Cream Skimming: Innovations in Insurance Risk Classification and Adverse Selection

David A. Cather

Risk Management and Insurance Review, 2018, vol. 21, issue 2, 335-366

Abstract: We demonstrate how innovations in insurance risk classification can lead to adverse selection, or cream skimming, against insurers that are slow to adopt such pricing innovations. Using a model in which insurers with insufficient pricing data cannot differentiate between low‐ and high‐risk policyholders and therefore charge both the same premium, we show how innovative insurers develop new risk classification data to identify overcharged low‐risk policyholders and attract them from rival insurers with reduced prices. Less innovative insurers thus insure a growing percentage of high‐risk customers, resulting in adverse selection attributable to their informational disadvantage. Next, we examine two cases in which “Big Data” innovations in risk classification led to concerns about cream skimming among U.S. auto insurers. First, we track the rapid adoption of credit‐based insurance scores as pricing variables in personal auto insurance markets. Second, we examine the growing popularity of usage‐based insurance programs like telematics, plans in which insurers use data on policyholders’ actual driving behavior to set prices that attract low‐risk customers. Issues associated with the execution of such pricing strategies are discussed. In both cases, we document how rival insurers quickly adopt successful innovations to reduce their exposure to adverse selection.

Date: 2018
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

Downloads: (external link)
https://doi.org/10.1111/rmir.12102

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:bla:rmgtin:v:21:y:2018:i:2:p:335-366

Access Statistics for this article

Risk Management and Insurance Review is currently edited by Mary A. Weiss

More articles in Risk Management and Insurance Review from American Risk and Insurance Association
Bibliographic data for series maintained by Wiley Content Delivery ().