# Risk Groups - Explained

What are Risk Groups?

# What are Risk Groups?

Not all of those who purchase insurance face the same risks. Some people may be more likely, because of genetics or personal habits, to fall sick with certain diseases. Some people may live in an area where car theft or home robbery is more likely than in other areas. Some drivers are safer than others. We can define a risk group can be defined as a group that shares roughly the same risks of an adverse event occurring.

Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks. If people are not separated into risk groups, then those with low risk must pay for those with high risks. In the simple example of how car insurance works, 60 drivers had very low damage of \$100 each, 30 drivers had medium-sized accidents that cost \$1,000 each, and 10 of the drivers had large accidents that cost \$15,000. If all 100 of these drivers pay the same \$1,860, then those with low damages are in effect paying for those with high damages.

If it is possible to classify drivers according to risk group, then the insurance company can charge each group according to its expected losses. For example, the insurance company might charge the 60 drivers who seem safest of all \$100 apiece, which is the average value of the damages they cause. Then the intermediate group could pay \$1,000 apiece and the high-cost group \$15,000 each. When the level of insurance premiums that someone pays is equal to the amount that an average person in that risk group would collect in insurance payments, the level of insurance is said to be “actuarially fair.”

Classifying people into risk groups can be controversial. For example, if someone had a major automobile accident last year, should the insurance company classify that person as a high-risk driver who is likely to have similar accidents in the future, or as a low-risk driver who was just extremely unlucky? The driver is likely to claim to be low-risk, and thus someone who should be in a risk group with those who pay low insurance premiums in the future. The insurance company is likely to believe that, on average, having a major accident is a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two sections discuss the two major problems of imperfect information in insurance markets—called moral hazard and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk groups.

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