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Outline the moral hazard and adverse selection risks insurers face, give an example of each, and set out how insurers can counter them.

FRM® Part I · Financial Markets and Products · Insurance Companies and Pension Plans · FRM1.FM.2.g

The idea

Moral hazard arises after the contract is signed. Once insured, the policyholder takes less care or exaggerates claims, for example a driver who parks carelessly because theft is covered. Adverse selection arises before the contract. People who know they are riskier are the most eager to buy, for example unhealthy applicants seeking generous health cover. If the insurer charges an average price the good risks leave and the pool worsens. Insurers counter moral hazard with deductibles, coinsurance, policy limits, exclusions and no-claims bonuses, so the insured keeps some of the loss. They counter adverse selection with underwriting, medical exams, questionnaires, risk-based premiums and waiting periods. A deductible is a loss-sharing tool aimed at behaviour after cover. A medical exam is a screening tool aimed at who buys. Do not swap the two labels.

Formulas

Insurer's payment with a deductible, coinsurance and a limit

Payment = min(c × (L − D), M)

c
the share of the loss after the deductible that the insurer pays
L
the insured loss
D
the deductible
M
the policy limit

Take off the deductible first, then apply coinsurance, then cap at the limit. Each feature leaves the policyholder a stake in the loss.

A practice question

From the question bank, with the reason each wrong option is wrong.

Moral hazard in insurance refers to the tendency of:

  1. policyholders to take less care once they are insured - correct
  2. insurers to charge premiums higher than expected lossesWhy not: This is pricing with a margin, not a behavioural risk of the policyholder.
  3. high-risk individuals to be most eager to buy insuranceWhy not: This is adverse selection, which occurs before the contract is signed.
  4. low-risk individuals to cancel cover when premiums increaseWhy not: This is a consequence of adverse selection, not moral hazard.

Moral hazard is a post-contract change in behaviour caused by the protection of insurance. Adverse selection is a pre-contract problem of who buys.

A harder one

A life insurer requires applicants for large policies to pass a medical examination and answer a detailed health questionnaire. This is mainly a counter to:

  1. reserve risk, because it increases the size of the loss reservesWhy not: Medical underwriting concerns pricing and acceptance of risk, not reserve estimation.
  2. longevity risk, because it ensures that annuitants live shorter livesWhy not: Screening does not change life expectancy across the population.
  3. moral hazard, because it penalises policyholders who later take more risksWhy not: The exam is done at inception and does not change post-contract behaviour.
  4. adverse selection, because it reveals risk information before issue - correct

The insurer is trying to reduce its information disadvantage before accepting the risk. That is the standard response to adverse selection.

The hardest tier

A policy covers a loss of USD 45,000 with a USD 2,000 deductible and 80% coinsurance. After the deductible, the insurer pays 80% of the remaining loss, subject to a policy limit of USD 40,000. The insurer's payment is closest to:

  1. USD 34,000Why not: Applies the coinsurance first and then deducts the deductible; the deductible comes first.
  2. USD 40,000Why not: Ignores the coinsurance (pays loss minus deductible = 43,000) and caps it at the policy limit.
  3. USD 34,400 - correct
  4. USD 36,000Why not: Ignores the deductible, so it overstates the insurer's share.

Loss after deductible = 43,000; insurer pays 80% = 34,400, below the 40,000 limit. Deductible, coinsurance and limit all keep the policyholder's stake in the loss.

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