Insurance is a type of investment which insures future uncertain events at a fair price. These uncertain events referred to by insurance providers are expectations of loss which can have a negative financial impact on a person. Insurance companies often determine the price of insurance premiums a person may pay according to the risk class he or she belongs to.
What is a risk class?
Risk class is a grouping of insurance policyholders having the same level of risk or with similar risk characteristics. In order to maintain a financially sound standing in the insurance industry, insurance providers set fair prices by classifying individuals by groups according to the level of risk they have. Risk classifications are normally based on the past experience or the previous records of a person and projections of future trends. However, Insurance companies also estimate insurance rate prices relying on wisdom, insight and good judgment especially when insuring persons without significant history.
In classifying policyholders, insurance companies evaluate the individual and assign him or her to the class with the same characteristic of level of risk. There are four risk classes in insurance namely the standard, substandard, preferred and declined and each class determines the insurance premiums an individual is expected to pay to the insurance company.
The standard class consists of people whose risk of death is the same as everyone else and the premiums paid under this class are base premiums. The substandard category represents people who have greater risk of dying than average persons. One common example of a person under this class is someone whose medical condition or illness decreases life expectancy or whose driving records show repeated traffic offenses whether major or minor. Insurance providers set higher premiums to people under this category mainly because of the high level of risk they present. The preferred class are composed of persons who have lower risk of dying and has a lifestyle which lengthens life expectancy. People under this category pay lesser insurance premiums compared to those under the standard class. Insurance companies consider people with greater risk of dying to be under the declined class. These people present extreme conditions that put insurance providers the risk in providing outrageously high payouts to the policyholders. An example of a person considered under the declined class is someone who has a life threatening job in Afghanistan.
One of the purposes risk class serves is to protect the financial soundness of the insurance company. Buyers are typically free to choose among various sellers but sellers have a limited ability to select buyers. Risk classification a way to effectively minimize and control adverse selection. The instability caused by adverse selection can greatly affect the solvency of an insurance company. Another purpose of risk class is to enhance fairness. This is to avoid discrimination and ensure that every person belonging to a class should have the same insurance costs and that individuals will be placed in a class which suits them according to their previous records and future tendencies.