THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 326

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PA R T I I I

Financial Institutions

Based on this information, the insurer can decide whether to accept you for the
insurance or to turn you down because you pose too high a risk and thus would
be an unprofitable customer.

Risk-Based
Premiums

Charging insurance premiums on the basis of how much risk a policyholder poses
for the insurance provider is a time-honoured principle of insurance management.
Adverse selection explains why this principle is so important to insurance company profitability.
To understand why an insurance provider finds it necessary to have risk-based
premiums, let s examine an example of risk-based insurance premiums that at first
glance seems unfair. Harry and Sally, both college students with no accidents or
speeding tickets, apply for auto insurance. Normally, Harry will be charged a much
higher premium than Sally. Insurance companies do this because young males have
a much higher accident rate than young females. Suppose, though, that one insurer
did not base its premiums on a risk classification but rather just charged a premium
based on the average combined risk for males and females. Then Sally would be
charged too much and Harry too little. Sally could go to another insurer and get a
lower rate, while Harry would sign up for the insurance. Because Harry s premium
isn t high enough to cover the accidents he is likely to have, on average the insurer
would lose money on Harry. Only with a premium based on a risk classification,
so that Harry is charged more, can the insurance company make a profit.2

Restrictive

Provisions

Restrictive provisions in policies are an insurance management tool for reducing
moral hazard. Such provisions discourage policyholders from engaging in risky
activities that make an insurance claim more likely. For example, life insurers have
provisions in their policies that eliminate death benefits if the insured person commits suicide within the first two years that the policy is in effect. Restrictive provisions may also require certain behaviour on the part of the insured. A company
renting motor scooters may be required to provide helmets for renters in order to
be covered for any liability associated with the rental. The role of restrictive provisions is not unlike that of restrictive covenants on debt contracts described in
Chapter 8. Both serve to reduce moral hazard by ruling out undesirable behaviour.

Prevention of
Fraud

Insurance providers also face moral hazard because an insured person has an
incentive to lie to the insurer and seek a claim even if the claim is not valid. For
example, a person who has not complied with the restrictive provisions of an
insurance contract may still submit a claim. Even worse, a person may file claims
for events that did not actually occur. Thus an important management principle for
insurance providers is conducting investigations to prevent fraud so that only
policyholders with valid claims receive compensation.

Cancellation of Being prepared to cancel policies is another insurance management tool. Insurers
can discourage moral hazard by threatening to cancel a policy when the insured
Insurance
person engages in activities that make a claim more likely. If your auto insurance
company makes it clear that coverage will be cancelled if a driver gets too many
speeding tickets, you will be less likely to speed.

2

Note that the example here is in fact the lemons problem described in Chapter 8.