Financial Markets and Institutions (2-downloads)

deductible. A deductible is the amount of any loss that must be paid by the insured

before the insurance company will pay anything. For example, if new canvas yacht

covers cost $5,000 and the yacht owner has $1,000 deductible, the owner will pay the

first $1,000 of the loss and the insurance company will pay $4,000. In addition to

deductibles, there may be other terms in the insurance contract aimed at reducing

risk. For example, a business insured against fire may be required to install and main-

tain a sprinkler system on its premises to reduce the loss should a fire occur.

Although contract terms and deductibles help with the moral hazard problem,

these issues remain a constant difficulty for insurance companies. The insurance

industry’s reaction to moral hazard and adverse selection are discussed in greater

detail in “The Practicing Manager” later in this chapter.

Selling Insurance

Another problem common to insurance companies is that people often fail to seek

as much insurance as they actually need. Human nature tends to cause people to

ignore their mortality, for example. For this reason, insurance, unlike many bank-

ing services, does not sell itself. Instead, insurance companies must hire large sales

forces to sell their products. The expense of marketing may account for up to 20%

of the total cost of a policy. A good sales force can convince people to buy insur-

ance coverage that they never would have pursued on their own yet may need.

Insurance is unique in that agents sell a product that commits the company to a

risk. The relationship between the agent and the company varies: Independent agents

may sell insurance for a number of different companies. They do not have any partic-

ular loyalty to any one firm and simply try to find the best product for their customer.

---

Chapter 21 Insurance Companies and Pension Funds

517

There are in excess of 60,000 independent agents in the United States. Exclusive

agents sell the insurance products for only one insurance company.

Most agents, whether independent or exclusive, are compensated by being paid

a commission. The agents themselves are usually not at all concerned with the level

of risk of any one policy because they have little to lose if a loss occurs. (Rarely are

commissions influenced by the claims submitted by an agent’s customers.) To keep

control of the risk that agents are incurring on behalf of the company, insurance com-

panies employ underwriters, people who review and sign off on each policy an agent

writes and who have the authority to turn down a policy if they deem the risk unac-

ceptable. If underwriters have questions about the quality of customers, they may

order an independent inspector to review the property being insured or request addi-

tional medical information. A final decision to accept the policy may depend on the

inspector’s report (see the Mini-Case box above).

Growth and Organization of Insurance Companies

Figure 21.2 shows the number of life insurance companies from 1950 to 2008. There

was a steady increase in the number until 1988. Since then the number has fallen

steadily. Another interesting point to note about Figure 21.2 is that insurance com-

panies can be organized as either stock or mutual firms. A stock company is owned

by stockholders and has the objective of making a profit.