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
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 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: 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

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 = 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 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