As with any other business, the business of insurance has its own risks and if not planned and taken into account, those risks have potential to actually wipe off the whole company! Such is the business of Insurance and that’s why risk management is the most important part of Insurance.
Just to get an idea of the risks involved, imagine the smart guy and the burnt house example that was used in the earlier articles, where he had assessed that 1 out of 100 houses will actually catch a fire and based on that, calculated premiums and his profits. Now, what if 5 houses actually catch fire. He might have to pay from his own pockets and that would result in huge losses. Now, if lady luck is really angry with him and 15 houses catch the fire! Well, in this case, he will go bankrupt!
Or to say, a new and upcoming insurance company happens to insure a gang of bike riders who, in the process of doing stunts, actually break each and every part of their bike, say every fortnight! That poor company will straight away go into losses paying for all the parts and the repairs! Or even normal riders, who, after insuring the bike, actually start driving at higher speeds and in the process, files for repairing more often than he normally does, knowing that insurance company will pay for that! That would be disaster for that insurance company! So, in the first case, the concerned company would actually have been better off doing business with the group of riders and in the second case, the behavior of the insured actually changed after insuring the bike! Some observation, this is!
Actually, the above examples describe the two types of risks that insurance companies face! Easy Peasy! The first one, where the insurance company should have avoided the group of bike riders but instead did business with them, is what we call as the problem of Adverse Selection. And the second one, where though the rider was actually a normal one, he became one to be avoided after he took the insurance, is what we call Moral Hazards in the language of risk management.
Now, going back to our example, the insurer did business with the group of riders because the insurers or the company were unaware of the fact that they are actually high risk group. Essentially, this means that there is a gap in the level of information between the two groups (The group of riders knew that they will be using the insurance a whole lot more than what the insurer believes!) and in the language of Risk Management and Insurance, we call that Asymmetry of Information. So, to be a bit more technical, adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece. So, in the simplest of terms,Adverse Selection is when you do business with people you would be better off avoiding.
Now, for the Moral Hazards, it simply means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for. And even that is a result of the asymmetry of information because the insurers didn't know that the behavior of the insured will change! So, in short, we can say that the risks are because of asymmetry of information. Aha, the golden funda!
To talk of hidden information and hidden characteristics! The damage they can do!
So, what does an insurance company do to mitigate these risks? This can be understood by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the general population. From the insurer's viewpoint, the higher mortality of the group which selects to buy insurance is adverse. The insurer raises the price of insurance accordingly, and as a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than they would buy at a lower price reflective of their lower risk.
But then, the reduction in insurance purchases by non-smokers is also adverse from the insurer's viewpoint, and perhaps also from a public policy viewpoint. Putting up the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out! Like Auto Insurance. Now, we know the reason why it’s compulsory! Blame the bad drivers on the road, the very few who files more claim individually than what a thousand others do!
In fact, to avoid adverse selection, firms need to try and identify different groups of people. This is why health insurance premiums are higher for smokers and obese people. In banking, banks check the previous credit history of people with debts.
Now, to focus more on Moral hazards, insurance companies mitigate the moral risks by building in incentives to stick to not being too extravagant. The insurance firms needs to provide incentives so that you still want to insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first Rs. 1500 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place. And they penalize bad behavior. You usually pay more if you have taken a claim the earlier year!
So this was about the risks that Insurance companies usually face. There are others such as fake claims and dishonest agents and all, but these two are the most fundamental of all. We will look at some other fundas in the upcoming articles. Keep Reading!
Just to get an idea of the risks involved, imagine the smart guy and the burnt house example that was used in the earlier articles, where he had assessed that 1 out of 100 houses will actually catch a fire and based on that, calculated premiums and his profits. Now, what if 5 houses actually catch fire. He might have to pay from his own pockets and that would result in huge losses. Now, if lady luck is really angry with him and 15 houses catch the fire! Well, in this case, he will go bankrupt!
Or to say, a new and upcoming insurance company happens to insure a gang of bike riders who, in the process of doing stunts, actually break each and every part of their bike, say every fortnight! That poor company will straight away go into losses paying for all the parts and the repairs! Or even normal riders, who, after insuring the bike, actually start driving at higher speeds and in the process, files for repairing more often than he normally does, knowing that insurance company will pay for that! That would be disaster for that insurance company! So, in the first case, the concerned company would actually have been better off doing business with the group of riders and in the second case, the behavior of the insured actually changed after insuring the bike! Some observation, this is!
Actually, the above examples describe the two types of risks that insurance companies face! Easy Peasy! The first one, where the insurance company should have avoided the group of bike riders but instead did business with them, is what we call as the problem of Adverse Selection. And the second one, where though the rider was actually a normal one, he became one to be avoided after he took the insurance, is what we call Moral Hazards in the language of risk management.
Now, going back to our example, the insurer did business with the group of riders because the insurers or the company were unaware of the fact that they are actually high risk group. Essentially, this means that there is a gap in the level of information between the two groups (The group of riders knew that they will be using the insurance a whole lot more than what the insurer believes!) and in the language of Risk Management and Insurance, we call that Asymmetry of Information. So, to be a bit more technical, adverse selection occurs when the seller values the good more highly than the buyer, because the seller has a better understanding of the value of the good. Due to this asymmetry of information, the seller is unwilling to part with the good for any price lower than the value the seller knows it has. On the other hand, the buyer, who is not sure of the value of good, is unwilling to pay more than the expected value of the good, which takes into account the possibility of getting a bad piece. So, in the simplest of terms,Adverse Selection is when you do business with people you would be better off avoiding.
Now, for the Moral Hazards, it simply means that people with insurance may take greater risks than they would do without it because they know they are protected, so the insurer may get more claims than it bargained for. And even that is a result of the asymmetry of information because the insurers didn't know that the behavior of the insured will change! So, in short, we can say that the risks are because of asymmetry of information. Aha, the golden funda!
So, what does an insurance company do to mitigate these risks? This can be understood by the link between smoking status and mortality. Non-smokers, on average, are more likely to live longer, while smokers, on average, are more likely to die younger. If insurers do not vary prices for life insurance according to smoking status, life insurance will be a better buy for smokers than for non-smokers. So smokers may be more likely to buy insurance, or may tend to buy larger amounts, than non-smokers, thereby raising the average mortality of the combined policyholder group above that of the general population. From the insurer's viewpoint, the higher mortality of the group which selects to buy insurance is adverse. The insurer raises the price of insurance accordingly, and as a consequence, non-smokers may be less likely to buy insurance (or may buy smaller amounts) than they would buy at a lower price reflective of their lower risk.
But then, the reduction in insurance purchases by non-smokers is also adverse from the insurer's viewpoint, and perhaps also from a public policy viewpoint. Putting up the premium will not solve this problem, for as the premium rises the insurance policy will become unattractive to more of the people who know they have a lower risk of claiming. One way to reduce adverse selection is to make the purchase of insurance compulsory, so that those for whom insurance priced for average risk is unattractive are not able to opt out! Like Auto Insurance. Now, we know the reason why it’s compulsory! Blame the bad drivers on the road, the very few who files more claim individually than what a thousand others do!
In fact, to avoid adverse selection, firms need to try and identify different groups of people. This is why health insurance premiums are higher for smokers and obese people. In banking, banks check the previous credit history of people with debts.
Now, to focus more on Moral hazards, insurance companies mitigate the moral risks by building in incentives to stick to not being too extravagant. The insurance firms needs to provide incentives so that you still want to insure your bike. This is why they will not insure for the full amount. Usually you have to pay the first Rs. 1500 of an insurance claim. Insurance firms also make the process of getting money difficult. This means that you become more reluctant to make claims and so will try to avoid having your bike stolen in the first place. And they penalize bad behavior. You usually pay more if you have taken a claim the earlier year!
So this was about the risks that Insurance companies usually face. There are others such as fake claims and dishonest agents and all, but these two are the most fundamental of all. We will look at some other fundas in the upcoming articles. Keep Reading!
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