Some Basic Principles of Insurance
Insurance is a contract in which an individual pays premiums to an insurer, who promises to compensate the insurant for a loss caused by some unpredictable circumstance covered by the agreement. Thus, insurance is a hedge against the costs of uncertain events. Risk aversion on the part of the insurant and the ability of the insurer to pool risks make insurance possible, likely, and generally efficient from an economic perspective.
Insurance may, however, entail some inefficiencies. Most notably, the so-called moral hazard problem arises when the insurant has some control over the insured event. For example, an insured business owner facing bankruptcy might hire an arsonist; if the owner could easily arrange for the burning of the business, insurers would be unwilling to provide insurance. Thus, for private insurance markets to exist, the insurer must be able to control moral hazard at a low cost.
In well- functioning insurance markets, the price of insurance, namely, the premium, is set at a level such that the present value of the stream of the insurant’s premiums is just equal to the expected present value of the individual’s insurance claims plus the cost of administering the contract, all measured over an appropriately long period of time. Insurants with similar risks of loss are grouped together into a risk class and are charged the same insurance premium. Thus, within a risk class, insurance claims and premiums tend to offset one another, both over time and across different insurants. In other words, risks are pooled both over time and among different members of the same risk class. As a consequence, over an appropriate span of time, the members of the risk class finance their own claims, producing neither a surplus nor a deficit. In any particular year, any member of the risk class may, of course, have a deficit or a surplus with the pool.
It follows that an insurant’s weekly, monthly, or annual insurance premiums will differ according to the risk class to which that individual is assigned. For example, teenagers pay higher automobile insurance premiums than do adults, house insurance is more expensive for dwellings located near frequent mud slides or in a hurricane area, life insurance is more expensive for people with severe medical conditions, and so on.
In some types of insurance, in which the insured event occurs repeatedly, the insurant may b reassigned periodically to a different risk class, depending on the person’s prior claims experience. This procedure is caked experience rating, and it is particularly helpful when the factors, such as age, sex, and marital status, are not very accurate predictors of the insurant’s risk class. Thus, if an insurant’s claims were very low over a period of years, the individual may be assigned to a lower risk class with a decreased premium. Perhaps the best known example of experience rating occurs in automobile insurance in the form of “good driver discounts.” Experience rating may also be affected through a special levy, such as deductibles or copayments, when an insurance claim is paid.
Two related aspects of experience rating are of special interest. First, experience rating implies incentives for the insurant to reduce claims by either controlling the uncertain events or by not submitting claims. Experience rating in automobile insurance may induce insurants to drive more carefully and/or to pay for minor accidental damage out of their own pockets, so as not to lose the “no claims bonus.” In this way, experience rating tends to reduce the various forms of moral hazard in insurance.
Second, experience rating implies that there is participation by the insurant in the insurance against the occurrence of the uncertain event. This is the coinsurance aspect of experience rating. The extent of this participation depends upon the degree of experience rating. As the degree of experience rating increases, the insurant’s premium (or copayment) corresponds more and more closely to his/her recent claims experience, so that the insurant pays more of the bill out-of-pocket.
Suppose, for instance, that the insurant has a claim for $5,000 and that consequently this individual’s premium either shows no change or rises immediately by $500 or $5,000. If the premium does not increase, there is no experience rating. If it rises by $5,000, experience rating is extreme in that the insurant suffers the entire loss. Since the total insurance premium includes a charge for administrative expenses, the insurant will reject contracts with such severe experience rating conditions: they impose costs (the $5,000 plus administrative fees) yet offer no insurance protection.
Experience rating appears to be particularly effective in discouraging relatively small and frequent claims against which insurants are quite willing to self-insure. Further, since these types of claims tend to have especially high administrative costs, their elimination is likely to reduce average insurance premiums.