RMI 2101 Lisa Zimmaro 1 Module II Topic 9 Requirements of an Insurance Risk Price of Insurance Administrative Costs Pure Premium Risk Charge Demand for Insurance o Fair Price Market Value o Stated Premium Pmax Maximum amount a person or firm is willing to pay for insurance o Price of Insurance Pmax Market Exists o Price of Insurance Pmax No Market Risk is not insurable If Pmax would be too low then Unique to Decision Maker o You are underestimating the frequency or severity o Subjective Specific Requirement for an Insured Risk o Random Act Accidental Not accidental Willful Intentional Moral Hazard o Insured should have control over increasing frequency severity but should have control over decreasing frequency severity o Suicide Homicide o Practice Risk Control Risk Reduction Techniques o Lower Premiums Incentives Solutions to Address The Moral Hazard of Insurance Payments 1 Deductibles 2 Higher Premiums 3 New Lower limits in place 4 Experience Rating Workers Comp premium will go up Solutions 1 4 are referred to as Skin in The Game A Loss should NOT be catastrophic to the Insurer But it can be catastrophic to the Insured If there is a Catastrophic Loss o Individual suffers Its OK o It is NOT OK for Insurer to suffer because then everyone will suffer Lose a lot of money What can Insurance Companies do to Prevent Catastrophic Loss Natural Disasters o Reinsurance o Diversifying o Line of Coverage is still property coverage Spread out geographically When its difficult to predict the overall expected loss Insurance Companies will o Raise Premium o Raise Risk Charge RMI 2101 Lisa Zimmaro 2 o They must Diversify Law of Large Numbers Insurance Companies do not expect want multiple losses to occur at the same time When Losses are not independent They happen at the same time Assumes that Random events are independent o Earthquakes o Hurricanes Diversify o Geographically Diversify o Diversify Financially o Diversify Lines of Coverage he same time o Life Insurance Workers Comp o Health Benefits Insurance TRIA Terrorism Risk Insurance Act EXAMPLES Workers Comp Terrorist Attack on the World Trade Center Multiple losses occurred at o Terror is excluded If designated a terroristic act Could be excluded Sexual Assault Molestation now being excluded Penn State Sandusky o Deep Pocket o Knew or Should have Known ER Large Loss Principle Insurable Interest o Smaller losses are better off being paid out of pocket or through savings o Demonstrate a Loss o In the event of a loss Insured must lose Financially or incur some other harm in order for there to be a valid contract Purpose of Insurable Interest o Reduces Moral Hazard o Unless the Insured stands to lose Financially they may cause the loss which violates Moral Hazard o Serves as a measurable amount of recovering o Cannot profit from Insurance When Must The Interest Exist o Property Liability Loss At the time of the loss o Life Insurance Interest must exist at the time that the contract is signed Loss should be Definite Determinable o Definite Easy to verify that a loss has occurred Death Fire Property Damage Difficult to Verify Theft Certain Types of Injuries o Determinable Easy to place a value on the loss or easy to determine the value RMI 2101 Lisa Zimmaro 3 SOLUTIONS o Definite Independent Verification Verify Police Report Official Documents Appraisals Claims Investigations Accident Reconstruction Surveillance Forensics o Determinable Limit Cap on Insurance Policy Determining the value in advance Art Antiques Collectibles Loss Settlement Rules In Contract Large Number of Homogeneous Exposure Units o Take advantage of the Law of Large Numbers Get Accurate estimate of premium Homogeneous Units o Risk Pool should be the same or similar risk with the same expected loss Underwriter of Insurance Company Has 2 Decisions o Insure or Don t Insure o If yes how much premium Auto Policy o History as a driver of Accidents of Violations Severity of Accidents Violations Education with driving instructor Credit Score Insurer thinks everyone in the group is the same o P 1 P 2 P 3 P 10 Change Premium P 5 o Age Sex Marital Status Location Type of Vehicle of Miles Driven Level of o Groups 1 4 Low Risk Over Paying o Groups 6 10 Higher Risk Under Paying o Groups 1 4 Leave go to other Insurance Company Lower Rates o Groups 5 10 Now the Average is P 7 Groups 5 6 Over Paying Group 7 OK Groups 8 10 Under Paying Eventually The Risk Pool Break Down RMI 2101 Lisa Zimmaro 4 o High Risk is Only 1 left o High Risk clients Premium has to go up dramatically Adverse Selection Death Spiral Adverse Selection wrong Insurer Offers Insurance in the Market Place for Stated Premium Arises when the assumption regarding homogeneous exposure units is o They want P 5 to be their customer o Otherwise only High Risk will buy coverage at a greater proportion than Low Risk o Insured knows more about the Risk than the carrier Insured is unwilling to share Asymmetric Information information o Insurer gets bad info Insured lied Lower Premium OR Lying because you are a high Risk o Rates that the Insurer can charge Assumes that the group is the same everyone is charged the same amount No incentive to be Low Risk In group No penalty for being High Risk Insurance Companies Cannot Ask The Right Question Low Risk subsidizing the High Risk o Some states have restrictions on the use of underwriting classifications o Gender Fair discrimination or Unfair o Social Equity Insurers can t alter premium because of factors outside the Insured s Social Cost control Can t Control Gender Race Age