Final answer:
Charging different premiums to policyholders within the same risk classification is known as price variance. An insurance company must charge actuarial fair premiums based on expected losses to align with risk and to prevent financial losses. Correct classification into risk groups is crucial to handle the moral hazard and adverse selection in insurance markets.
Step-by-step explanation:
Charging different premiums to policyholders in the same risk classification is referred to as price variance. When an insurance company charges the actuarially fair premium to each group separately based on expected losses, it ensures that premiums are aligned with the risk level. For instance, different groups of drivers can be charged varying amounts that reflect the average damages caused by that group – the safest drivers might pay $100, while the highest risk group might pay $15,000.
If an insurance company were to charge the same premium to the group as a whole, it would not be taking into account the different levels of risk presented by each subgroup. This approach could lead to financial losses for the insurer if higher-risk individuals incur more claims than the average premium covers. Additionally, this could also result in either cross-subsidization where lower-risk individuals are effectively paying for the higher risks of others, or in the higher-risk individuals being undercharged for their level of risk, which would not be sustainable for the insurer in the long run.
Classifying individuals into risk groups can be contentious. The classification directly impacts the premium amount, with the moral hazard and adverse selection being two issues that arise when categorizing individuals into risk groups. An insurance company needs to carefully balance these factors to maintain fairness and profitability in its pricing strategies.