Why does a disability insurer assign applicants to different risk classes (preferred, standard, substandard) rather than charging everyone the same premium?
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Answer & full 3-part explanation (select an option above, or peek)
Why A is correct
Risk classification groups applicants by their expected claim experience so each class pays a premium proportionate to its own probability of loss. Preferred risks, who are unlikely to claim, pay less; substandard risks, whose health, occupation, or hobbies raise claim likelihood, pay more. Without classification, a single premium would force low-risk insureds to subsidize high-risk ones, which both penalizes good risks and invites adverse selection as high-risk applicants flock to the underpriced product. Classification therefore keeps the premium structure fair, actuarially sound, and sustainable for the disability pool as a whole.
Why the other options are wrong
- B) Classification is used to price risk fairly, not to purge applicants. Higher classes still receive coverage, just at a premium or with terms that reflect the elevated probability of loss; denial is reserved for unacceptable risks.
- C) State law does not mandate exactly three premium levels. Preferred, standard, and substandard are common industry descriptors, but insurers may use a range of classifications and premium structures as long as they are actuarially sound.
- D) Uniform pricing for all members would actually simplify administration, but it would also force low-risk insureds to subsidize high-risk ones, driving the pool toward adverse selection. Classification exists to avoid that cross-subsidy.
Memory hook
Classify the risk so each class pays its own way, no free rides.