RISK CLASSIFICATION MONOGRAPH
such as peace of mind, they are generally aware that a cost must be incurred to provide these benefits. Although most individuals lack the information or the ability to model explicitly the expected cost of the coverage they are considering, many observers nevertheless have noted the reluctance of potential participants to apply for coverage when the price significantly exceeds the participant’s perception of the expected cost. C.
EXPECTED COST AND THE SUCCESS OF FINANCIAL OR PERSONAL SECURITY SYSTEMS
In Section I.G, the satisfaction of three criteria was identified as being necessary, if not necessarily sufficient, for the success of a financial or personal security system. These criteria tend to be satisfied by systems in which prices for coverage are related to expected cost. 1.
Coverage is widely available to those in the at-risk group who desire it
If the price paid by (or the contribution made on behalf of) each participant in a system fully covers the expected cost of providing his or her coverage, together with any necessary additional provisions, coverage providers generally will be willing to offer coverage. This is true even if the cost of providing coverage is high, since the coverage provider will receive a large enough payment to offset what it estimates its cost will be. In a fully competitive system, providers will view both high-expected-cost risks and low-expected-cost risks as potential sources of profit and will have incentive to offer coverage. Similarly, in a singleprovider system, if the cost of coverage and any necessary additional provisions for new participants will be covered by the contributions made by or on behalf of those participants, both high-expected-cost and low-expected-cost potential participants can be covered. Under both competitive and single-provider security systems, therefore, if prices (or contributions) are expected-cost-related, coverage will tend to be widely available to those in the at-risk group who desire it. Achieving this result requires more than merely setting prices so that the total charged all covered risks exceeds the aggregate cost of coverage. If this condition holds but the prices for some covered risks exceed their expected costs while the prices for other covered risks are less than their expected costs, coverage providers in a voluntary system will have incentive to cover the former risks and attempt to avoid covering the latter. If the aggregate amount charged to or made available on behalf of all covered risks in a single-payer system exceeds the aggregate cost of coverage, but amounts for some covered risks exceed the expected costs and for others are less than expected cost, underestimation of the proportion of high- to low-expected cost risks can occur, leading to funding inadequacies and the need to reduce costs, often by restricting coverage. In either
American Academy of Actuaries
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