Chapter Outline - University of Rhode Island
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Transcript Chapter Outline - University of Rhode Island
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
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
2
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
3
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
4
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
5
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
6
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
7
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
8
Factors Limiting the Insurability of Risk
Ins301 Ch 8&10
9
Deductibles
Example:
policy with a $500 deductible
then policyholder pays first $500 of losses
Types of deductibles
per occurrence
aggregate
Ins301 Ch 8&10
10
Deductibles and Claim Processing Costs
Deductibles reduce cost of processing small claims
Example:
Fixed claim processing cost of $200
Loss =
$2000
100
0
with probability 0.01
with probability 0.10
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
11
Deductibles, Moral Hazard, and Adverse
Selection
Deductibles reduce moral hazard why?
Deductibles might be used to reduce adverse
selection. How?
Ins301 Ch 8&10
12
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
13
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
14
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
15
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
16
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
17
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
18
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
19
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
20
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
21
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.
Ins301 Ch 8&10
22