THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 327

CHAPTER 12

Nonbank Financial Institutions

295

Deductibles

The deductible is the fixed amount by which the insured s loss is reduced when
a claim is paid off. A $250 deductible on an auto policy, for example, means that
if you suffer a loss of $1000 because of an accident, the insurer will pay you only
$750. Deductibles are an additional management tool that helps insurance companies reduce moral hazard. With a deductible, you experience a loss along with the
insurer when you make a claim. Because you also stand to lose when you have
an accident, you have an incentive to drive more carefully. A deductible thus
makes a policyholder act more in line with what is profitable for the insurer; moral
hazard has been reduced. And because moral hazard has been reduced, the insurance provider can lower the premium by more than enough to compensate the
policyholder for the existence of the deductible. Another function of the
deductible is to eliminate the administrative costs of handling small claims by forcing the insured to bear these losses.

Coinsurance

When a policyholder shares a percentage of the losses along with the insurer, their
arrangement is called coinsurance. For example, some medical insurance plans
provide coverage for 80% of medical bills, and the insured person pays 20% after
a certain deductible has been met. Coinsurance works to reduce moral hazard in
exactly the same way that a deductible does. A policyholder who suffers a loss
along with the insurer has less incentive to take actions, such as going to a specialist unnecessarily, that involve higher claims. Coinsurance is thus another useful management tool for insurance providers.

Limits on the
Amount of
Insurance

Another important principle of insurance management is that there should be limits
on the amount of insurance provided, even though a customer is willing to pay for
more coverage. The higher the insurance coverage, the more the insured person can
gain from risky activities that make an insurance payoff more likely and hence the
greater the moral hazard. For example, if Zelda s car were insured for more than its
true value, she might not take proper precautions to prevent its theft, such as making sure that the key is always removed or putting in an alarm system. If it were
stolen, she would come out ahead because the excessive insurance payment would
allow her to buy an even better car. By contrast, when the insurance payments are
lower than the value of her car, she will suffer a loss if it is stolen and will thus take
precautions to prevent this from happening. Insurance providers must always make
sure that their coverage is not so high that moral hazard leads to large losses.

Summary

Effective insurance management requires several practices: information collection
and screening of potential policyholders, risk-based premiums, restrictive provisions, prevention of fraud, cancellation of insurance, deductibles, coinsurance,
and limits on the amount of insurance. All of these practices reduce moral hazard
and adverse selection by making it harder for policyholders to benefit from engaging in activities that increase the amount and likelihood of claims. With smaller
benefits available, the poor insurance risks (those who are more likely to engage
in the activities in the first place) see less benefit from the insurance and are thus
less likely to seek it out.