It is interesting to consider what the effect of the imperfect classification of risks is, both on the insuring companies and on the insured. To the companies it would make no difference of any kind, if all adopted the same classification and applied it in the same way. A general un derestimating of risks would of course lead to ruin. But an imperfect classification, as a re sult of which there were as many risks overesti mated as there were -underestimated, would do them no harm. An average of all kinds, of risks would be perfectly safe for them, provided all kinds of risks were charged for according to the average. Thus if there are ten risks, which, when properly estimated, amount to 1. 2, 3. and so on up to 10, the risk assumed by a company which insured them all would amount to 55; hut the company is equally safe whether it charges each risk according to its proper value. 1. 2. 3, and so on up to 10. or charges each of them according to the average risk, which is Where there are competing gompanies, however, and one estimates risks more closely than the others, the result of imperfect classifi cation is an unfavorable selection of risks. If one company assumed all risks from 1 to 10 at their proper valuation, while another assumed them all at the average valuation of the for mer company would get all the small risks, those from I to 5. and the latter the large ones, those from 6 to 10. We see, then, that where all in surance companies use the same classification, they have no incentive to perfect their system, but where one company introduces a more ac curate classification, others are constrained to do the same or suffer from adverse selection.
The effect of imperfect classification of risks upon the insured is to cause a disproportionate distribution of the burden of insurance. In an ideal system this burden would be so distributed that each person would pay to the company in proportion to the risk he brought upon it. This ideal can never he reached, but the more nearly exact the calculation of risks, the more closely is the ideal approximated. The extent to which the attempt is made to estimate the risks ac curately varies in the different forms of insur ance. It is probably carried furthest in fire insurance, while in life insurance and other simi lar kinds comparatively little attention is Laid to it. Most life insurance companies recognize only two classes of risks, those which conic up to a certain standard and those which fall below it. The latter are rejected, while the former are all accepted at equal rates for equal ages. Vet in many cases the examining physicians would have no hesitation in declaring that sonic of those accepted would in all probability live long er than others. The result of this imperfect classification of risks is like that already noted, that in the long run the stronger and healthier lives pay a part of the cost of insurance of those possessing less viability. This injustice is par
tially eliminated through the return to the in sured of a part of their premiums in the form of dividends, of which the longer lives receive the larger share. But that can mean no more than that the premium rates are scaled so high that the excess paid by the stronger lives is suffi cient to make up the deficiency on the weaker and leave a remnant to be returned as dividends.
The fact that most insurance companies re fuse to insure lives that do not come up to a certain standard suggests the question, What is an insurable risk? The answer clearly is that any risk—that is, any chance of loss depending on the occurrence of any uncertain event—is in surable, provided there are sufficient data to enable the degree of probability to be estimated, and provided it is of such a nature that the in sured cannot too easily make use of the insur ance for his own economic advantage. However hazardous the risk, it may he covered by putting the premium high enough. It is sometimes stated that only those risks are insurable which threaten a large number of individuals at the same time. The larger the number of risks, the more closely the degree of probability can he estimated; but it is possible to make some esti mate of it on the basis of a very small number of risks, and cover the high degree of uncertainty by a high premium rate. No more is it true that the danger must be of such a nature that the loss cannot actually befall a large proportion of the insured at the same time. Here again it is a question of putting the premium rates high enough and accumulating large reserves. If every one of the insured lost at the same time. the company could meet the loss provided it had estimated the risks correctly. Nor. finally, does it make any difference how great the danger of loss may be. It is simply a matter of adjusting premiums to risks. A life insurance company insuring only the lives of consumptives might be on just as sound a financial basis as one which made a specialty of insuring only extra-healthy lives.
But while the theory of insurance is equally applicable to all forms of uncertain losses, its actual extension is limited by practical diffieul ties. The chief one of these is the impossibility of inducing people to pay the high rates which would make it safe for a company to assume very hazardous risks. Unless there is consider able difference between the uncertainty to which an individual is exposed and that to which an insurance company is exposed from the same risk, the gain from insurance becomes very slight, whet' the cost of conducting the business is added to the first cost of the insurance. It is evident, however, that many risks are still untouched by insurance companies which offer a fair field for their activity.