Final Insurance Outline

Introduction

1. Background

1. Insurance is “a risk-distribution arrangement for the compensation of loss that is entered into by one party as its business”

   1. The principal sellers of insurance are stock companies (owned by SHs) and mutual companies (owned by insureds)

2. Insurance exists because people are risk averse. This means that, all else equal, people prefer to reduce variance even at the cost in a slight diminution in expected value (due to the payment of administrative costs as part of the premium)

   1. Explanations of risk aversion: diminishing marginal utility of wealth

3. Functions of insurance:

   1. Risk transfer from relatively risk averse (insured) to relatively risk neutral (insurer)

      1. Insurer does not experience diminishing marginal utility of wealth. For a corporation, wealth is utility

   2. Risk pooling (diversification): By insuring a large number of insureds posing homogenous and independent risks, an insurer can reduce the variance in its expected losses to a very small range

      1. Law of large numbers: the average obtained from a large number of trials should be close to the expected value, and will tend to become closer as more trials are performed

         1. A consequence of this theorem is that highly unpredictable individual events may be highly predictable in the aggregate

      2. Dynamics of insurance markets:

         1. The smaller the pool of insureds, the higher the premium that is required to insure the risk

         2. If premium is calculated correctly, the insured’s expected value remains the same (minus administrative costs), but variance is eliminated

   3. Risk allocation: Insurers attempt to set a premium that is proportional to the degree of risk posed by each insured.

      1. Insurers thereby create incentives for insureds to optimize the degree of risk they pose

4. Social functions of insurance:

   1. Insurance affects norms

   2. Acts as a surrogate regulator or instrument of governance

      1. E.g., drivers who cannot obtain liability insurance because of their accident records are effectively prohibited from driving

   3. Insurance has a redistributive effect

      1. Redistributes wealth from the lucky to the unlucky

   4. Because of social role, insurance necessarily subject to regulation beyond that of other private activity

      1. Solvency regulation is crucial to maintain the market

      2. Mutual insurers that run large surplus are required to rebate money to insureds

2. Adverse Selection & Moral Hazard

Adverse Selection and Moral Hazard are two market dynamics resulting from asymmetrical information benefitting the insured; each dynamic creates inefficiency in insurance markets.

5. Adverse Selection: A dynamic that can occur in an insurance market where (a) individuals present different levels of risk; and (b) there is asymmetrical information benefitting the insured, such that (c) high-risk individuals are more likely to seek coverage than low-risk individuals.

   1. This dynamic drives up premiums, which causes low-risk individuals to exit market, further driving up premiums

      1. Cost of coverage becomes increasingly expensive, pool of insureds becomes increasingly small

      2. Market can unravel completely

Insurance does not work well when the insured’s behavior affects its risk:

6. Moral Hazard is “the tendency of any insured party to exercise less care to avoid an insured loss than would be exercised if the loss were not insured.”

   1. Essentially, the concern is that insurance may skew incentives, either allowing the insured to completely externalize the cost of a loss and thus become loss-neutral, or by allowing the insured to claim a profit from a socially destructive activity (if the amount of recovery exceeds the insured interest)

      1. Deductibles can make sure that the risk of loss is not completely externalized

      2. Increased monitoring can reduce the risk of moral hazard

         1. If insurers had perfect ability to monitor insureds, insurance would not be plagued by moral hazard

To combat Adverse Selection and Moral Hazard, insurers seek to obtain more information about insureds (underwriting) – or to cause insureds to internalize some of their losses (experience-rating, use of deductibles, and dollar-limits on coverage).

Adverse Selection must not be overstated. Applicants may incorrectly estimate their own risk. And if especially risk averse, applicants may remain in the insurance pool even if they are charged more for coverage than perfect actuarial calculations would dictate. The result may be a tolerable level of cross-subsidization within the risk pool.

Moral Hazard exists to varying degrees for different forms of insurance. E.g., given drivers’ instinct for self-protection, auto liability insurance probably does not significantly influence driving behavior.

• What is distinctive about insurance contracts that make them worthy of their own course?

  • Specific policy concerns raised by: moral hazard and adverse selection

  • One other distinctive feature: the contracts often involve large losses, which means large contract disputes. A lot of money at stake, so the temptations for opportunism or strategic behavior or shirking are considerable

    • Significant temptation for claimants to file false claims

    • Significant temptation for insurers to deny valid claims

      • Market forces put some pressure on insurers to pay claims, for fear of developing reputation of being unreliable

      • “Post claim underwriting” – tendency for insurers to closely scrutinize contracts for prior misrepresentations after claims are lodged

      • Offering lowball settlements to parties who are under duress – too risk averse to seek litigation – highly unequal bargaining power between individual who has suffered loss and insurance company

        • The tort of insurance bad faith attempts to respond to “lowballing” concern. See Whiten v. Pilot Ins. Co., in which the defendant “pursued a hostile and confrontational policy calculated to force the appellant to settle her claim at substantially les than its fair value.” The plaintiff in that case prevailed on a bad faith claim and was awarded...

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