Final answer:
Risk Retention Groups are liability insurers owned by their policyholders that cater to those with similar risks. They serve as a self-insurance mechanism, where actuarial fairness is crucial to ensure premiums cover claims, operating costs, and profits. Classifying into risk groups can be controversial due to the problems of moral hazard and adverse selection. The correct option is B.
Step-by-step explanation:
Risk Retention Groups (RRGs) are liability insurers that are owned by their policyholders. They are designed for policyholders that face similar risks and who want to retain a portion of those risks collaboratively. RRGs are a self-insurance option whereby the members are insureds that collectively cover each other's losses.
Owners of RRGs share a common business or activity with similar liability risks, which creates a natural group to share and manage these risks. For instance, healthcare providers might join a Risk Retention Group to insure against malpractice claims, thereby sharing the risk among themselves.
Classifying individuals into risk groups is a common practice in the insurance industry to set premium rates fairly based on similar risk profiles. This practice entails understanding that not all policyholders face the same level of risk, and it's influenced by various factors like location, personal habits, or past claims.
However, the process can be contentious when determining how to classify policyholders, especially after a policyholder experiences an adverse event like a car accident. The insurance company must then decide if the event indicates a higher future risk or was merely an unfortunate occurrence.
Actuarial fairness is important as it ensures that over time the premiums collected cover the claims paid out, the operating costs of the insurance company, and allow for a profit. Aligning premiums with risk helps maintain this fairness but is challenged by imperfect information, leading to two major issues: moral hazard and adverse selection.
Both issues arise when policyholders or insurers act on asymmetric information regarding risk, potentially leading to misclassification into risk groups or inappropriate pricing of insurance policies. It's crucial for insurers to balance the need for accurate risk assessment with the potential for disputes over classification into risk groups.