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Chapter 5

Chapter 5 BU353.docx

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Wilfrid Laurier University
Heather Graham

BU353 Chapter 5 – Insurability of Risk, Contractual Provisions, and Legal Doctrines Week 3 Factors that Limit the Insurability of Risk Premium Loadings -Because premiums almost always have a positive loading, risk-averse people will demand less than full coverage -As the loading increases, the quantity of coverage demanded is likely to decrease -Higher premium loadings generally imply less coverage -Exposures with low severity of losses are not likely to be insured on an individual basis because the fixed costs associated with underwriting and distribute a policy makes the loading very high compared to expected loses -Items with low value and thus low severity are more likely to be insured if they are bundled together with other exposures -When the probability of a loss is high, insurance is less likely to be provided -With a high probability of loss, expected claim costs are high, which in turn causes administrative costs, which are proportional to expected claim costs, to be high -When losses are highly correlated across potential policyholders, the variance of the distribution of average loses also will be high -When insurers are uncertain about the true expected losses of insured, parameter uncertainty is said to exist -A high level of parameter uncertainty about expected losses can limit the insurability of losses -Parameter uncertainty causes the distribution of average losses around the insurer’s estimate of expected loss per policyholder to have greater variance, which is the same effect as having high correlation in losses -Some parameter uncertainty always exists; insurers simply cannot know the true expected losses of group of insured Moral Hazard -Moral hazard – the effect of insurance on the insured’s incentives to reduce expected losses -Insurers understand that insurance reduces policyholders’ incentive to prevent losses -As a result of moral hazard, insurance contracts are not likely to offer full coverage -Moral hazard increases the cost of coverage that is provided by increasing expected claim costs -Two conditions for moral hazard: -Expected losses must depend on the insured’s behaviour after having obtained insurance -It must be costly for the insurer to observe precautions by policyholders and measure their impact on expected claim costs -Insurance can affect the incentive to take precautions -To solve this, make the premium or coverage contingent on the insured’s behaviour during the policy period – Ex. If a driver increases expected claim costs by driving fast, then the premium could be increased immediately or coverage reduced -Monitoring can be expensive – monitoring will be used only if it is cost-effective -Monitoring is common after a claim occurs -Two major methods of reducing moral hazard: -Experience rating -Limiting coverage -One reason for experience rating is to incorporate new information about future expected claim costs into the premium -Since insurance creates moral hazard, providing less insurance reduces moral hazard -Moral hazard implies that there is a trade-off between risk shifting and incentives -A balance is needed between people being risk averse and people being carefree when they have insurance Adverse Selection -Adverse selection – situations in which consumers have different expected losses, but the BU353 Chapter 5 – Insurability of Risk, Contractual Provisions, and Legal Doctrines Week 3 insurer is unable to distinguish between the two types of consumers and charge them different premiums -Classification (basing premiums on expected claim costs) reduces adverse selection -Insurers understand adverse selection, and they design and price policies taking it into account -Adverse selection limits the insurability of risk for consumers with low expected losses Contractual Provisions that Limit Coverage Deductibles -A common way to limit the amount of coverage is through deductibles, which eliminate coverage for relatively small losses -Deductibles chosen by policyholders are likely to increase in size as premium loadings increase -One reason that policies have deductibles is to reduce the costs of processing small claims that occur relatively frequently -Deductibles reduce moral hazard -Insurers may also be able to use deductibles to induce: -High expected loss consumers to choose a policy that is price to reflect their expected claim costs -Low expected loss consumers to choose a policy with a larger deductible that is priced to reflect their lower expected claim costs -Contracts may be designed to induce consumers to reveal their expected loss by their choice of deductible -The extent to which insurers actually are able to design policies to induce consumers to separate themselves into distinct risk classes is uncertain Coinsurance -Coinsurance – requires an insured to pay a specified proportion of the loss -The effect of coinsurance is to provide less than full coverage, in line with what risk-averse consumers prefer when policies have a positive loading -Reduces moral hazard -Since the insured pays part of any loss with a coinsurance provision, the insured has a greater incentive to reduce losses with the coinsurance provision Policy Limits -Policy limit – insurance policies use these to limit the amount of coverage by placing an upper limit on the amount that the insurer will pay for any loss -Always used in liability insurance policies -Keep people from paying for coverage in excess of the amount of loss that they could sustain Coordination of Loss Payments (Pro Rata and Excess Coverage Clauses
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