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Explain the link between insuring against operational risk and the moral hazard and adverse selection problems that insurance companies face.

FRM® Part I · Valuation and Risk Models · Operational Risk · FRM1.VR.7.j

The idea

Insurance can transfer operational losses, but it creates two classic problems for the insurer. Moral hazard arises after the policy is bought: a protected firm has less incentive to maintain controls or take care, so losses rise. Insurers respond with deductibles, coinsurance (the insured bears a share of each loss), policy limits and exclusions, so the insured keeps some skin in the game. Adverse selection arises before the policy is bought: firms that know their controls are weak or their risks high are the most eager to buy, and the insurer cannot observe this. If it charges one average premium, low-risk firms find it expensive and leave, the pool worsens and premiums rise. Insurers respond with disclosure requirements, audits, risk-based pricing and exclusions. The timing test is simple. Hidden action after purchase is moral hazard. Hidden information before purchase is adverse selection.

A practice question

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

Moral hazard in the context of insuring operational risk is best described as:

  1. Higher-risk firms being the most likely to buy insurance in the first placeWhy not: This describes adverse selection, which happens before the policy is bought.
  2. The insured firm taking less care to avoid losses once protected by the policy - correct
  3. The insurer refusing to pay valid claims after a loss has occurredWhy not: Describes claims-handling or counterparty risk, not moral hazard.
  4. A mismatch between the insured loss and the loss actually suffered by the firmWhy not: This is basis risk, a different concept.

Moral hazard is a change in behaviour after cover is in place: protected firms spend less effort on prevention.

A harder one

An insurer adds a deductible and a coinsurance clause to its operational risk policy. These features mainly reduce which problem?

  1. Adverse selection, because they make high-risk firms ineligible for coverWhy not: They do not exclude high-risk firms; they change incentives after the policy starts.
  2. Basis risk, because they align policy payouts with the loss actually sufferedWhy not: They reduce the insurer's payout; they do not improve the match between payout and loss.
  3. Insurer credit risk, because the insured pays part of the premium up frontWhy not: Deductibles and coinsurance do not concern the premium or the insurer's solvency.
  4. Moral hazard, because the insured bears part of every loss and keeps an incentive to prevent them - correct

Keeping the insured exposed to part of each loss restores the incentive to take care, which is the moral hazard remedy.

The hardest tier

An insurer compares clients. Before buying cover, buyers had a 30 percent higher loss frequency than comparable non-buyers. After buying, the buyers' loss frequency was unchanged from their own pre-purchase level. This pattern points to:

  1. Moral hazard, not adverse selectionWhy not: Moral hazard would appear as a rise in buyers' loss frequency after purchase.
  2. Adverse selection, not moral hazard - correct
  3. Both adverse selection and moral hazardWhy not: The unchanged post-purchase frequency shows no behavioural change, so moral hazard is not indicated.
  4. Neither; the pattern is explained by basis riskWhy not: Basis risk is a mismatch between hedge and loss and does not explain higher frequency among buyers.

Riskier firms were already more likely to buy before cover (selection), while behaviour did not change after cover.

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