Chapter 10 Insurability of Risk, Contractual Provisions, and Legal Doctrines

Chapter 10 Insurability of Risk, Contractual Provisions, and Legal Doctrines I. Multiple Choice 1. Which of the following is not a factor that limits the insurability of risk? a. b. c. d. moral hazard adverse selection competition administrative and capital costs Answer: c Type: K 2. The reason that higher premium loadings generally lead to lower demand for insurance coverage is that: a. the fair premium becomes too large relative to the expected cost of not purchasing insurance. people don’t like insurers to make too much profit. exposures with low severity always have high administrative costs. exposures with high frequency are less likely to be insurable. b. c. d. Answer: a Type: K 3. Which of the following types of exposures are most likely to be insured on an individual basis? a. b. c. d. exposures with high severity and low frequency exposures with low severity and low frequency exposures with high severity and high frequency exposures with low severity and high frequency Answer: a Type: K 4. The primary limiting factor on the insurability of highly correlated loss exposures is a. b. c. d. high administrative costs high capital costs the moral hazard problem adverse selection 159 Answer: b Type: A 5. The conditions necessary for moral hazard to arise in insurance contracts include all of the following except: a. b. c. d. The expected losses must depend in part on the insured’s behavior The insurer must have some ability to impact the insured’s behavior It must be costly for the insurer to observe policyholder behavior It must be costly for the insurer to measure the impact of policyholder behavior on expected claim costs Answer: b Type: K 6. Which of the following is not a method of reducing the impact of moral hazard on expected claim costs? a. b. c. d. deductibles experience rating careful risk classification careful investigation of claims Answer: c Type: K 7. Insurers use deductibles to: a. b. c. d. reduce claims processing costs reduce moral hazard problems mitigate adverse selection problems all of the above Answer: d Type: K 8. Health insurance policies often have coinsurance provisions that require the policyholder to pay a. a minimum amount of claims in a given year before the insurance company will be responsible for payment. the first $500 of all claims all of the claims that exceed the policy limits a specified proportion of every loss b. c. d. Answer: d 160 Type: A 9. The primary limiting factor on the insurability of a high frequency, low severity loss exposure is a. b. c. d. high administrative costs high capital costs the moral hazard problem adverse selection Answer: a Type: A 10. Thom and Judy, a married couple, are employed at different companies and both of their employers provide complete family health insurance with pro rata clauses, no deductibles, and no coinsurance. If Thom has knee surgery that costs $5,000, he can recover a. b. c. d. $5,000 from each insurer since the full premium has been paid for that coverage. $5,000 from his own insurer only. $2,500 from each insurer. $5,000 from his own insurer who will then try to collect $2,500 from Judy’s insurer. Answer: c Type: A 11. An insurance contract which specifies that the insurer pay a pre-set amount upon the occurrence of a loss is called: a. b. c. d. a valued contract an indemnity contract a coinsurance contract an insurance-to-value contract Answer: a Type: K 12. The legal principle which states that an insurance policy cannot pay more than the financial loss suffered is called the principle of: a. b. c. d. insurable interest moral hazard adhesion indemnity Answer: d 161 Type: K 13. Since insurance contracts are generally standard forms with many detailed provisions drawn up by the insurer, they are considered to be: a. b. c. d. contracts of adhesion unenforceable if the insured cannot negotiate terms insurable interests contrary to the indemnity principle Answer: a Type: K 14. If an insurance buyer has intentionally concealed information from the insurer, the legal remedy in most states is that: a. b. c. d. the policyholder can be sued for bad faith the insurer can void the contract the insured can void the contract both b and c Answer: b Type: K 15. Janet needs to purchase property coverage on her downtown business building. The building is worth $150,000. The insurer has an insure-to-value (coinsurance) requirement of 80%. If Janet purchases $80,000 of property coverage what proportion of each loss (should one occur) will the insurer pay? a. b. c. d. 3/4 2/3 8/10 10/12 Answer: b Type: A II. Fill-Ins 1. The three major factors that limit insurability of risk in private insurance markets are: premium loadings , moral hazard , and adverse selection . 2. John has full insurance on his car. John’s tendency to leave his car unlocked when he goes to the mall is an example of moral hazard . 162 3. Adverse selection exists when individuals differ in their probability of loss and insurers cannot distinguish high risk from low risk individuals. High risks will be more likely to purchase insurance than low risks. 4. A method of reducing the adverse selection problem for insurers is classification . (Other answers are possible.) 5. A coinsurance provision in an insurance contract requires an insured to pay a specified proportion of the loss. 6. The insurer’s legal remedy for situations where a policyholder has misrepresented or concealed relevant information on an insurance application is to void the contract . risk III. Problems and Short Answer Questions 1. Suppose that an insurer offered a small business owner a policy for theft insurance with no deductible i.e. the insurance company would pay any and all claims for thefts of merchandise or equipment at the insured’s place of business. Explain how moral hazard might make the total claims higher than they would be if the policy required a deductible. Answer: Moral hazard refers to the effect of insurance on the insured’s incentives to reduce expected losses. If there were no deductible, then the businesses would have no incentive to take precautions against potential thefts, such as the installation of cameras, careful inventory monitoring, locking the building, etc. Furthermore, there might even be incentives to pass on some normal business expenses to the insurer such as those due to damaged inventory. Type: A 2. For each of the following types of insurance, provide three common examples of moral hazard that would be expected to impact the claim costs. a. b. automobile physical damage (collision) insurance health insurance Answer: a. driving too fast, tailgating, failing to observe street signs, failing to lock car doors, inflating costs of repair, etc. (Answer should not include actions that primarily increase risk of injury to persons, such as seatbelt usage and children’s car seats.) b. poor eating habits, failure to exercise regularly, alcohol consumption, etc. 163 Type: A 3. You are considering a homeowner’s insurance policy. The policy includes damage to your home and its contents but limits the coverage for losses of jewelry to a total value of $1,000. In addition, the policy has a $500 deductible. For an additional amount, you can increase the coverage on your jewelry, subject to an appraisal. You can also pay a higher premium to reduce the deductible to $200. Explain the purpose of these contractual provisions from the insurer’s point of view. Answer: The limitation on jewelry losses is to control moral hazard, since these losses are not easily verifiable by the insurer. Without the limitation, the average premium would have to be higher. The deductible is a method of limiting the administrative costs associated with high frequency, low severity claims that can be budgeted for by the homeowner. Both provisions may also help to control adverse selection, since low risk homeowners will be more likely to purchase this policy and high risk homeowners might opt for the more expensive, higher coverage policy. Type: A 4. For each of the following scenarios, indicate what law or legal principle prohibits the scenario from occurring. a. You have a medical injury due to a car accident and you make claims to both your health insurer and your automobile insurer in order to get double recovery. You purchase life insurance on your sickly 90-year old neighbor with yourself as the beneficiary. He dies and you make a claim. You fail to disclose information regarding your rheumatoid arthritis condition when you apply for health insurance. You later request coverage for a hip replacement surgery. You purchase automobile liability insurance. You later have an accident that was your fault and your insurer denies the claim noting a small clause in the contract that excludes coverage for any accidents caused by the insured. b. c. d. Answer: a. indemnity; b. insurable interest; c. misrepresentation (or concealment) and the principle of utmost good faith; d. adhesion contracts and the doctrine of reasonable expectations. Type: A 164 Use the following information to answer questions 5-8. Happy Time Day Camp has the following distribution for its annual liability costs: Loss = 5. $2,000,000 $100,000 $5,000 $0 with probability .0001 with probability .001 with probability .1 with probability .8989 What are the expected claim costs for Happy Time? Answer: ($2,000,000)(.0001) + ($100,000)(.001) + ($5,000)(.1) = $800 Type: A 6. If an insurer offered Happy Time a policy with 50% coinsurance, what are the expected claim costs on this policy? Answer: ($1,000,000)(.0001) + ($50,000)(.001) + ($2,500)(.1) = $400 Type: A 7. If an insurer offered Happy Time a policy with a $5000 annual deductible, what are the expected claim costs on this policy? Answer: ($1,995,000)(.0001) + ($95,000)(.001) = $294.50 Type: A 8. If an insurer offered Happy Time a policy with a $500,000 limit, what are the expected claim costs on this policy? Answer: ($500,000)(.0001) + ($100,000)(.001) + ($5,000)(.1) = $650 Type: A 165