Optimizing insurance pricing by incorporating consumers’ perceptions of risk classification

From a regulatory viewpoint, for example, the judgment of the European Court of Justice (ECJ) led to an adjustment of existing underwriting on March 1, 2011 introducing a ban on the use of the gender criterion in insurance pricing. Because of the court’s decision, insurance companies had to offer unisex premiums from December 21, 2012 onwards in the European Union (EU, ECJ 2010, p. 7). In this specific context, the question arose whether current risk-based pricing methods are adequate.

American research intensively dealt with fairness issues and the adjustment of insurers’ pricing methods because of gender discrimination during the late seventies. The starting point of this process in the U.S. were debates on the adequacy of using group mortality tables in pricing pension plans that result in different pension payments for both sexes. Several authors analyze whether the use of these gender-specific tables is fair and examine how they may lead to gender discrimination in pension scheme calculation (Hedges 1977; Martin 1977; Myers 1977; Brilmayer et al. 1979; Kimball 1979; Laycock and Sullivan 1981; Benston 1982, 1983; Hickman 1983). Two U.S. Supreme Court judgments (the Manhart Case, U.S. Supreme Court 1978 and the Norris Case, U.S. Supreme Court 1983) ruled that the use of life tables that lead to differences in pension payments for each sex violates Title VII of the 1964 Civil Rights Act.

The use of genetic tests in pricing life insurance is banned within most Western Europe states, with a few exceptions for high sum insurance (Durnin et al. 2012, p. 127). This aspect is not further explored in this study because the use of genetic tests continues to have little relevance for insurance pricing.

The pay-as-you-drive (PAYD) approach has been partially tested through pilot projects and was successfully implemented in pricing motor insurance by several countries, e.g., the U.K. and the Netherlands. Insurers in Germany and France have also considered introducing PAYD insurance rates.

The European segment includes Western (31.7 % of global premiums written) as well as Central and Eastern Europe (1.6 %). The latter countries together comprise one percent of global premiums written (Seiler et al. 2013, p. 33).

From an economic viewpoint, risk-adequate pricing based on various risk-rating factors help to reduce information asymmetries (Teufel et al. 2001, p. 17). This phenomenon is widespread in the insurance market, with the consequence that insurers often only know a potential policyholder’s average loss occurrence probability (Teufel et al. 2001, p. 17). Without risk differentiation based on individual consumer data, insurance companies determine price based on the worst risk. The result is that “good” risks are too expensive and the premiums for “bad” risks are accordingly too low (Abraham 1985, p. 408). These adverse selection effects can lead to financial losses, and under unfavorable management or market conditions, they can also result in market failure with negative effects for society as a whole (Akerlof 1970, p. 488). Furthermore, inadequate risk evaluation and classification lead to unfavorable risk behavior (namely, moral hazard, Abraham 1985, p. 405). Rothschild and Stiglitz (1976, p. 648) argue, “if individuals were willing or able to reveal their information, everybody could be made better off.”

Cunningham et al. (2005, p. 167) define perceived risk “as a multidimensional construct of physical loss, financial loss, psychological loss, time loss, performance risk, and social risk.”