Heterogeneity in Risk Classification

The traditional method of pricing insurance divides risks into various classes for the purposes of collecting statistics, estimating loss distribution, designing products, underwriting (acceptance or rejection), and pricing. Risks are assigned to classes according to various characteristics, for example, age or medical condition. Each member of a class is charged a premium, which is the expected value of the loss distribution assumed to apply to each member of the class. A critical assumption of the traditional method is that classes are essentially homogeneous; that is, all risks in the class have the same loss distribution. Only if all risks in a class are similar can it be argued that the class expected value is the appropriate premium for each individual in the class.