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

Insurance Costs and Fair Premiums 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

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

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

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

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

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

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

Factors Limiting the Insurability of Risk Ins301 Ch 8&10

Deductibles Example: Types of deductibles policy with a $500 deductible then policyholder pays first $500 of losses Types of deductibles per occurrence aggregate Ins301 Ch 8&10

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

Deductibles, Moral Hazard, and Adverse Selection Deductibles reduce moral hazard why? Deductibles might be used to reduce adverse selection. How? Ins301 Ch 8&10

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

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

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

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

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

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

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

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

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

Legal Doctrines Utmost good faith Contract of adhesion 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. Ins301 Ch 8&10