CHAPTER 1
RISK:a person, property or entity that is insured / the chance that something may harm it
RISK SPREADING: taking on risk and parceling it out amongst a group
REASONS PEOPLE BUY INSURANCE
RISK TRANSFERRING: buying insurance transfers risk from you to the ins. co.
RISK AVERSION: preference for certainty over noncertainty. An insurance premium is a small, certain loss that protects against a large unexpected loss.
LAW OF LARGE NUMBERS
· We can be more certain about future experience of large groups in the aggregate than we can about future experience of any one individual in that group.
· Insurance Co’s use past data to predict the future and price their policies.
· It is better to insure a large # of ppl. for small premiums than a small # of ppl. for large.
Magnitude of Risk
Chance of Winning Lottery = 1/1000
Lottery Prize = $5,000
Therefore, most you should pay for ticket is $5
Chance of Winning Lawsuit = 50% or (½)
If you Win: $1 million
If you Lost: $0
Formula: (50% x $1 mil) + (50% x 0) = value
Note: Insurance Premiums will be higher than their value because you must factor in the costs to run a company and administer insurance.
4 PROBLEMS THAT HINDER ABILITY TO SPREAD RISK
1. MORAL HAZARD
· Information Problem
· PH side Moral Hazard: Insurance theoretically reduces a person’s incentives to:
1.) protect against loss (ex-ante moral hazard – PH side)
ex. Leave keys in car, car unlocked, insurance fraud: “TORCH MY RIDE”
2.) minimize the cost of the loss (ex-post moral hazard – PH side)
ex. Go to the most expensive mechanic
· IR side Moral Hazard = IR’s incentive not to pay out claim once premiums are rcd, or to pay out only a small amount for the accident. Reason: they keep whatever money remains.
· Principal/Agent problem
STRATEGIES TO ADDRESS MORAL HAZARD PROBLEM
1.) “Contract on Care” – incentivise, or make a “deal w/i a deal” to encourage good behavior
Ex.: premium discount for car alarms / medical discount for PH’s with gym memberships
2.) “Community of Fate” – attempts to link the PH’s fate with the IR’s
Ex.: Deductibles and Co-payments
3.) “Contractual Requirements/Exclusions” – do not cover risks that pose high degree of moral hazard. Ex. Cosmetic surgery is not included under medical insurance.
2. ADVERSE SELECTION
PH Side
· = the theoretical tendancy for high-risk people to be more interested in insurance.
· =Information Problem / Solution: increase info about PH’s so IR’s know who is most risk.
· The Lemons Problem: If a peach – $400 and a lemon = $200, and there is a 50-50 chance of getting lemon, then the most people will pay is $300. Result: peaches are undervalued and people will keep them, while only lemons will remain in market and sell for more than they are worth.
· vs. Propitious Selection: cautious people tend to insure themselves more heavily. Also, if insurance is mandatory then everyone has it and market will not be all lemons.
IR SIDE
· Lemon Insurance Co’s (who can’t or won’t pay claims) are left in market, and without information (finance reports/yearly earnings) as to whether they are solvent or licensed, people will use them.
· Solution: Insurance Regulation
Insurance Company policies and procedures react to PH side Moral Hazard and Adverse Selection.
Insurance Regulators respond to IR side M.H. and A.S. (license/marketing regs).
SEE MISREPRESENTATION SECTION for A.S.
3. OPPORTUNISM
· Insurance = a Contract; payment for promise: unilateral
· Premium is consideration for Promise to pay.
· Issues: Potential Non-performance of that promise, inability to keep promise (insolvency)
· Opportunism: IR already has your premium so now they want to pay out as little as possible.
4. EXTERNALITIES
· = A cost or benefit that accrues to people who are not in the contactual relationship.
· Example of a Negative Externality: pollution
· Example of a Positive Externality of Insurance: everyone feels more secure.
FUNCTIONS OF INSURANCE INSTITUTIONS
1. Risk Spreading
2. Loss-Prevention: research ways of preventing harm (fire resiliant materials)
3. Gatekeeping (insurance req’d to drive car on road, to buy a home, etc.)
4. Social Stratification (Ex. Liberty Mutual Ads)
5. Capital Accumulation and Allocation (Invest and Grow Capital)
6. Knowledge / Research Production (Collect and Analyze Info)
INSURANCE AND SOCIAL RESPONSIBILITY
A. Accountability: financial
B. Trustworthiness: redlining = identifying geographical locations where IR will not issue policies
C. Causation: Ex. Workers’ comp. (see p. 17)
D.Freedom: PH freedoms are limited by insurance agreements that require responsibilites
E. Solida
was approved by state regulators was not good enough.
Dissent:
Argues that majority should not use “Implied Warranty” reasoning because that is based on the UCC which only covers sales of “goods” and insurance is not a “good”.
DOCTRINES AVAILABLE TO POLICYHOLDER’S TO ENFORCE POLICY
1. Reasonable Expectations (must be actual expectations)
2. Unconscionability
3. Estoppel (Promissory or Equitable)
4. Contra Proferentum
5. Waiver/Estoppel
6. Implied Warranty (not common, UCC)
7. Misrepresentation
INSURER’S DEFENSE
1. K’s should be enforced AS WRITTEN. (response to R.E.D.)
WAIVER AND ESTOPPEL
CASES: Darner, Bible, and Jenkins
Waiver: occurs when a party voluntarily and unilaterally relinquishes a known right
– may be express or implied
– the party waiving the right must be:
1) aware the right is being waived
2.) intending to forgo that right
EXAMPLE: An IR who accepts late premium payment knowingly waives the right to then deny a claim based on late payment, EVEN if they deposit the check saying “I do not intend to waive my right..”
Estoppel: occurs when one party’s acts or representations reasonably induce detrimental reliance on the part of another.
EXAMPLE: If agent assures PH that coverage won’t lapse due to late payment, and PH relies on this then coverage lapses, the IR will be estopped from claiming that the policy did not cover a loss occuring during the lapse.
DARNER MOTOR SALES, INC (Equitable Estoppel)
Issue: Darner’s business leased cars to people and in the lease agreement it specified they were covered 100/300. Darner switched insurance companies and noticed that the coverage said only 15/30. He spoke with the company who assured him that the umbrella policy would cover the lessee’s for the remaining amount. In reliance on this statement, Darner kept his lease agreement language as 100/300. A lessee got into an accident and demanded
