Definition

Insurance is an instrument to give protection against the risk resulting from various perils or hazards, such as health risks, invalidity or death, accidents, unemployment, theft, fire, and many more. Contracts are offered by insurance companies providing risk-sharing mechanisms that allow their customers to replace these risks. Insurance market is characterized by failures that impose particular negative consequences on one or both market sides: given the failures, different remedies may improve the market outcome.

Introduction

Insurance plays three economic functions: (i) the transfer of risk from a risk-averse individual to the risk-neutral insurer, (ii) the pooling of risk so that the “uncertainty” of each insured becomes the “certainty” of the insurance companies that this risk will occur to a percentage of their customers, and (iii) the allocation of risk for which each insured pays a price that should reflect the risk he contributes (Abraham 1995).

For these three reasons, insurance contracts increase social welfare while at the same time induce people to have a preventive behavior and contribute to internalize damage. At a macroeconomic level, decreasing the economic effects of risks, insurance encourages companies to operate in risky sector and to make investments that they would not make otherwise. Meanwhile, life insurance plays a role as a long-term investment and savings instrument (Shavell 2000).

Asymmetric Information

The insurance market is characterized by the fundamental problem of bilateral asymmetric information. On one hand, individuals do not have complete information in understanding complicated insurance contracts and lack the ability to assess the adequacy of premium to risk. On the other hand, insurers suffer from lack of information regarding the risk characteristics of individuals. This second asymmetry generates the two phenomena of moral hazard and adverse selection.

Moral hazard (hidden action) depends on the insurers’ impossibility to perfectly know the extent their customers’ behavior may affect the occurrence and/or the dimension of the loss.

To be precise, the term moral hazard refers to at least two different situations in which the insured’s behavior can affect the probability of the various outcomes: (i) situations when insurance may induce greater use of a service by an insured individual or cause the insured to exercise less care and (ii) situations when an insured individual purposely causes harm or otherwise falsifies loss in order to collect insurance benefits or to inflate the loss.

In the case of moral hazard, the insured’s behavior changes, and the insurer is unable to either predict this change in advance or to prevent it by exempting such behavior from the insurance contract coverage (Shavell 1979).

In fact, after signing an insurance contract, the insured may have less incentive to act carefully or take preventive measures, influencing both the damage probability and/or the loss dimension.

Moral hazard, even if severe, does not cause a complete breakdown of markets, but it raises the cost of insurance and, consequently, reduces the degree of insurance coverage negatively affecting market outcomes (Tennyson and Warfel 2009).

In this case, a remedy is monitoring the insured’s behavior: ex ante the loss occurrence, to monitor the level of care in preventing the loss, insofar as the insured’s behavior has any influence over the risk; ex post, to monitor the amount of claim when loss occurs, beyond the services the claimant would purchase if not insured and assuming the insured individual can influence the magnitude of the claim. Also incentive schemes linking the price of insurance to observed past behavior (e.g., bonus/malus systems) can be used as devices to contain this problem (Derrig 2002).

Adverse selection (hidden information) refers to the inability of insurers to observe risk characteristics of their customers, leading to offer a contract based on the average risk of the entire group of customers. In this case, more high-risk individuals purchase insurance; higher payouts by insurance companies force them to raise rates which, in turn, makes the insurance less attractive to low-risk individuals.

As a consequence, this may reduce the stability of the market equilibrium, and the market may completely break down, such as the famous “market for lemons” (Akerlof 1970).

In the case of adverse selection, a remedy would be to use statistical data to separate different categories of risky individuals by classification instrument.

Theoretically in determining the premium to be charged, insurers should estimate the expected losses for each individual being insured. But given the informational asymmetry, the insurance companies apply risk classification trying to group the individuals in such a way that those with a similar loss probability are charged the same rate. The risk classification systems are clearly supported by statistical data showing differences in the event rate in different groups (Porrini 2015).

In practice, insurers have to identify risks that are independent, uncorrelated, and equally valued and to aggregate them in order to reduce the total risk of the set. An efficient risk classification reduces adverse selection, because it makes insurance more attractive to the low-risk individuals.

Classifying insurance risks increases the efficiency of contracting in terms of asymmetric information. However, the benefits are conditional on general principles, such as the nondiscrimination, and generally to consumer protection issue.

Insolvency

Generally, the default of a company generates economic damages, first to shareholders, but in many cases also to the customers. Particularly, in insurance market, the insured individuals may lose future benefits and insurance coverage with possibly precarious economic situation in many cases and imposing to rely on a public coverage of these losses.

Moreover, this is reinforced by the consequences of the so-called inversion of the production cycle that comes from the fact that insurance services are only delivered after they are purchased and in many cases years later. This creates the necessity to monitor the financial condition and solvency of insurance companies over an extended period of time.

This feature leads potentially to insufficient capitalization and suboptimal solvency levels, by giving insurers scope for hiding poor underwriting and under-reserving, and these are motivations for government interventions aimed at monitoring to improve management discipline.

Regulation for solvency dates to the nineteenth century, when insurance insolvencies in the USA and Europe led to the establishment of state regulatory authorities. Given the social role and the involvement of insurance in the systemic risk issue (Faure and Hartlief 2003), solvency becomes the primary focus of insurance regulation worldwide. Regulatory tools include risk-based capital requirements, electronic auditing of accounts, and a wide variety of limits on the ways that companies can invest the funds held in reserve to pay claims.

Moreover, regulation can be used to steer capital into preferred fields, given that insurance is an institution for storing and accumulating capital, competing with banking and securities firms. Although banking, insurance, and securities have traditionally been subject to different regulatory regimes, there is recently a “convergence” in the financial services marketplace that places great strain on the existing regulatory institutions (i.e., the diffusion of the business model of bank insurance).

The most common instrument of regulation for solvency consists of technical provisions that correspond to the amount required by the insurer to fulfil its insurance obligations and settle all commitments to policyholders arising over the lifetime of the portfolio. Technical provisions can be divided into those that cover claims from insurance events which have already taken place at the date of reporting and those that should cover losses from insurance events which will take place in the future.

Most countries supplement the above requirements by regulating the portfolio choices of insurance firms with the aim to ensure that insurers invest and hold adequate and appropriate assets to cover capital requirements and technical provisions.

The main focus of numerous national regulation is to ensure that insurance companies are able to honor their payment obligations in a continuous way, the most important instrument being that of a generalized capital and reserve rules, possibly supplemented by additional supervisory rules, such as investment restrictions and provisions of regular inspection by supervisory authorities.

Conclusion

Because the insurance business has become highly important to society’s development, it is relevant to find remedies to the failures that can impede a correct functioning of the market.

On one hand, the insurance market is characterized by fundamental problems of asymmetric information. Moral hazard and adverse selection play a central role in the insurance market, and to correct the consequent severe market failures, monitoring and risk classification can be implemented.

On the other hand, the insolvency issue is justified by the enormous amounts of funds and investments in the hands of insurance companies; as such, their default would have an extreme impact, and regulation is necessary to guarantee the payback for policyholders and beneficiaries.