The Theory of Risk Classification

Risk classification is the avenue through which insurance companies compete in order to reduce the cost of providing insurance contracts. While the underwriting incentives leading insurers to categorize customers according to risk status are straightforward, the social value of such activities is less clear. This chapter reviews the theoretical and empirical literature on risk classification, which demonstrates that the efficiency of permitting categorical discrimination in insurance contracting depends on the informational structure of the environment and on whether insurance applicants become informed by the classification signal.