Ins301 Ch 8&10 1 Fair Premiums, Insurability of Risk and Contractual Provisions Fair Insurance Premiums What limit the insurability of risk Contractual provisions Legal Doctrines
Ins301 Ch 8&10 1
Fair Premiums, Insurability of Risk and Contractual Provisions
Fair Insurance Premiums What limit the insurability of risk Contractual provisions Legal Doctrines
Ins301 Ch 8&10 2
Insurance Costs and Fair Premiums
Fair premium The premium level that is just sufficient to fund the
insurer’s expected costs and provide insurance company owners with a fair return on their investment. It includes
Expected claim costs Investment income Administrative costs Fair profit loading
Ins301 Ch 8&10 3
Claim tail and present value
The lag between the time that coverage is sold and claims are paid is known as the claim tail.
It affects expected losses
Ins301 Ch 8&10 4
Example
Suppose a liability claim longs for 3 years. In the first year, the loss amount on average is $700. In the second year, the loss amount is $200. the loss amount is $100 in the third year. Interest rate is 5%. What is the expected loss?
Ins301 Ch 8&10 5
Premium loadings
Two Bicycles one worth $200 and the other worth $6000. Assume that the probability of each bike being stolen is 0.05. Assume that the fixed costs of paying employees to market, underwrite, and process an application for bike insurance are $100 and that capital costs are 0. ignoring investment income, what are the fair premiums for both?
Ins301 Ch 8&10 6
Moral Hazard
If you purchase a full-coverage theft insurance, will you still take precautions to reduce the likelihood of theft?
Ins301 Ch 8&10 7
Conditions for Moral Hazard
Two conditions cause moral hazard Expected losses depend on insured’s behavior Effect of behavior on expected losses is costly to
observe and measure Example:
Claim costs increase with driving speed Costly for insurers to monitor driving speed
Ins301 Ch 8&10 8
Adverse Selection
If insurer is unable to distinguish between the two types of consumers with different risk level and thus change them the same premium, what will happen?
Ins301 Ch 8&10 9
Factors Limiting the Insurability of Risk
Ins301 Ch 8&10 10
Deductibles
Example: policy with a $500 deductible then policyholder pays first $500 of losses
Types of deductibles per occurrence aggregate
Ins301 Ch 8&10 11
Deductibles and Claim Processing Costs
Deductibles reduce cost of processing small claims Example:
Fixed claim processing cost of $200 $2000 with probability 0.01
Loss = 100 with probability 0.10
0 with probability 0.89
Expected claim cost w/o a deductible = ______ Expected claim cost w a $100 deductible = ______ Marginal cost of insuring the $100 loss equals _______
Ins301 Ch 8&10 12
Deductibles, Moral Hazard, and Adverse Selection
Deductibles reduce moral hazard why? Deductibles might be used to reduce adverse
selection. How?
Ins301 Ch 8&10 13
Coinsurance
With coinsurance, insured pays a proportion (the coinsurance rate) of any loss
Example: Insured pays 20% of all medical costs
Reason for coinsurance provisions Insureds demand less than full insurance when the
policy has a loading Reduce moral hazard
Ins301 Ch 8&10 14
Policy Limits
A policy limit is the maximum amount that the insurer will pay
Liability insurance always has a policy limit
Property insurance often has a policy limit
Ins301 Ch 8&10 15
Purpose of Policy Limits
Reduce classification costs when consumers have information that is costly for insurers to obtain
Example: Homeowners’ policy might limit coverage for jewelry losses
to $2,500 Those with more expensive jewelry buy special coverage Insurer does not have to investigate the value of each
policyholder’s jewelry
Ins301 Ch 8&10 16
Pro Rata and Excess Coverage Clauses
Issue: How is coverage divided when multiple policies apply to the same loss
Pro rata clause: divide in proportion to amount of coverage
Excess clause: one policy pays losses in excess of the other policy’s limit
Why have these clauses? prevent coverage in excess of loss, which would cause
moral hazard
Ins301 Ch 8&10 17
Exclusions
Policies exclude coverage for some types of losses
Why?
reduce administrative costs reduce capital costs reduce moral hazard reduce adverse selection
Ins301 Ch 8&10 18
Indemnity versus Valued Contracts
Indemnity contract - insurer pays based on the amount of loss that occurred
Example: auto physical damage
Valued contract - insurer pays a pre-determined amount
Example: life insurance
Ins301 Ch 8&10 19
Indemnity versus Valued Contracts
Type of contract is largely explained by The costs of assessing value: when the amount of loss
can be assessed at low cost following the loss, more likely to have indemnity contracts
Moral hazard: when moral hazard is less likely to be a problem, fixing the insurance payment before a loss can avoid costly haggling following a loss (e.g., life insurance)
Ins301 Ch 8&10 20
Insurance-to-Value in Property Insurance
Also called coinsurance Specifies the percentage of the property’s value
that must be insured to receive full reimbursement in the event of a loss
Typical coinsurance percentage is 80%
Ins301 Ch 8&10 21
Legal Doctrines
Indemnity principle: an insurance policy cannot pay more than the financial loss suffered.
Insurable interest: if you want to get paid from insurance company, you got to have interest. Example, A and B are not related, A buys a life
insurance and set B as the beneficiary Subrogation: after a party receives claim payment
from an insurer, it has to transfer the right to seek additional compensation to the insurer
Ins301 Ch 8&10 22
Legal Doctrines
Utmost good faith Misrepresentation (page 195) Concealment (196)
Contract of adhesion Favors insureds, if disagreement
Doctrine of reasonable expectation Policies would be interpreted based on the
expectation of a person who is trained in the law.