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

A life insurer offers two policy menus without knowing customers' health: Policy X has full cover at a high premium; Policy Y has partial cover at a low premium. Customers choose according to their own risk type, so the choice itself reveals it. Which concept does this describe, and what condition makes it work?

This is screening through self-selection. The uninformed insurer offers a menu of contracts so that high-risk customers prefer full cover and low-risk customers prefer cheaper partial cover. It works only when each type finds its own contract better than the alternative, which is incentive compatibility.

  1. ASignalling by the insurer; it works if premiums are identical
  2. BScreening through self-selection; it works if the contracts are designed so each risk type prefers its own contractCorrect
  3. CMoral hazard control; it works if claims are never verified
  4. DCredit rationing; it works if the interest rate is raised
  5. Predatory pricing; it works if the insurer undercuts rivals

Explanation

The uninformed party designs a menu so that types sort themselves, which is screening by self-selection. It requires incentive compatibility: high-risk customers must prefer full cover, and low-risk customers must prefer partial cover. Signalling is done by the informed party, so option A is wrong.

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