APPLICATION. Insurance Management
Insurance, like banking, is in the financial intermediation business of transforming one type of asset into another for the public. Insurance providers use the premiums paid on policies to invest in assets such as bonds, stocks, mortgages, and other loans; the earnings from these assets are then used to pay out claims on the policies. In effect, insurers transform assets such as bonds, stocks, and loans into insurance policies that provide a set of services (for example, claim adjustments, savings plans, friendly insurance agents). If the insurer's production process of asset transformation efficiently provides its customers with adequate insurance services at low cost and if it can earn high returns on its investments, it will make profits; if not, it will suffer losses.
In Chapter 9 the economic concepts of adverse selection and moral hazard allowed us to understand principles of bank management related to managing credit risk; many of these same principles also apply to the lending activities of insurers. Here again we apply the adverse selection and moral hazard concepts to explain many management practices specific to insurance.
In the case of an insurance policy, moral hazard arises when the existence of insurance encourages the insured party to take risks that increase the likelihood of an insurance payoff. For example, a person covered by burglary insurance might not take as many precautions to prevent a burglary because the insurance company will reimburse most of the losses if a theft occurs. Adverse selection holds that the people most likely to receive large insurance payoffs are the ones who will want to purchase insurance the most. For example, a person suffering from a terminal disease would want to take out the biggest life and medical insurance policies possible, thereby exposing the insurance company to potentially large losses. Both adverse selection and moral hazard can result in large losses to insurance companies, because they lead to higher payouts on insurance claims. Lowering adverse selection and moral hazard to reduce these payouts is therefore an extremely important goal for insurance companies, and this goal explains the insurance practices we will discuss here.