THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 325

CHAPTER 12

Nonbank Financial Institutions

293

held, in the sense that an individual or firm cannot own more than 20% of the voting shares. Small demutualized companies (those with equity under $1 billion) are
eligible to be closely held.

AP PL ICAT I ON

Insurance Management
Insurance, like banking, is 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.
The economic concepts of adverse selection and moral hazard discussed in
Chapter 8 also apply to the lending activities of insurers. Here 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.

Information
Collection and
Screening

To reduce adverse selection, insurance providers try to screen out good insurance
risks from poor ones. Effective information collection procedures are therefore an
important principle of insurance management.
When you apply for auto insurance, the first thing your insurance agent does
is ask you questions about your driving record (number of speeding tickets and
accidents), the type of car you are insuring, and certain personal matters (age, marital status). If you are applying for life insurance, you go through a similar grilling,
but you are asked even more personal questions about such things as your health,
smoking habits, and drug and alcohol use. The life insurer even orders a medical
evaluation (usually done by an independent company) that involves taking blood
and urine samples. Just as a bank calculates a credit score to evaluate a potential
borrower, the insurer uses the information you provide to allocate you to a risk
class a statistical estimate of how likely you are to have an insurance claim.