Demand Elasticity, Risk Classification and Loss Coverage When Can Community Rating Work?

This paper investigates the effects of high or low fair-premium demand elasticity in an insurance market where risk classification is restricted. The effects are represented by the equillibrium premium, and the risk-weighted insurance demand or "loss coverage". High fair-premium demand elasticity leads to a collapse in loss coverage, with an equillibrium premium close to the risk of the higher-risk population. Low fair-premium demand elasticity leads to an equillibrium premium close to the risk of the lower-risk population, and high loss coverage--possibly higher than under more complete risk classification. The demand elasticity parameters which are required to generate a collapse in the coverage in the model in this paper appear higher than the values for demand elasticity which have been estimated in several empirical studies of various insurance markets. This offers a possible explanation of why some insurance markets appear to operate reasonably well under community rating, without the collapse in coverage which insurance folklore suggests.

Keywords: adverse selection, loss coverage, risk classification, demand elasticity, community rating.