Topic 6: Market Failures Related to Managing Risk

Risk Pooling

The process of combining risks from multiple individuals into a larger group

Optimal Risk Pooling

A risk pool that is large and homogeneous

Homogeneous Risk Pool

A pool where all individuals face the same probability distribution of losses

Law of Large Numbers

The principle that as the risk pool gets larger and larger, the risk faced by the insurer falls and approaches zero

Risk Transfer

The act of an individual buying insurance to pass their risk to the insurer

Economic Benefits of Large Risk Pooling

Risk pooling allows risk transfers to exist and is the source of economic benefit for insurance

Definition of Insurance

A device that pools exposures to loss of individuals into a group, where funds paid by members (premium) are used to pay for the losses that occur (Risk Sharing Arrangement)

Loss Income Transfer in Risk Pooling

The transfer of money/wealth in a risk pool to those who do not have a loss to those who do have a loss

Risk Income Transfer in Risk Pooling

The transfer of money/wealth in a risk pool from low-risk individuals to high-risk individuals, often occurring through the premium structure

ex. Younger Male Drivers pay more vs. Female drivers

Reasons to Purchase Insurance

Peace of Mind; Protect Assets; Enhance Creditworthiness; Law Regulatory Compliance

Information is Power

The idea that an insurance company’s ability to accept risk transfer relies on its data, which makes its predictions more accurate, leading to less risk

Indemnification

The insurer agrees to compensate the insured in the event of a covered loss, aiming to restore them to their financial position prior to the loss

Full Indemnification

Placing the insured in the exact same financial position as they were prior to the loss (all losses were covered)

Partial Indemnification

Sharing or limiting the amount paid for a loss

Cost Sharing → Deductibles; Co-Pay; Co-insurance

Forms of Indemnification

• Repair/Replace an Asset

• Cash Reimbursement

• Services (Attorney in Liabilities Case)

Principle of Indemnity

The rule that the insured should not collect more than the Actual Cash Value (ACV) of the loss

Violations to the Principle of Indemnity

• Life Insurance

• Rare Items

Insurance Supply

The price at which insurers are willing to sell insurance, represented by Gross Premium (GP)

Gross Premium (GP) Forumula

Expected Losses + Risk Charge + Admin (Loading)

Insurance Demand (Pmax)

The maximum price an individual is willing to pay for insurance against a particular risk

Characteristics of an Insurable Risk

1. Large Number of Similar Objects

2. Losses are Accidental or Unintentional

3. Losses can be Determined and Measured

4. Losses Not Catastrophic to Insurer

5. Large Loss Principle

Large Number of Similar Objects (Life & Auto Insurance)

The nature of the objects must be similar so that reliable statistics can be formed

Losses are Accidental or Unintentional

The loss must be accidental. The insured should have no control over increasing its frequency or severity, which helps avoid Moral Hazard

Moral Hazard

A problem that arises when the insured has control over the loss, causing expected losses to go up, leading to price to go up

Solutions to Accidental/Unintentional Losses (Methods to Control Moral Hazard)

• Deductible/Co-Pay

• Claim Investigations

• Policy Limits

Losses Can Be Determined and Measured

The insurer must be able to determine if a loss occurred and the dollar amount of that loss (some losses can’t be measured like “pain and suffering”)

Losses Not Catastrophic to Insurer

Loss events should typically be one random event leading to one claim to allow for diversity

Catastrophic Risk

A single random event (like an earthquake or flood) that results in many losses simultaneously, making it a “big problem” because it’s difficult for the insurer to diversify risk and predict overall cost

Law of Large Numbers Assumption

For the LLN to work and reduce risk, the random events being pooled must be independent (not all happening at the same time). Catastrophic risks violates this assumption

Solutions for Catastrophic Risks

• Good underwriting

• Diversity of Risks

• Reinsurance (transferring some risk to another insurer)

Large Loss Principle

The idea that insurance should primarily be reserved for high-severity, low frequency events (large losses) and that individuals/the business should deal with the small losses themselves

Misrepresentation

A false statement made by the applicant or when filing a claim. The insurer can deny the claim

Concealment

The failure to provide relevant information to the insurer. It is the insured’s job to know and disclose it. The insurer can deny the claim

Principle of Subrogation

The substitution of the insurer for the insured to collect damages from a third party who caused the loss (the person at fault’s insurance company)

Public Policy Issue #1: Terrorism

Occurred after 9/11 because of the widespread exclusion of terrorism on policies created a demand for terrorism coverage that insurers did not want to sell/stop selling

TRIA (Terrorism Risk Insurance Act)

Federal law enacted in 2002 to serve as a reinsurance for insurers to offer terrorism coverage, allowing the economy to recover and businesses to feel secure

Purpose of TRIA

To address the market failure where Terrorism was too unpredictable for insurers to properly price the exposure. The law allows the government to be a kind of reinsurance for insurance companies

Public Policy Issue #2: Flood

A type of risk that insurance companies don’t want to sell because it’s too common and too catastrophic

Subsidized Flood Premiums

Premiums for flood insurance are set by the government, leading to a situation where taxpayers essentially subsidize people living in flood zones (people pay less than for the true cost of the risk)

Loss Control Methods to Handle Flood Risks

• Proper grading

• Waterproof paint

• Sump Pumps

• Moving equipment to the roof

Adverse Selection

The result of asymmetric information where information is only known to the insurer and not the insured