standard

is also a way of avoiding

spurious measures which likely have potentially

identifiable

Of course,

persists

if a strong statisticalwith no emergence
perceivedof practicalreasonableness

Homogeneity

paper precludes

measurement .i0

for classification

knowing a risk's true expected

then the degree ofas well.

While the scope of this
it is helpful

loss or accident

697-

to recall thatis the impoasiblility
likelihood.

See Richard G. Woll, "A Study of Risk Assessment",
1979.
-

over time,some current debate as to the possi-

entering that debate,

one of the reasonslO

subdivisions,

may be enhanced over time,is also undergoingbility of statisticalcorrelation

subsets.

of
Given

PCAS LXVI,

t h e randomness o f a c c i d e n t and loss occureence, and the f a c t
tests must use a c t u a l loss distributions

that statisticalindividuals,

it may be difficult

to gain more than a glimpse or an

insight

into possible distributionsclass.

This

especiallyisabout the functionalforof accident

true s i n c elikelihoods

assumptions

form of the accident

must

also

withinbe madelikelihood model (as well

as of the loss severity model).

Furthermore,

the real test of homogeneityclassification

cell, not in the separate

to classify the risk.
for a classification

It is also not necessary
to have identical

expected

within the class, even if true individual
were "knowable".

Finally,possible distribution
the lower expected
identifiedof expected

used in combination(or even likely)
losses for all risks

risk accident

even if inferences

likelihood

can be made about alosses within a classification,

loss insureds deduced(or identifiable)risks themselves.

is in the most refined
variables

to exist are not in any way

to the insurer or even known by the

Therefore,

it is bordering on a philosphicalto assert that such a class is too h~terogeneous,game

and is therefore

not permissible.

The SRI spoke to that fallacy ms follows:"Indeed, the rationale that proscribing the use of certain
rating variables is in the public interest because, underimperfect risk assessment systems, actuarial fairness is notachieved for some -- albeit unidentifiable - individuals is
fundamentally contradictory.
It promotes a remedy for unfairness to some that increases the unfairness ~yerall (by the sameactuarial yardstick) and redistributes it."11

SRI International, Choice of a Regulatory
Insurance, May 1979, p. 58.
-

698

-

Environment

for Automobile

Well-Defined
The second broad standard

is that of being well-defined,

to ensure that each risk is actually placed
cation end to avoid unequal application
system.

The "exhaustive"

and helps

in the right classifi-of the classification

quality allows more risks to be accepted

and, once accepted,

gives a complete method of rating them.

clusivity"

two different

precludes"No ambiguity"

statisticalrates for the exact same risk.

also prevents unequal

while protection

treatmentfrom misrepresentation

data consistent"Ex-of the same risk,

by insureds will keep theas well as enhancing

the equal treatment

of inaureds.

Practical
The dictionary definitionof practicalrefers to "workable,

useable,and sensible" and the final two standards

deal with these goals.

Being cost-effective

an inefficientis importanteven attempts to be too precise)the value of the information

becausesystem (orcould increase total costs beyond

to be obtained.

If, for example,

itcosta an insurer ten dollars on each policy to find only a small
portion of risks who could save twenty dollars,

it is not worth theeffort.

In final perspective,

one of the advantagesof classifying was touse the Law of Large Numbers on actual observed
past instead of relying on pure businessexperience of thejudgment.

If there is no

method or attempt to test class average prices by actual datap thesystem is tantamounta classification

to schedule rating.

Of course, whether or not

rating factor is tested

frequently depends upon thelikelihood of change

in a short period of time, and the relative

size and importanceof the rating factor.
-

699 -

NON-STANDARDSIn t h i spaper,

necessaryt h e word " s t a n d a r d s "and s u f f i c i e n t

consistentconditions

has been used to denotefor

insurance

a set

of

classifications,with the nature of insurance as well as insurance statutes.

However,the dictionary

definition

parisonin measuring or judging..,also includes "a basis of comquality."

indeed likely that other characteristics
desirable.

It is possible orof classification

may beFailure to include these in the basic standards meansthat it is felt that their presence

is not required to render theclassification

system valid and appropriate.

Two different

qualities

correlatives- controllability

that have been recently espoused are actuallyand incentive value.

By controll-ability is meant the ability of an insured to determine by his own
efforts(presumably

If that quality

consciously)

is present,

the class to which he is assigned.

it is argued,

the insured will have the

incentive to change to a lower rated class and thus reduce his OWN
losses as well as the losses of the overall system.

One can sympathize with a risk that presents
over which it has little or no control~
criterion,

and make others with lower inherent risk subsidize thehigher risk is, in effect,
sation insurance,
an inherently
type work.

a denial of reality.

for example,

the logging or lumbering

Not to charge for that difference
Similarly,

an essential classification,

yet is obviously

Controllability

In workers'

compen-industry has

higher risk of injury to workers than clerical office

the essence of classification.

primarily

a much higher hazard,

but to deny use of that

therefore

is an extraneous

age in life insurance

isuncontrollable.

add-on, which has benefits

in the area of public understanding.
- 700 -

would be to contradict

Incentive value also has public appeal, and in its obverse may be
importantto the overall

insuring process.

Whetherit be classifi-

cations or exposure base, or indeed the existence of inaurancej
presence of an insurance contract
towards

theshould not encourage a laxity

loss control or create a moral hazard of exaggerated

or

false claims. 12

Whileincentive value could be a noble addition to a rating system,

it is not a necessary one, nor should classification
by it as a standard.

Personallines risks,

for example,

easily subjected to loss prevention measuresrisks.

Even so-called

insurance may be

incentive to prevent accidents.

drivers wear seat belts despite the life saving evidence,prospectcannot helike large commercial"merit rating" in automobile

nothing more than a theoreticalplans be judged

Few

so theof saving a few dollars of insurance surcharge certainly

will not induce the modification
Study, a major conclusion
as deterrent
correction

measures

In a DOTin this area was also reached:

concentrateof 'driver error,'ineffective. ''13

of driving behavior.

(Of course,

on a punitive"As long

approach to thethey are likely to remain relatively
once an accident

occurs,the fear ofa surcharge may affect the reporting of accidents and submissionofcollision claims, hut that may be in conflict with the liability
insurance

12

13

policy "condition"requiring notification

C.A. Williams et.al., Principles
Vol. I, 1978, p. 128.

of Risk Management

U.S.
Department of Transportation, Causality,
Deterrence in Hishway Crashes, 1970, p. 245.

-

701

of accidents).

-

and Insurance,

Culpability

andCausality

is also recently

cations to possess,behavioral

definedrelationshippotential. "14cited as a desired quality
as follows:

betweena particularrating

The use of the term "behavioral"

to accept as a standard,

becausefor classifi-"the actual or implied
factor and loss

makes this difficult

living in the river valley does notcause the river to flood, yet certainly

increases

the hazard

involvedin flood insurance.

Merit rating

in autoinsuranceis almost totally non-causal.

fact that an insured has been involved
behaviorally

in a past accidentThe

does notcause him to get in the next one or even to have becomea worse driver.

And yet the same critics of current

accident

record as an ideal rating variable.

instead,a reasonable

relationshipsuch a rigid chain of causality
As the earlier mentioned
bility for crashes

to the hazard of loss, without

or behavior,

DOT Study concluded:is rarely unilateralisolate from the multiplicity

rating cite pastof causes

is more appropriate.
"...driverresponsi-

sad is often impossible
involvedtoin almost every

crash. ''15

By classifying

risks,

an insurer does not seek to determine

cause of the accidents.
identified,

To the extent high risk insureds

society may benefit

the

are

by focussing attention on the needfor possible remedies.

1415" F i n a l Report o f t h e R a t e s and R a t i n g P r o c e d u r e s Task F o r c e " o fthe (NAIC) Automobile Insurance (D-3) Subcommittee, November
1978, p. 5.

DOT,

p.

209.
-

702

-

Separation

has been defined

sufficiently

different

as "a measurein their expectedof whether classes
losses to warrant

are

the

setting of different

premium rates. "16

so-calledquestion where it is felt that if one class rate"overlap"

were close to another,
accident

likelihoods

some inaureds

This deals with thein the first class would haveclose to those in the second class, and there-

fore may be mis-clsssified.

This is related
supposedly

to the homogeneity

whetherclassifications

undesirable,
Finally,

If the insureds who

deserve co be in the second class are not identifiable,

then it is questionable
Secondly,question.

you can call them mis-classified.

with mean rates close together are not

if the hazard being reflectedeven if some insureds

is a gradual one.

in a $300 rated class truly deserve

to be in a $305 class, the system is still working well from a
cost/benefit

standpoint.

Therefore,

the concept

not appear very useful in the context

Reliability
objective,of separation doesof classification

standards.

has also been a term which includes qualities
clearly defined,

are consistentand easy to verify,

with the standards

17that areall of which

earlier mentioned,

and about which

there is little or no controversy.

However,social acceptability

connote a variety of meanings
insurance classifications.

and admissibility
and contexts

are terms which

regarding the use of

By way of perspective,

it is one thing

to give advice as to the public's view of certain

rating variables

among alternatives
16

17of equal value.

It is quite something else

Division of Insurance, C o ~ o n w e a l t h of Massachusetts, Automobile
Insurance Risk Classification:
Equity and Accuracy, 1978, p. 3.
Massachusetts,

p. 3.
- 703 -

totheunpopularity

subjectively

say

that

by

some,

some

variables.

or

even

their

we.

earlierofthroughpublicBB perceived

Rateadequacyendpublicacceptability

cited

SRI

suggestedthat

opinionpolls,
are

pre

often

in

choosevarir

conflict.

The
among

the

set

of

clearly

explainableprevent

ion,

meant

as

Reportpoesible
to

end

are

ones,
the

public,adjueted

to

sound

business

advice,isilluatretedbyconditions,

without

loss

provideofprecision,

incentivessocialmoree.

rather

than

their

insurer8

for

18
a set

comments

on

that

the

loss

That

this

of

necessary
very

a

YBB

next

page:

“On the otherhand,
the opinionthat
distinctions
based
on sex,or any othergroup
variable,necessarily
violateindividual
rightsreflects
ingnoranceof the basic
rulesof logicalinferencein thatit would
arbitrarily
forbidthe use of
relevant
information.
It would
be equally
fallacious
to rejecta classification
systembased
on sociallyacceptablevariables
becausethe resultsappeardiscriminatory.
For example,acleseification
systemmay be built
on u8e of car,mileage,merit
rating,and othervariables,
excludingsex.
However,when verifying
the average
rates
accordingto sex one may
discoversignificant
differences
betweenmales
end females.
Refusing
to ellovsuchdifferences
would
be attempting
todistortreality
by choosing
to be selectively
blind.
“lheuse of racing
territories
is a canein point.
Geographicaldivisions,hovever
designed,
are often
correlatedwithsociodemographic
factorssuch
as incomelevel
end race
becauseofnaturalaggregationor forced
segregationaccordingto thesefactors.
Again
we conclude
that
insurancecompanies
shouldbefree
to delineate
territories
and assess
territorialdifferences
At the same time,insurancecompanies
88 wellas theycan.
shouldrecognizethat
it ia in their
bestinterest
to beobjective
and u8e clearly
relevant
factors
to defineterritories19
lest
they
be accusedof invidiousdiscriminationby the public”.

MOreOVer,ina later

work,

of

is

determination

whet

the

SRI

unfairly

to

the

use

of

variables

whose

18
19

SRI
SRI

Report,Report,

1976,
1976.

pp. 89-90.
p. 91.

clearlystated:discriminatory
predictive-

704

validity-“The

regulator’.

shouldrelatecannotbeonlysubstantiated and to unequal application of a classification
system. ''20 Furthermore, they put the context of extremesocial intolerability in the legislative arena:"One possible standard does exist for exception to thecounsel that particular rating variables should not be
proscribed. What we have called 'equal treatment' standardof fairness may precipitate a societal decision that theprocess of differentiating among individuals on the basisof certain variables is discriminatory and intolerable.
This type of decision should be made on a specific,
statutory basis. Once taken, it must be adhered to in
private and public transactions alike and enforced by the
insurance regulator. This is, in effect, a standard for
conduct that by design transcends and preempts economic
considerations.
Because it is not applied without economic
cost, however, insurance regulators and the industry
should participate in and inform legislative deliberations
that would ban th~lUSe of particular rating variables as
discriminatory."

Admissibility, as per the Massachusetts definition, begins withfederal and state statutory requirements regarding discriminationand privacy, but continues

in the social acceptability vein:"There are also distinctions that, while not clearly illegal,
are 5sing increasingly questioned. These include sex, income,and marital status. Clearly, it is preferable to avoid such
distinctions. Distinctions are best able to meet the text ofadmissibility if they are within an individual's ability tocontrol and are causally related to the probability of loss.
It would be undesirable, for example, to charge higher rates
for redheads than brunettes even if it could be shown statistically that people with2~ed hair have more accidents thanthose with brown hair."Use of the words "preference" and "desirability",

from a perceptionof the public's view and using popular intuition about controllability and causality, again con firms that this characteristic is in
the form of business marketplace advice.

20

21
22

Insurers who can combine

SRI International, Choice o f a Regulatory Environment for
Automobile Insurance, May 1979, p. 93.
$RI, 1979, p. 94.
Massachusetts, 1978,

p.

4.
-

705

-

sound and relevant rating variables with the public's view of what
is better will obviously be more successful.

However, unless oruntil possible substitute variables are found which do not sacrificeaccuracy and do not create subsidies,the failure to use appropriate,

though unpopular, variables will only cause some individuals availability problems and still others to be overcharged relative totheir risk.

REGULATION VERSUS COMPETITION
Given that insurance regulators must enforce the rate regulatory
laws, a logical question to be asked is whether natural competitive
forces will reinforce or conflict with the standards for insuranceclassifications.

Regarding homogeneity,

it is obvious t h a t

the essence of competition

will be to try to find rateable subsets of existing classifications
to price more accurately and equitably (prices matching costs).

If classes are too broad, underwriters will tend to select risks
out.

However,

it takes more discipline to define objective andpractical new classifications to maximize the number of risks to be
written voluntarily.

If several different

companies are licensed ino group under the same management control,

the competitive drive formore homogeneity can be partially met by a different set of underwriting standards for each company in the group.

If there is only a strong statistical correlation

for a particularvariable, without an obvious relationship to hazard of loss, competitive forces will definitely strive to find a closer link.

If nocloser link is found over an extended period of time, as mentioned
earlier, the reasonableness of the relationship becomes much moreestablished.
- 706 -

T h e r e i s an a n a l o g y h e r e w i t h t h e s t a t i s t i c a llung cancer and cigarettet o be a h e a l t hhazard.

correlation

betweensmoking which for many years wee not held

In f a c t ,there

h a s y e t t o be found i n h ~ a n

medicine e cause and effect link showing lung cancer resulting
tobacco smoking.

Conceivably(but unlikely),

could have other characteristics
also less prevalentrelated with carcinogens

in non-smokers.

to avoid the use o f statisticalfound.

The answer,

informationfromcigarette smokers
that areof course,

is notuntil better data is

Indeed, the U.S. Surgeon General end others have taken

strong steps based mainly (end reasonably)
evidence.

on the statistical

Even though the actual risk of death from lung cancer

among the heaviest
non-smokers.
contract

smokers

is very small,

it is many times that ofStated another way, most heavy smokers will notlung cancer; yet all of them have had certain privileges

revoked and rights modified.

One can normally expect marketplace
well-defined

there is a temptation

jectivity

as a trade-off

for all risks.

to allow some ambiguity or sub-for additionalcosts needed to gain con-information.

Regarding p r a c t i c a l i t y ,restraint

for those who useclass plans allowing equal treatment

However,sistent

rewards

competitive forces willon overspending to a t t a i n r a t i n gpart o f the w o r k a b i l i t yplace a n a t u r a linformation.

of c l a s s i f i c a t i o n s

However,i n v o l v e s t e s t i n g therating factors with actual data to minimize

the subjectivity

pricing.

instinct, however,

There is a potentiallyrely on judgment

and assumptions

for the appropriate

conflictingoftoto avoid the cost of truly testing

price relationships.

- 707 -

Of course,

to the extent

that other insurers

find cost-effectiveclass relativities,

then as long as there is the ability to exchange

information,

any pricing inequities

Some exmmples of potentiallyclassifications

ways of better measuring

will be short term.

unfair discrimination

in insurance

might include the following:

The use of occupation

as a rating variable

for auto liability

insurance may be a problem with regard to ambiguity
population

into exhaustive

likely being reasonably

similarly,

categories,

relatedin splitting theas well as not all cells

to the hazard of loss.

national origin (if not already proscribedhave problems with the mutually exclusive

Use of unverifiable
psychologicalby law) would

and exhaustive

categories.

criteria or too subjective wording,such as withprofiles would also present major problems.

of characteristics

which are easily circumvented

The useby some insureds.

and not others can favor the pricing of some to the detrimentofothers.

Another example of possible unfair discrimination
failure to reflect premium differences
different

for identifiable

subsets of broader classifications,reason existed

would be thesuch as the cost of determining

and rateably

unless some overriding
the necessaryin-formation being too high for the overall system.

The pricing impact of not subdividing

depends upon the size of thesubsets and the resulting differencesin price for each of the

subclasses.

It may be that only a small amount of premium can be

-

708

-

saved by refinement,

if one of the subclasses

is very large end also

the lowest priced (such as rating by past accident
insurance where accident-freemostor claim-free

drivers usually save atfive percent over the cost of not having

If, however,those differences
insureds

For example,
since,

would constituteare not identifiable

identify

those who do.

a subsidy.

But, if the set ofthen there is no subsidy.

that all of insurance

likelihood

is a subsidy

those who do not have accidents

This is fallacious

However,of an accident whicharebecause you cannot

in advance those who will have accidents.

people buy insurance.

in a system andthe failure to reflect

in advance,some have alleged

as the reasoning goes,subsidizing

such a program).

lower risk insureds were identified

were useable as a rating classification,

record in auto

That is why

you can identify those with a higher
is what classification

Failure to classify would therefore

is all about.

be a subsidy by those with alower loss likelihood of those with higher loss expectancy.

Some also allege that it is a cruel disservice
risk insureds
However,in advance through refined classification

insurers should not be blamedrisks in society.

In a report

the U.S.

of Transportation

Department"Regardless
exist.

to identify the highfor the existence of highfrom the Federal Trade Commissionof law and underwriting

The present system

plans.

in 1970,

toit concluded:

systems, high risk drivers

identifies

them; it does not create

them." 23 In fact what insurers do by keeping track of the sourcesof accidents
23

is to help identify those segments of the population

Report of the Division of Industry Analysis, Bureau of Economics,
Federal Trade C o ~ i s s i o n to the Department of Transportation,
Price Variablilit~ in the Automobile Insurance Market, August]970, p. 144.
- 709 -

when l o s s"In t h e

p r e v e n t i o n may be t h e a n s w e r r a t h e rinterestsof loss control

g r o u p must be i d e n t i f i e dand p r e v e n t i o n ,end t r e a t e d

In o t h e rwords,

producesan i n o r d i n a t e

if high risk

licensings h o u l d be c o n s i d e r e d ,beforedriving

pooling.
high-risk

the accidentso c c u r . ''24

areas

p e r h a p s more s t r i n g e n t

o r mass t r a n s p o r t a t i o n

improvements,

but do not hide the information,

time as the source of the problem is solved,
Report on Risk Classification,
the use of knowledge

thisin h i g h d e n s i t yamount o f l o s s ,or other alternatives,

than risk

until suchto paraphrase

the SRI

society should not legislate against

in a free society.

25

SOM)qARY

The purpose of this paper was to view the issue of reasonableclassifications
itself.

from the perspective

In this way perhaps

classifications
essential

between theand the non-essential.

in the past few years about what is fair or

but this evaluation

should not take place without

standing of what classifications
Affordability
insurancethat many have felt

ought to possess could be distinguished

Much has been written
unfair,of the nature of insurance

the qualities

are designed

an under-to do in insurance.

is one example of s quality which society might likerates to have, but the essence of classifications

to highlighthigh-risk,

high-cost

Unfortunately

in that instance and in possibly

servessegments of the population.
others the solution

to the problem may lie outside the scope of insurance classifications
or even the insurance mechanism
24
25

itself.

DOT, p. 144.
SRI, The Role of Risk Classification in Property and Casualty
Insurance, 1976, Executive Summary Report, p. 25.
-

710

-

REFERENCES

Division of Insurance, Commonwealth of Massachusetts.
Automobile
Insurance Risk Classification:
Equity and Accuracy, 1978.

"Final Report of the Rates and Rating Procedures Task Force" to the(NAIC) Automobile (D-3) Subco~nittee, November 1978.

Houston, D.B.
and Insurance,"Risk, Insurance, and Sampling."
XXXI No. 4, pp. 526-530.

The Journal of Risk

Long, John D.
"Soft Spots in Insurance Theory."
Issues in Insurance,
Vol. II. Malverne, Pennsylvania:
American Institute for Property
and Liability Underwriters, 1978.

Report of the Division of Industry Analysis, Bureau Of Economics,
Federal Trade Cormmission to the Department of Transportation.
Price
Variability in the Automobile Insurance Market, August 1970.

SRI International.
Choice of a Regulatory Environment for Automobile
Insurance, May 1979.

Stanford Research Institute.
The Role of Risk Classification
Property and Casualty Insurance.
Final Report, May 1976.

U.S. Department of Transportation.
in Highway Crashes, 1970.

inCausality, Culpability and Deterrence

Williams, C.A., Head, G.L., Glendenning, G. William.
Principles of Risk
Management and Insurance, Vol. I, Malverne, Pennsylvania:
AmericanInstitute for Property and Liability Underwriters, 1978.

WOiI, Richard G.

"A Study of Risk Assessment."

-

711

-

PCAS LXVI,

1979.