Financial Markets and Institutions (2-downloads)

2. The insured must provide full and accurate information to the insur-

ance company.

3. The insured is not to profit as a result of insurance coverage.

4. If a third party compensates the insured for the loss, the insurance company’s

obligation is reduced by the amount of the compensation.

5. The insurance company must have a large number of insureds so that the risk

can be spread out among many different policies.

6. The loss must be quantifiable. For example, an oil company could not buy a pol-

icy on an unexplored oil field.

7. The insurance company must be able to compute the probability of the 

loss occurring.

The purpose of these principles is to maintain the integrity of the insurance

process. Without them, people may be tempted to use insurance companies to gam-

ble or speculate on future events. Taken to an extreme, this behavior could under-

mine the ability of insurance companies to protect persons in real need. In addition,

these principles provide a way to spread the risk among many policies and to estab-

lish a price for each policy that will provide an expectation of a profitable return.

Despite following these guidelines, insurance companies suffer greatly from the prob-

lems of asymmetric information that we first described in Chapter 2.

Adverse Selection and Moral Hazard 

in Insurance

Recall that adverse selection occurs when the individuals most likely to benefit

from a transaction are the ones who most actively seek out the transaction and are

thus most likely to be selected. In Chapter 2 we discussed adverse selection in the

context of borrowers with the worst credit being the ones who most actively seek

loans. The problem also occurs in the insurance market. Who is more likely to

apply for health insurance, someone who is seldom sick or someone with chronic

health problems? Who is more likely to buy flood insurance, someone who lives on

a mountain or someone who lives in a river valley? In both cases, the party more

likely to suffer a loss is the party likely to seek insurance. The implication 

of adverse selection is that loss probability statistics gathered for the entire 

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Part 6 The Financial Institutions Industry

population may not accurately reflect the loss potential for the persons who actu-

ally want to buy policies.

The adverse selection problem raises the issue of which policies an insurance

company should accept. Because someone in poor health is more likely to buy a

supplemental health insurance policy than someone in perfect health, we might pre-

dict that insurance companies should turn down anyone who applies. Since this does

not happen, insurance companies must have found alternative solutions. For exam-

ple, most insurance companies require physical exams and may examine previous

medical records before issuing a health or life insurance policy. If some previous ill-

ness is found to be a factor in the person’s health, the company may issue the pol-

icy but exclude this preexisting condition. Insurance firms often offer better rates

to insure groups of people, such as everyone working at a particular business, because

the adverse selection problem is then avoided.

In addition to the adverse selection problem, moral hazard plagues the insur-

ance industry. Moral hazard occurs when the insured fails to take proper precau-

tions to avoid losses because losses are covered by insurance. For example, moral

hazard may cause you not to lock your car doors if you will be reimbursed by insur-

ance if the car is stolen. When hurricanes are approaching, many yacht owners do

not take down their old canvas covers because they hope the covers will be destroyed

by the hurricane, in which case the owners can file a claim with the insurance com-

pany and get money to buy new covers. Those with new canvas will take precau-

tions to protect it.

One way that insurance companies combat moral hazard is by requiring a