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IAI Actuarial Core Principles · Business Economics · Pricing strategies in the financial services sector

A bank in India charges higher interest rates to borrowers it classifies as higher default risk, using credit scores. Which statement best explains why risk-based pricing can improve efficiency compared with a single rate for all borrowers?

Risk-based pricing matches the interest rate to expected default cost, so low-risk borrowers no longer subsidise high-risk ones and are less likely to leave the market. This limits adverse selection. It does not eliminate default risk or make everyone pay the same.

  1. AIt ensures all borrowers pay the same effective cost of credit
  2. BIt reduces cross-subsidy from low-risk to high-risk borrowers and limits adverse selectionCorrect
  3. CIt eliminates default risk entirely
  4. DIt guarantees that the bank earns a monopoly profit
  5. It removes the need for collateral in all loans

Explanation

Pricing by risk aligns price with expected cost, so safer borrowers are not charged to subsidise riskier ones and are less likely to be driven out of the market. It does not remove default risk, ensure equal costs, or guarantee monopoly profit.

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