Financial Markets and Institutions (2-downloads)

Insurance Management

Insurance companies, like banks, are in the financial intermediation business of trans-

forming one type of asset into another for the public. Insurance companies use the

premiums paid on policies to invest in assets such as bonds, stocks, mortgages, and

other loans; the earnings from these assets are then used to pay out claims on the poli-

cies. In effect, insurance companies transform assets such as bonds, stocks, and loans

into insurance policies that provide a set of services (for example, claim adjustments,

savings plans, friendly insurance agents). If the insurance company’s production

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process of asset transformation efficiently provides its customers with adequate insur-

ance services at low cost and if it can earn high returns on its investments, it will make

profits; if not, it will suffer losses.

In Chapters 2 and 7 the concepts of adverse selection and moral hazard allowed

us to understand why financial intermediaries such as insurance companies are

important in the economy. Here we use the adverse selection and moral hazard con-

cepts to explain many management practices specific to the insurance industry.

In the case of an insurance policy, moral hazard arises when the existence of

insurance encourages the insured party to take risks that increase the likelihood of

an insurance payoff. For example, a person covered by burglary insurance might

not take as many precautions to prevent a burglary because the insurance company

will reimburse most of the losses if a theft occurs. Adverse selection holds that the

people most likely to receive large insurance payoffs are the ones who will want to

purchase insurance the most. For example, a person suffering from a terminal dis-

ease would want to take out the biggest life and medical insurance policies possi-

ble, thereby exposing the insurance company to potentially large losses. Both adverse

selection and moral hazard can result in large losses to insurance companies because

they lead to higher payouts on insurance claims. Minimizing adverse selection and

moral hazard to reduce these payouts is therefore an extremely important goal for

insurance companies, and this goal explains the insurance practices we discuss here.

Screening

To reduce adverse selection, insurance companies try to screen out poor insurance

risks from good ones. Effective information collection procedures are therefore an

important principle of insurance management.

When you apply for auto insurance, the first thing your insurance agent does is

ask you questions about your driving record (number of speeding tickets and acci-

dents), the type of car you are insuring, and certain personal matters (age, marital

status). If you are applying for life insurance, you go through a similar grilling, but

you are asked even more personal questions about such things as your health, smok-

ing habits, and drug and alcohol use. The life insurance company even orders a

medical evaluation (usually done by an independent company) that involves taking

blood and urine samples. The insurance company uses the information you provide

to allocate you to a risk class—a statistical estimate of how likely you are to have

an insurance claim. Based on this information, the insurance company can decide

whether to accept you for the insurance or to turn you down because you pose too

high a risk and thus would be an unprofitable customer for the insurance company.

Risk-Based Premium

Charging insurance premiums on the basis of how much risk a policyholder poses for

the insurance company is a time-honored principle of insurance management. Adverse

selection explains why this principle is so important to insurance company profitability.

To understand why an insurance company finds it necessary to have risk-based

premiums, let’s examine an example of risk-based insurance premiums that at first

glance seems unfair. Harry and Sally, both with no accidents or speeding tickets, apply

for auto insurance. Harry, however, is 20 years old, while Sally is 40. Normally, Harry

will be charged a much higher premium than Sally. Insurance companies do this

because young males have a much higher accident rate than older females. Suppose,

though, that one insurance company did not base its premiums on a risk classifica-

tion but rather just charged a premium based on the average combined risk for those

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You may recognize that the example here is in fact an example of the lemons problem described in

Chapter 7.

it insures. Then Sally would be charged too much and Harry too little. Sally could

go to another insurance company and get a lower rate, while Harry would sign up

for the insurance. Because Harry’s premium isn’t high enough to cover the acci-

dents he is likely to have, on average the company would lose money on Harry. Only

with a premium based on a risk classification, so that Harry is charged more, can

the insurance company make a profit.

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Restrictive Provisions

Restrictive provisions in policies are another insurance management tool for reducing

moral hazard. Such provisions discourage policyholders from engaging in risky activ-

ities that make an insurance claim more likely. One type of restrictive provision keeps

the policyholder from benefiting from behavior that makes a claim more likely. For

example, life insurance companies have provisions in their policies that eliminate death

benefits if the insured person commits suicide. Restrictive provisions may also require

certain behavior on the part of the insured that makes a claim less likely. A company

renting motor scooters may be required to provide helmets for renters in order to

be covered for any liability associated with the rental. The role of restrictive provisions

is not unlike that of restrictive covenants on debt contracts described in Chapter 7:

Both serve to reduce moral hazard by ruling out undesirable behavior.

Prevention of Fraud

Insurance companies also face moral hazard because an insured person has an incen-

tive to lie to the company and seek a claim even if the claim is not valid. For exam-

ple, a person who has not complied with the restrictive provisions of an insurance

contract may still submit a claim. Even worse, a person may file claims for events that

did not actually occur. Thus, an important management principle for insurance com-

panies is conducting investigations to prevent fraud so that only policyholders with

valid claims receive compensation.

Cancellation of Insurance

Being prepared to cancel policies is another insurance management tool. Insurance

companies can discourage moral hazard by threatening to cancel a policy when the

insured person engages in activities that make a claim more likely. If your auto insur-

ance company makes it clear that if a driver gets too many speeding tickets, cover-

age will be canceled, you will be less likely to speed.

Deductibles

The deductible is the fixed amount by which the insured’s loss is reduced when a

claim is paid off. A $250 deductible on an auto policy, for example, means that if

you suffer a loss of $1,000 because of an accident, the insurance company will pay

you only $750. Deductibles are an additional management tool that helps insurance

companies reduce moral hazard. With a deductible, you experience a loss along with

the insurance company when you make a claim. Because you also stand to lose

when you have an accident, you have an incentive to drive more carefully. A

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deductible thus makes a policyholder act more in line with what is profitable for

the insurance company; moral hazard has been reduced. And because moral haz-

ard has been reduced, the insurance company can lower the premium by more than

enough to compensate the policyholder for the existence of the deductible.

Another function of the deductible is to eliminate the administrative costs of

small losses by forcing the insured to bear these losses.

Coinsurance

When a policyholder shares a percentage of the losses along with the insurance com-

pany, their arrangement is called coinsurance. For example, some medical insur-

ance plans provide coverage for 80% of medical bills, and the insured person pays

20% after a certain deductible has been met. Coinsurance works to reduce moral haz-

ard in exactly the same way that a deductible does. A policyholder who suffers a

loss along with the insurance company has less incentive to take actions, such as

going to the doctor unnecessarily, that involve higher claims. Coinsurance is thus

another useful management tool for insurance companies.

Limits on the Amount of Insurance

Another important principle of insurance management is that there should be lim-

its on the amount of insurance provided, even though a customer is willing to pay

for more coverage. The higher the insurance coverage, the more the insured per-

son can gain from risky activities that make an insurance payoff more likely and hence

the greater the moral hazard. For example, if Zelda’s car were insured for more than

its true value, she might not take proper precautions to prevent its theft, such as mak-

ing sure that the key is always removed or putting in an alarm system. If her car were

stolen, she comes out ahead because the excessive insurance payoff would allow

her to buy an even better car. By contrast, when the insurance payment is lower than

the value of her car, she will suffer a loss if it is stolen and will thus take the proper

precautions to prevent this from happening. Insurance companies must always make

sure that their coverage is not so high that moral hazard leads to large losses.

Summary

Effective insurance management requires several practices: information collection and

screening of potential policyholders, risk-based premiums, restrictive provisions, pre-

vention of fraud, cancellation of insurance, deductibles, coinsurance, and limits on the

amount of insurance. All of these practices reduce moral hazard and adverse selection

by making it harder for policyholders to benefit from engaging in activities that

increase the amount and likelihood of claims. With smaller benefits available, the poor

insurance risks (those who are more likely to engage in the activities in the first place)

see less benefit from the insurance and are thus less likely to seek it out.

Credit Default Swaps

CDSs have been mentioned several times earlier in this text, but it is appropriate

to discuss them in the context of insurance. A CDS is insurance against default on

a financial instrument, usually some kind of securitized bond. Typically, the holder of

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debt will buy a CDS from an investment or insurance company, such as AIG to shift

the risk of default to a third party. When the probability of default is low, the cost

of the CDS is similarly low. By lowering the risk of these insured bonds with default

insurance, the market price of the bonds would increase.

Between 1995 and 2009 the amount of CDSs exploded, along with the market-

ing of securitized mortgages. By their peak in 2008 there were about $62 trillion of

CDSs outstanding (note that the GDP of the entire world is about $60 trillion). A

London subsidiary of the giant insurance company, AIG, was issuing vast amounts.

Since most players in the market did not anticipate the collapse of the real estate and

mortgage bond markets, few saw great risk in the CDSs being issued around the

world. One reason for the growth was that there was no real regulatory restraint.

At the beginning of this chapter, we noted that one of the primary tenets of insur-

ance is that before you can buy an insurance policy, you must have something to lose.

You cannot buy insurance on your neighbor just because you think he has been

looking unhealthy lately. The CDSs market allowed speculators to do just that with

companies. If they saw a company that looked unhealthy, even though they may

not hold any interest in the firm, they could buy insurance against its failure. Many

likened this to gambling, and in fact, Congress passed a law that exempted CDSs from

state gaming laws as part of the Commodity Futures Modernization Act of 2000.

As the mortgage crisis unfolded and the true risk that had been accepted by

issuers of CDSs became clear, they led to their near bankruptcy and eventual need

for a $182 billion bailout of AIG.

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