Abstract
While it may seem quite obvious, insurance is only a viable solution for those risks that are insurable and that yield insurance products that are marketable. What makes a risk insurable and an insurance product marketable? Insurable means that an insurance company can set a premium that accurately reflects the applicable risk. Marketable means that there must be enough individuals or businesses willing to buy coverage for the risk at a premium that covers costs and yields a profit for insurers.
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Notes
The pure premium normally considers loss adjustment expenses for settling a claim. We will assume that this component is part of total losses. For more details on calculating pure premiums see Launie, J., J. Lee, and N. Baglini, Principles of Property and Liability Underwriting (Third Edition), Insurance Institute of America, Malvem, PA, 1986.
Shah, Haresh et al., “Managing Seismic Risk,” Journal of Risk and Uncertainty, (in press).
A comprehensive review of the theoretical literature on the impact of these factors on the pricing of insurance and the viability of insurance markets can be found in the paper by Georges Dionne and Scott Harrington entitled “An Introduction to Insurance Economics” in Dionne, Georges and Scott Harrington, Foundations of Insurance Economics, Kluwer Academic Publishers, Boston, 1992, as well as in the other papers in the volume that the two authors have edited.
For more details on the survey and the analysis of findings see Kunreuther, Howard, Jacqueline Meszaros, Robin Hogarth and Mark Spranka, “Ambiguity and Underwriter Decision Processes,” Journal of Economic Behavior and Organization, 26, 1995, pp. 337–352.
The questionnaire instructions stated that pure premiums should exclude “loss adjustment expenses, claims expenses, commissions, premium taxes, defense costs, profits, investment return and the time valuation of money.”
Stone, John, “A Theory of Capacity and the Insurance of Catastrophic Risks: Part I,” and “... Part II,” Journal of Risk and Insurance, 40, 1973, pp. 231–243 (Part I) and 40, 1973, pp. 339-355 (Part II).
This model of underwriter behavior is consistent with recent analyses as to why insurance firms want to purchase reinsurance. For more details see Doherty, Neil and S. M. Tinic, “A Note on Reinsurance under Conditions of Capital Market Equilibrium,” Journal of Finance, Vol. 36, 1982, pp. 949–953, and Myers, David and Clifford Smith, “On Corporate Demand for Insurance: Evidence from the Reinsurance Market,” Journal of Business, 63, 1990, pp. 19-40.
Berger, Larry and Howard Kunreuther, “Safety First and Ambiguity,” Journal of Actuarial Practice, 1995.
The expected loss for a random individual in the population is calculated as follows: [50(.l)(100) + 50(.3)(100)]/100=20.
See Akerlof, George, “The Market for ‘Lemons’: Quality Uncertainty and the Market Mechanisms,” Quarterly Journal of Economics, 84, 488–500 for the classic study on why changing price will not overcome the adverse selection problem.
This solution has been developed by Rothschild and Stiglitz. See Rothschild, Michael and Joseph Stiglitz, “Equilibrium in Competitive Insurance Markets: An Essay on the Economics of Imperfect Information,” Quarterly Journal of Economics, 90, 1976, pp. 629–650.
This is an example of ex post moral hazard where the insurer does not know the nature of the accident and hence cannot determine whether the damage claim is exaggerated. For a more detailed discussion of ex post moral hazard in the context of insurance problems, see Spence, Michael and Richard Zeckhauser, “Insurance, Information and Individual Action,” American Economic Review, 61, 1971, pp. 380–387.
For more details on the role of deductibles and coinsurance in reducing the chances of moral hazard, see Pauly, Mark, “The Economics of Moral Hazard: Comment,” American Economic Review, 58, 1968, pp. 531–536.
We are assuming that the firm will not be able to purchase a second insurance policy for $500,000 to supplement the first one and, hence, be fully protected against a loss of $1 million (except for deductibles and insurance clauses).
The probabilities for the independent events were calculated as follows. L=0 occurs if neither policy suffers a loss which occurs with p=(9X.9)=.81;L=100 occurs if either policy I or 2 suffers a loss which has p=(2 X. 1 X.9)=. 18; L=200 occurs if both policies 1 and2suffer losses which have p=(.l X.l)=.01.
Hogarth, Robin and Howard Kunreuther, “Pricing Insurance and Warranties: Ambiguity and Correlated Risks,” The Geneva Papers on Risk and Insurance Theory, 17, 1992, pp. 35–60.
Of course, the purchase of insurance by itself does not say anything about the magnitude of the risk. if the tank were risky, the insurer would charge a high premium that the insured could still choose to purchase. The concept of “seal of approval” used here is based solely on the availability of insurance, not the price of coverage.
Total demand refers to the number of policies sold over a number of years. If a policy is sold in the future it needs to be discounted to the present since the costs of developing and marketing the insurance are assumed to be incurred today. Given a 10 percent discount rate, 1,000 policies sold one year from now would be treated as if only 900 policies were sold.
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© 1997 Springer Science+Business Media New York
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Freeman, P.K., Kunreuther, H. (1997). The Insurability and Marketability of Risk. In: Managing Environmental Risk Through Insurance. Studies in Risk and Uncertainty, vol 9. Springer, Dordrecht. https://doi.org/10.1007/978-94-011-5360-7_6
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DOI: https://doi.org/10.1007/978-94-011-5360-7_6
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