INTRO TO RISK MGT AND INS
INTRO TO RISK MGT AND INS RMI 3500
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REAL Cities le m NEW 5615 w m m vitLiL Kansas City Star The MO Sepiembev 2 mm Page 3 Sampling errors in Kansas could cost farmers millions POXANA HEGEMAN sievaiuvs s1aie Emma s said 2mm Kansaswneai amp iuiiuwed Wis gmwmg seaseh by iaiesphhg heezes ahe harvesi rams The hme wheai ievi e hawesiwas iheh damaged by spvuuimg hemihe uniimeiy mmsiuve iieids h ah e un e save me and munEy eh iesis euhhg ihe harvest Puiansky said pinceduveswnen ihey were W39EIYNEH he said Whaiisimsivaimgisinaiinisisveaidamage Hisducumenied iiisnuianissueinai chaiiengesine miegmyuicmp hsmaheeg PuianskysaidTuesday We are nuHaikmg aim igyahihamehi geiiesied We aveiaikmg abuui veaisampling veaiiesis veai numbers We avejusi debaimg ihe sampling pvuiucui The pmbiem a ems ai ieasiZDDD Kansas larmels ahe pvubabiy muve h a yegmh ihai yahgeshem Cuiby e Gameh Guy and Wesircenivai Kansas Puiansky said every duiiav ihey eah receive in siay h hushessg he said vEspunswE as n uuid he in ihe pmbiem that would allow us to keep the program integrity element alive and help the farmers out of the situation they are inquot Pugh said Pugh said quotprogram integrityquot means keeping it as an insurance program and not a grant program that gives money away Among those affected is Tim Peterson a fourthgeneration farmer who cultivates 2800 acres near Monument in northwest Kansas He put 800 acres into hard white winter wheat and the wheat he cut out of those acres had 80 to 90 percent sprout damage Peterson had harvested a full day before word got out ofthe sampling problem He figured the five truckloads of wheat that were improperly sampled cost him about 6500 in insurance payments But many of his farming neighbors lost tens of thousands of dollars more he said quotEverything about this season was so unusual and then to find out we didn39t jump through the right hoops in order to get the insurance we thought we had That makes a farmer a little upset You think you are doing the right thing and then a technicality comes up and you are disqualifiedquot Peterson said He still considers himself fortunate he expects to collect 40000 for sprout damage on the rest of his crop thanks to the quick action of a local extension agent who caught the problem In a telephone interview Peterson called extension agent Brian Olson a quotheroquot for getting the word out fast once he saw what was happening Olson a Kansas State University crops and soils specialist who works at the northwest area office said he alerted radio stations because it was the best way he knew to reach people in the rural area quotThere are some guys out there with substantial dollars that are just going to vanish The problem l have with the whole thing as far as I can tell it wasn39t the farmers39 fault They took their wheat to the elevatorquot Olson said He said the breakdown occurred somewhere in the communication among the Risk Management Agency the elevators and the crop insurance agents quotBut in the end the farmer is the one that is going to pay the pricequot Olson said First glance First glance Because of sampling mistakes at Kansas grain elevators farmers could lose millions of dollars in insurance payments for sproutdamaged wheat File photoSprout damage may have caused more than 15 million in damage to the Kansas wheat crop but farmers may lose millions in insurance payments because of sampling errors at the state39s grain elevators Copyright 2004 The Kansas City Star Co 9400 Reading 1 The Economics of Insurance By Robert Klein Reading Objectives 1 Explain the concept of risk aversion and its importance to individuals demand for insurance 2 Discuss other factors in uencing the demand for insurance 3 Discuss other important insurance principles and the problems of adverse selection and moral hazard 4 Show how the interaction of supply and demand determines the quantity of insurance purchased and its price 5 Explain the concepts of extemalities and principalagent con icts and their relevance to the study of insurance Understanding the economics of insurance is essential to understanding how insurance markets lnction This reading provides a highlevel overview of important economic concepts and principles relevant to insurance The economic theory underlying risk aversion and maximizing expected utility under uncertainty explains why individuals are willing to pay a risk premium over the expected payout on an insurance policy for insurance The standard economic framework for analyzing the interaction of supply and demand for a given commodity lays a foundation for understanding how insurance markets work The special problems of moral hazard and adverse selection have signi cant implications for the terms under which insurance is sold and purchased Finally extemalities and principalagent con icts provide lrther insights into the economics of insurance markets I Determinants of the Demand for Insurance A Risk Aversion and Expected Utility Economists have been intrigued by the question of why people would buy insurance if the premium they would have to pay would exceed the expected payout that they would receive on the policy The expected payout is equal to the expected loss or claims payments that an insured would receive ie the probability of having a loss multiplied times the amount of the loss that might occur For example if a person faces a 10 percent probability of having a 10000 loss their expected loss or payout on an insurance policy would be 10001 Obviously an insurer o ering such a policy would have to charge a premium equal to this expected loss plus a loading for the insurer s expenses and cost of capital in servicing the policy At first blush in pure monetary terms it might seem that people would be neutral about a purchasing an insurance policy at a premium that would equal the expected payout that they would receive on the policy Further it might seem that people would not be willing buy a policy that would cost more than the expected payout It would be comparable to asking someone to bet a dollar on a coin ip but if he wins he gets less than a dollar2 However if we make certain reasonable assumptions about how 1 In reality people face a range of possible losses each with an associated probability In such a situation the expected loss could be calculated by multiplying the probability of each potential loss times the loss and summing all of these calculations 2 This would be equivalent to equalizing the amounts that would be won or lost but changing the odds so that the probability of winning is less than the probability of losing Actually organized gambling offers negative expected payouts For example state lotteries pay out much less in winnings than they receive in revenues in order to fund their operating expenses and return money to the state treasury for various purposes Presumably gamblers accept this because they derive utility from gambling eg entertainment value in excess of the expected payouts on their wagers peoples utility varies with the amount of wealth they have or would have under diiTerent scenarios we can develop a plausible explanation for why they would buy insurance even if the premium exceeds the expected payout they would receive Utility theory is the foundation for analyzing people s preferences and demand for things they value In theory people allocate their expenditure of resources to maximize their utility ie the satisfaction or pleasure they derive from anything that has value including leisure Economists use utility functions and budget constraints to determine peoples demand functions for a good and how much they would be willing to pay for it The key assumption underlying the demand for insurance is that most peoples utility curves plotting utility against wealth are concave ie the slope of the utility curve becomes atter as wealth increases The intuition is that the marginal increase in utility derived from a given increase in wealth decreases as wealth increases In other words a poor Bill Gates derives more utility from an extra dollar than a wealthy Bill Gates This is illustrated in Figure l Economists have extended this concept in the context of maximizing expected utility to imply that people with a concave utility function are quotrisk aversequot meaning the value of a dollar lost is greater than the value of a dollar gained This implies that people would pay something to ensure that they would keep the amount of wealth they have if they would otherwise face the chance that they would lose all or a portion of their wealth Similarly if people were asked to put their wealth at risk as they would be if they invested in an asset that might decline in value they would demand a rate of return higher than the rate of return for a riskless asset The concept of risk aversion is re ected in the advice that quota bird in handquot is worth more than quottwo birds in the bushquot Figure 1 Risk Averse Utility Utility o 1 2 3 A Wealth Economists apply this concept to the demand for insurance If someone is risk averse they are willing to pay something for insurance to keep what they have rather than take the chance of having a loss What they are willing to pay for this security or reduction in uncertainty ie objective risk is called a quotrisk premiumquot It is the amount above their expected loss or the expected payout on an insurance policy that people are willing to pay to have insurance This can be illustrated with the following example depicted in Figure 2 Fred has 20000 in the bank and a house worth 100000 with a 15 percent chance of re that will totally destroy the home there is no chance of a partial loss His total wealth is 120000 In the absence of insurance Fred will experience one of two possible scenarios 1 there is no fire and he retains wealth of 120000 or 2 there is a re he loses his house and his wealth decreases to 20000 Now let s assume that Fred has the option of buying an insurance policy that will pay the value of his house if it is destroyed by fire Further for the moment let s assume the premium for this policy is equal to he expected loss or pure premium which is 15000 15 x 100000 ie there is no loading for the insurer s expenses Fred will choose to buy insurance if his expected utility from doing so exceeds his expected utility from not buying insurance To determine what Fred will do we need to postulate a utility function for him Let s assume that he has the following utility function UW 10gW where U utility W wealth Figure 2 Maximizing Expected Utility U 20 Uhllty 0 2b 92 105 120 w EU 10 x U105 U105 Note UW 111WV ealth This lnctional form where the amount of utility is equal to the natural log of the amount of wealth results in a concave utility curve consistent with the assumption of diminishing marginal utility and risk aversion Using this functional form and the other information we have we can calculate and plot Fred s expected utility without insurance and with insurance and hence determine what choice he will make to maximize his utility The expected utility if Fred does not buy insurance is EUNI 085 x log120000 015 x log20000 085 x 117 015 x 99 1143 The expected utility if Fred does buy insurance is EUI og120000 15000 1156 Fred will buy insurance if his expected utility from buying insurance exceeds his expected utility from not buying insurance ie EUI is greater than EUNI In our example Fred will buy insurance because EUI equal to 1156 is greater than EUNI equal to 1143 Note in this example we started with an unrealistic assumption that the insurer would charge a premium equal to the expected loss on Fred s policy with no loading for expenses We know that in reality insurers have to charge a premium that includes a loading to cover their costs for servicing policies This raises the following question What is the risk premium or loading that Fred would be willing to pay for insurance ie how much more than the expected payout on the policy would he be willing to pay We can determine this amount in dollars by calculating the dilTerence between the money equivalents of EUI and EUNI By subtracting the amount of wealth W that would be needed to generate EUNI from the amount of wealth W needed to generate EUI we ale calculating the risk premium or the additional amount Fred would be willing to pay for insurance Since EUW equals the natural log of W we can calculate W and W by taking the antilogs of EUNI and EUI which is the same as raising EUNI and EUI to the 10111 power Hence Fred s risk premium W W 105000 92000 13000 This means that Fred would be willing to pay up to 13000 more than the expected payout on his policy or a total premium of 28000 which is equal to the sum of the expected payout or loss and Fred s risk premium 15000 13000 If an insurer charges less than 28000 Fred will buy insurance If the insurer charges more than 28000 this would be necessary if the insurer s loading for expenses was more than 13000 then Fred would not buy insurance The concept of risk aversion and its implications for insurance demand is important because it tells us the circumstances and terms under which people would be willing to buy insurance In order for their to be a viable market for insurance enough people have to be risk averse and willing to pay quotrisk premiumsquot suf cient for insurers to cover their expected claims payments and their expenses If people were not risk averse no one would buy insurance unless they were coerced to do so Further the more risk averse someone is the greater will be his demand for insurance all else equal This concept has further application in understanding when it is economically feasible to sell some types of insurance to some people and not others When insurers expenses are relatively low in relation to the expected losses from covering a paiticular risk people are more likely to buy insurance and the premium is more likely to be economically feasible This helps to explain why it is more optimal to purchase higher liability limits than low deductibles It also explains why it does not make sense for very old people to buy life insurance the premium they would have to pay the expected loss plus the insurer s loading for expenses would exceed the face amount of the policy B Other Factors In uencing Demand It is reasonable to surmise that other factor may in uence peoples demand for insurance besides their degree of risk aversion One important factor is the information they have and their perception of the risks they have In the above example we implicitly assumed that both Fred and the insurer knew that there was a 15 percent chance that his house would be totally destroyed by a fire However if Fred believed that his probability of loss was less than 15 percent the premium he would be willing to pay would be less than 28000 The lower Fred s perception of his risk the less he would be willing to pay for insurance ie the lower would be his demand for insurance Depending on the disparity between Fred s perception of his risk and what insurers perceive it to be it is possible that Fred would not buy insurance at the premium insurers would need to charge Hence relatively low consumer demand for certain types of insurance eg earthquake and ood insurance could be partially caused by consumers underestimation of their risk Conversely relatively high demand for demand for certain types of insurance such as ight insurance could be due in part to travelers overestimation of their risk of being killed in a plane crash Peer behavior may further in uence a person s demand for insurance Your perception of risk may be affected by your neighbors or friends perception of risk Further if your relatives or friends purchase insurance you may be more likely to purchase insurance and vice versa Wealth and income also in uence demand This happens in two ways First wealth and income determine consumers budget constraints in purchasing various goods and services including insurance and what they can afford to pay for insurance Second a person s wealth and income can determine what they stand to lose if they have an accident or are sued as well as their ability to lnd their losses from the assets they hold The effects of these di erent considerations can move in different directions so one cannot say that wealth and income will always have a positive effect on the demand for insurance However observation suggests that greater wealth and income tend to increase a person s demand for insurance Of course even if someone can a ord and would be willing to buy insurance we might expect a person to compare the relative costs and bene ts of different risk transfer options and choose the one that maximizes their utility More speci cally if a person can find a less costly way to transfer risk than insurance they would presumably choose this lowcost option over insurance There are various forms of noninsurance risk transfers such as defaults on debt obligations charity and government financial assistance3 For example some people might choose to go without insurance if they can declare bankruptcy and escape their debts if they sulTer a major financial loss Similarly if 3 Noninsurance risk transfers also can be attempted through contractual provisions that would require the other party to indemnify the first party or assume some risk involved in the transaction 10 people believe that their nancial losses or expenses would be covered by the government or charity they might forgo insurance A good example of this kind of thinking is the decision by some people to not buy health insurance even though they could afford to pay for it Some of these people may believe that hospitals andor the government will cover their medical costs if they do not have health insurance Similarly some people with few assets might consider themselves judgment proof and will try to avoid buying auto liability insurance They have little to lose if they cause an accident and are sued for the damages they in ict on others As discussed below the ability to extemalize risk to others can have a negative effect on a person s demand for insurance Consequently the government or other entities at risk may force people to buy certain kinds of insurance Obviously this will increase the demand for insurance For example most states require drivers to purchase minimum auto liability insurance so that there will be at least some coverage for any damages they may cause Also on home mortgages lenders will typically require borrowers to insure their home because the home serves as collateral to back the loan II Other Important Insurance and Economic Concepts A Diversi cation of Risk The principal purpose of insurance is the spreading or diversi cation of risk Risk is endemic to life and business Individuals and firms face a number of perils that threaten them with financial losses Pure risk involves no chance of economic gain and uncertainty about whether a financial loss will occur and possibly how much that nancial loss will be Speculative risk involves the chance of gain or loss and is not insurable The chance of damage to one s home from a re or storm is an example of a pure risk The cause of such a loss is accidental and uncertain Homeowners do not know whether they will have such a loss and when it would occur Homeowners only know that such a loss might occur because of a random act of nature or other event outside of their control Moreover homeowners have nothing to gain from losing their home Individuals and rms can reduce the pure risks they face through insurance mechanisms designed to diversify or spread this risk across a wider base of exposures andor over time This is accomplished by pooling losses for a group of risks in some manner Members of the group share all losses that are incurred by its members In effect members of the group exchange a smaller more certain nancial contribution for protection against a larger uncertain loss Combining losses for a group and sharing them in some manner among group members makes this possible In this sense insurance is a mechanism by which pure risks are transferred through pooling Assuming that pool members are risk averse ie they value greater certainty and the reduction of risk pool members will be willing to pay a risk premium to cover the administrative and transaction costs of the pool in retum for the reduction in risk This concept of risk pooling underlies insurance purchased from an insurance company as well as other forms of risk sharing among members of a group Uncertainty and the law of large numbers make insurance valuable as well as feasible Insurance experts refer to the difference between actual losses and expected losses as objective risk As the number of members of an insurance pool increase the random or uncertain aspect of the occurrence of accidents and claims for bene ts ie objective risk is reduced and there is greater certainty about the total losses that the pool will suffer4 This allows the pool to allocate its costs among its members in the form of smaller certain premiums or assessments In effect pool members exchange their fair share of total pool costs in return for protection against the risk of loss hat they would otherwise face individually Uncertainty and risk is reduced through sharing all losses among the group members and the greater predictability of losses achieved by increasing the number of members of the pool It should be stressed that pooling losses does not necessarily mean that every pool member will make an equal contribution to the pool In theory equal contributions only make sense if every member of the pool has the same risk of loss In practice most pools contain members whose risk varies Individual pool contributions can be based on members relative degree of risk so that individuals with greater risk pay higher premiums As explained below this maintains lowrisk pool members incentives to remain in the pool Pools can be organized in various ways eg group selfinsurance insurance companies etc but the basic concept is the same B Ef ciency and Equity Ef ciency is a concept that is more often discussed by economists than insurance experts but it is relevant to all markets and insurance systems The highest level of 4 The law of large numbers can be illustrated by a coin tossing experiment We know that the on any given toss of a coin the probability of it turning up heads is 50 percent 5 and the probability of it turning up tails also is 50 percent or 5 However if we toss the coin twice we may get heads both times tails both times or one head and one tail Yet if we toss the coin a 1000 times the frequency of heads is likely to be close to 500 or onehalf of the tosses The more times we toss the coin the more closely will the frequency of heads approach onehalfofthe tosses ef ciency is achieved when resources are utilized in the best way possible to maximize social welfare ie the combined utility of all members of society This means that the bene ts of an activity should at least equal its cost or the activity should not be undertaken and that all activities are performed at the lowest cost possible When this occurs society reaps the maximum value from the employment of its resources With respect to insurance this means that people and rms are managing risk in the best manner possible from their perspectives as well as society s perspective Managing risk ef ciently requires selling and purchasing optimal insurance contracts as well as retaining and controlling losses to the extent that it is cost effective to do so Equity is another word for fairness terms that can imply diiferent things to different people Some might interpret equity to mean that all insureds should pay the same premiums or receive the same bene ts from insurance contracts regardless of their relative risk A variation of this view of equity is based on the ability to pay those with greater resources would be expected pay more than those with fewer resources Alternatively others de ne equity to mean that individuals should pay costs according to the bene ts they receive Based on this interpretation equity in insurance markets is achieved when individuals pay premiums commensurate with their relative risk ie highrisk insureds pay higher premiums than lowrisk insureds There is a tradeoff between the rst interpretation of equity and ef ciency Equal premium payments among insureds with different levels of risk will reduce ef ciency Lowrisk insureds will be induced to buy too little insurance and highrisk insureds will be induced to buy too much Incentives to mitigate losses also will be distorted by equalizing premium payments Individuals who do not pay the full cost of their insurance will have less incentive to reduce their risk to lower their premiums The second interpretation of equity is consistent with maximizing economic ef ciency Allocating the full costs of activities to their bene ciaries will encourage insurance and loss prevention expenditures that maximize social welfare Individuals and firms will be induced to reduce their risk of loss if the resulting premium savings exceeds their cost of reducing risk eg investing in loss prevention Consequently there is no tradeolf between this notion of equity and ef ciency C Adverse Selection Adverse selection occurs when highrisk individuals are more likely to purchase insurance than lowrisk individuals Rejda 2001 This assumes that insureds have better knowledge of their risk than insurers Insurers seek to avoid adverse selection through accurate risk classi cation and pricing and declining to sell insurance to risks for which they cannot determine or charge an adequate premium Ef cient or riskbased insurance pricing discourages adverse selection but insurers may face constraints in obtaining adequate information and accurately assessing an individual s risk Rothschild and Stiglitz 1976 This leads to potential adverse selection because insurers cannot accurately distinguish between insureds risk levels and are subject to selling insurance to highrisk insureds at a price less than their expected cost This will induce highrisk insureds to purchase more insurance and lowrisk individuals to buy less insurance Chaiging equal premiums to pool members with different risk levels will induce lowrisk individuals to leave the pool and highrisk individuals to join the pool When this occurs an insurance pool tends to shrink to smaller and smaller groups of highrisk insureds until the pool eventually collapses5 Adverse selection constitutes a market failure in that the informational constraints faced by insurers cause the market to provide a less than an optimal amount of insurance and eventually collapse in the extreme case Consequently insurers strive to obtain information on insureds risk and employ pricing underwriting and policy design measures that discourage adverse selection and help the market function more effectively However regulators and other government of cials may or may not approve insurers efforts to avoid adverse selection depending on regulators perceptions of what is ef cient and equitable D Moral Hazard Moral hazard is another type of market failure that occurs when having insurance causes insureds to expend less effort to avoid losses and under certain circumstances intentionally cause losses Insurance experts draw a distinction between moral hazar and morale hazard According to insurance experts moral hazard constitutes a defect in character that would prompt an insured to cause a loss This might occur when the insured stands to gain financially from causing an accident and ling a claim For example this could happen if a homeowner could insure a home for more than its market value and gain nancially from its loss 5 In theory insurers might attempt to get individuals to reveal their risk level by offering policies that provide full protection and others that do not Presumably highrisk individuals will have a greater preference for full insurance coverage at an appropriate price However in practice there are impediments to the success of such a strategy and it is not clear that most insurers employ it Morale hazard arises when an insured has diminished incentives to prevent losses but would not gain nancially from an insured event When this is the case the insured may exercise less care in preventing or controlling losses but would not be induced to cause a loss An example of morale hazard would be a situation where an insured homeowner would be more careless in preventing losses such as failing to lock his doors when he leaves his home Economists tend to use the term moral hazard to cover both phenomena and this how most people use the term in practice Economists focus on the role of incentives and how rational people will respond to incentives Hence a rational person might be tempted to cause a loss if their insurance would pay them more than the value of the item he would lose Of course a person s ethics or awareness of other costs eg criminal sanctions could dissuade him from such behavior The tendency for insurance to prompt an insured to exercise less care is probably more signi cant as this could occur consciously or even subconsciously and the noninsured costs associated with an accidental loss may be less signi cant or apparent Insurers combat moral hazard by imposing deductibles policy limits and co insurance provisions that force the insured to bear some portion of his or her loss Insurance contracts also will typically become void if it can be proven that the insured intentionally caused a loss Retaining some portion of the potential loss increases the insured s incentive to decrease the chance of loss While such measures have a desirable effect on insureds incentives they result in incomplete insurance and diminish the amount of protection Alternatively insurers may seek to improve safety incentives by olTering discounts for loss prevention measures and declining to sell insurance to individuals who do not demonstrate a commitment to safety Again regulators may find some of these measures acceptable and others to be problematic E Indennity and Insurable Interest The principles of indemnity and insurable interest govern the design of many insurance contracts to mitigate the moral hazard problem Under the principle of indemnity insureds should not pro t from a covered loss and should be restored to no better than their financial position prior to the loss Rejda 2001 The objective is to ensure that insureds do not gain financially from losses and reduce moral hazard If insureds could pro t from insurance coverage of a loss they would have an incentive to cause losses and a disincentive to take precautions to avoid losses Most property and liability contracts are contracts of indemnity Losses in such contracts are typically settled on the basis of actual cash value eg replacement cost less depreciation or fair market value However there are some insurance contracts that constitute exceptions to the indemnity principle A valued policy pays the face amount of insurance regardless of the actual cash value of the loss Valued policies are sometimes used to insure items for which it would be dif cult to determine the actual cash value or market value such as rare antiques Some states have valued policy laws that require payment of the face amount of insurance in the event of total losses to real property from certain perils Certain coverages are offered on a replacement cost basis where the cost of replacing the insured property is paid with no deduction for depreciation For such contracts insurers typically require a minimum ratio of the market value to replacement cost eg 70 percent be met to diminish moral hazard Also insureds are actually required to repair or replace the damaged property they cannot take the full replacement cost as cash to be used for other purposes Finally life insurance contracts are not contracts of indemnity but rather are valued policies that pay a stated bene t in the event of the insured s death The second important concept is the principle of insurable interest According to the principle of insurable interest the insured must sulTer some form of loss or harm if the insured event occurs Rejda 2001 Insurable interest is necessary to prevent gambling reduce moral hazard and measure the insured loss Otherwise individuals could purchase insurance contracts as a matter of speculation eg insuring another s home in which the insured did not have a nancial interest andor gain from causing a loss The same principle applies to life insurance contracts Allowing someone to purchase a life insurance policy on a person with whom they had no family relationship or pecuniary interest would raise obvious questions about the insurance buyer s intentions 111 Supply Demand and Competition A Supply Demand and Market Equilibrium The economics of insurance markets are driven by the supply of and demand for insurance coverage see Varian 1992 Insurance markets like other markets tend to settle at a price and quantity where the amount of insurance that insurers are willing to supply equals the amount that insureds demand at a price agreeable to both Changes in the supply of andor the demand for insurance will change this point of equilibrium Regulation or other external interventions in the market also can a ect supply and demand changing the point of market equilibrium or causing an imbalance between the amount of insurance that insurers are willing to sell and the amount that consumers wish to purchase When economists use the term supply they think in terms of a schedule of the quantities of a product that firms are willing to supply at diiTerent prices The supply function for a market is the sum of the supply functions of individual insurers The supply of insurance is determined primarily by the cost of providing coverage ie the present value of expected claim costs or bene ts paid to insureds expenses and the cost of capital Insurers costs include a risk load or risk premium to re ect the cost of uncertainty about their future liabilities6 In the short run the supply function for insurance is likely to be upward sloping ie insurers require higher prices to provide larger quantities of insurance coverage because their perunit costs increase with the quantity of insurance they provide In the long run the supply function for most insurance markets should be relatively at or price elastic That is the quantity of insurance that insurers are willing to supply should expand to meet increased demand without a signi cant increase in average cost that would require an increase in the market price In the long run insurers costs are generally variable ie xed investments in their facilities can be adjusted to produce a given amount of insurance at the most ef cient scale of operation This assumes that 6 Note that if an insurer is able to reduce objective risk through pooling a large number of exposures then the risk premium that the insurer would require would be less than the sum of risk premiums that its insureds are willing to pay to transfer risk to the insurer 20 ideally there are no signi cant baniers to entry and that capital can ow easily into a market to meet increased demand for insurance without an increase in perunit costs As discussed above the demand for insurance is determined principally by consumers risk actual or perceived degree of risk aversion income and assets other options for managing risk and compulsory insurance requirements Generally the greater risk that an individual or rm faces and the lower their ability to accommodate potential losses using other nancial resources they greater will be their demand for insurance To the extent that consumers are risk averse ie they gain additional utility from reducing their risk they will be willing to pay a premium that exceeds their expected loss without insurance that is necessary to cover insurers expenses transaction costs and cost of capital The demand for insurance is somewhat sensitive to price ie the higher the price the less insurance consumers will want to purchase all else equal At the same time this price sensitivity or elasticity may be somewhat low for some coverages that consumers perceive to be essential or are mandated by government or lenders eg auto and homeowners insurance Figure 3 graphs the determination of the price and quantity of insurance sold in the long run in a given market The downwardslanted line D represents the market demand curve for insurance indicating the total number of policies or amount of insurance demanded at various premium levels The downward slope of the demand curve indicates that less insurance is demanded at higher prices In other words higher premiums cause some buyers to drop out of the market or buy less insurance The long run market supply curve is represented by the at line LS which assumes that in the long run insurers can provide increased insurance without increasing its price 21 Figure 3 Supply and Demand S S A pc D O Qc Quantity 22 Under perfect competition in the long run the market price or rate will equal average and marginal cost pc and the number of policies or amount of insurance sold will equal QC In other words the market price will be just suf cient to cover insurers costs operating at an ef cient level and the quantity of insurance sold will equal the quantity of insurance that consumers demand at that price Total premiums will equal total cost which is equal to the area OpCAQC and quoteconomic pro tsquot will be absent7 This means that consumers will receive any surplus utility re ected in the diiTerence between the price of insurance and what they would be willing to pay for it The income eamed by insurers will be just suf cient to cover their costs including their cost of capital and no more Note that in this model we assume that insurers are price takers and sell insurance at the price determined by the intersection of market demand and market supply The impact of market competition is re ected in the market loss ratio The loss ratio is equal to total losses divided by total premiums which is equivalent 0 the average loss cg divided by the market price p The loss ratio re ects the dollar amount of loss protection policyholders receive for a dollar39s worth of premiums Under perfect competition the loss ratio will equal the ratio c gpc ie the average loss divided by the competitive market price It should be noted that if insurers claims costs or expense costs rise eg due to higher accident rates this will push up the supply curve LS and result in a higher market price and less insurance being purchased 7 The term economic profitsquot refers to profits in excess of insurers39 cost of capital 23 B Theory of Competition Perfect Competition The characteristics of a competitive market provide a benchmark for comparing alternative market structures and evaluating markets in the real world Competition is considered desirable from society s standpoint because it ensures that resources are being used in the best way possible An industry is considered perfectly competitive only when the number of firms selling a homogeneous commodity is so large and each rm s share of the market is so small that no firm is able to affect the price of the commodity by varying its output In addition perfect competition requires that there be no baniers to the entry and exit of firms and that resources be perfectly mobile in and out of the industry The longrun equilibrium outcome of a competitive market possess three desirable properties 1 The incremental or marginal cost of producing the last unit of output will be equal to the price that consumers are willing to pay for it 2 There will be no quotexcessquot or quoteconomicquot pro ts Investors will receive a return just suf cient to induce them to maintain their investment at the level required to produce the industry39s equilibrium output ef ciently 3 Each firm will be producing at an output level where its average cost will be at a minimum ie maximum e iciency In essence a large number of firms and the lack of barriers to entry and exit lead to independent and competitive pricing which results in optimal market performances 8 This principle is taken to its logical limit under the theory of contestable markets which argues that even high concentration may not permit firms to maintain a price above the competitive price if entry and exit are costless and can occur rapidly However the reality may be that very few markets if any have costless entry and exit empirical support for the theory of contestable markets has not been forthcoming Still the 24 Conversely high market concentration and entry barriers will tend to constrain competition and cause suboptimal performance Perfect competition also requires complete and perfect knowledge Martin 1988 All firms should know the relevant technologies and buyers and sellers should be fully informed about all aspects of the product they are buying and the market Conditions with respect to consumer information and consumer choice may be more relevant when other conditions for perfect competition are violated When entry is signi cantly constrained the fact that buyers lack information about prices andor are forced by law to buy a product could result in higher prices or diminished product quality or services Workable Competition The conditions for perfect competition are never satis ed in reality Many industries are characterized by a limited number of firms considerable product diversity among firms entry barriers informational limitations extemalities and other structural impediments to competition Hence competition will always be something less than perfect For this reason the concept of quotworkable competitionquot has been developed as a practical standard to evaluate the structure and performance of industries Scherer and Ross 1990 Arguably workable competition exists when the structural characteristics of a market reasonably approximate the conditions for perfect competition and government intervention cannot improve the performance of the market This view appropriately focuses analysis on the question of whether regulation or other forms of government intervention can make a market work better disciplinary effect of potential entry into markets cannot be disputed For a discussion of the theory of contestable markem see Baumol Panzar and Willig 1982 25 The analysis of insurance markets requires the examination of market structure and performance in a dynamic context If a market is relatively unconcentrated entry barriers are low pro ts appear to be in line with other industries of similar risk and there is no evidence of gross inef ciency then it is unlikely that government intervention could signi cantly improve performance On the other hand if a market is highly concentrated entry is restricted and longrun pro ts substantially exceed those in other industries then some form of regulatory action may be bene cial Worlmble competition does not require that all rms in the market operate at maximum e iciency at all times or that no sale is ever made at a price above the quotcompetitive pricequot or insurers average cost What is relevant is whether the market over the long run rewards ef cient rms and punishes inef cient firms When this occurs then a market will be driven to greater ef ciency over time to the maximum bene t of consumers Alternative Market Structures The main alternatives to a structurally competitive market are monopoly and oligopoly A monopoly occurs when there is only one seller of a commodity for which there are no close substitutes A monopolist possesses market power that allows it to constrain the quantity of a good supplied to raise the market price In other words under a monopoly the quantity of a good sold and purchased is lower and the price paid is higher than under perfect competition The monopolist sets quantity and price to maximize pro ts and consumer surplus is reduced to zero Hence consumers are disadvantaged by a monopoly and social welfare is less than what would be achieved under perfect competition For this reason governments seek to break up monopolies or 26 regulate them closely if they olTer significant economies of scale or other advantages Monopolies rarely if ever occur naturally in insurance markets because the technology required to underwrite insurance can be easily replicated by multiple firms However governments sometime create an insurance monopolist by allowing only one firm or government agency to sell insurance Oligopoly occurs when a few relatively large sellers and each possess a share of the market sufficient to cause them to recognize the interaction of their decisions in determining the market price and output This recognition creates a basis for cooperative behavior and limits on competition explicit or implicit for the purpose of increasing pro ts Entry barriers lrther facilitate explicit and implicit cooperative behavior by preventing new firms from entering the market and undermining existing price and output agreements anong firms already in the market Entry also can be deterred if exit from the market would be costly Oligopoly is more likely in insurance than monopoly but cost conditions and the lack of entry baniers typically prevent a small number of insurers from manipulating a market There are some insurance markets that are so small that they only allow a small number of insurers to serve the market efficiently This tends to be restricted to certain specialty insurance markets However the threat of potential entry by other insurers can deter oligopolistic behavior even in these specialty markets Monopolistic competition is another possible market structure that is relevant to insurance Under monopolistic competition there are numerous firms but they do not sell a homogenous commodity Their products are sufficiently di erentiated so that each firm effectively faces a separate demand curve for its product At the same time firms 27 products are highly substitutable so that they must compete on price as well as the features of their products Because consumers will switch for a small diiTerence in price or quality in such a situation firms are forced to compete and be ef cient and charge prices that just cover their costs as is the case with perfect competition Because insurers vary their products and quality of service to some degree but also compete aggressively on price insurance markets might be compared to monopolistic competition The above comments with respect to worlmble competition also would apply to monopolistic competition In other words a monopolistically competitive market also could be worlmbly competitive Cyclical and Excessive Competition There are circumstances where the structure of an insurance market may lead to too much competition and negative pro ts for insurers Unexpected increases in claim costs and aggressive price competition can also adversely affect operating results In the standard competitive model economists assume that firms will not price below vaiiable cost in the short run and average total cost in the long run Economists also assume that firms know what their costs are when they set prices In reality however insurance rates have to be set prospectively based on projected costs Absent any regulatory constraints if insurers underestimate future costs economic pro ts will be negative There are signi cant concerns about underpricing and cyclical pricing in longtail liability lines of insurance ie lines of insurance where claims may not be reported and paid for several or more years a er a policy expires Cummins Harrington and Klein 1991 Economic losses are more likely if insurers systematically underestimate loss 28 costs take excessive risls or engage in underpricing strategies aimed at trading shortrun losses for longrun market share gains Indeed the speculative and subjective nature of insurance pricing could serve to facilitate deliberate or systematic underpricing if insurer managers are inclined to make optimistic assumptions to support lower prices and increased shortterm pro ts Several factors might contribute to systematic underestimation of costs and prices by insurers An increase in the rate of cost in ation is one factor To the extent that advisory organizations and insurers tend to project costs based on historical information they may not appropriately account for the effect of signi cant changes in the economic environment or other cost drivers For that matter insurers measurement of historical costs may be understated particularly in longtail lines such as workers compensation where ultimate liabilities may not be determined until several years alter the close of the policy period Underreserving is a serious concem in many longtail lines Underestimates of historical costs will contribute to underestimates of future costs Because the longterm adverse effects of underpricing may not be revealed for some time insurers are not forced to confront the implications of their pricing decisions until a er those decisions are made Since the market cannot sustain economic losses in the long run prices below cost or the competitive price must eventually rise This a possible explanation for the cyclical movement of prices observed in longtail lines Prices eventually rise as insurers sulTer excessive losses which force them to reduce the amount of insurance they supply The long tail may delay the reconciliation of the market price and loss costs but it cannot ultimately prevent it 29 Insurance buyers and regulators may be willing to tolerate some cyclicality in the supply of insurance as a reasonable price to pay for the bene ts obtained from aggressive competition among insurers However severe underpricing may raise solvency concerns for regulators and hard markets may increase pressure on regulators to restrict price increases and take steps to expand the availability of insurance Unfortunately experience indicates that it is dif cult for regulators to control cyclicality in the supply of insurance and their actions can worsen market conditions The most effective regulatory approach may be to intervene against insurers who are engaging in severe underreserving and underpricing IV Extemalities and Principal Agent Con icts A Extemalities The economic theories underlying extemalities and principal agent con icts have important implications for insurance markets that are not typically discussed in introductory texts An extemality occurs when individuals or rms choices and activities affect others but these effects are not re ected in market transactions Extemalities can be positive or negative For example my neighbors may derive value from the painting of my house but they do not help pay for the paint and my decision to paint the house is not in uenced by the value my neighbors derive Alternatively if I choose to erect a massive satellite dish in my yard it may negatively affect the aesthetics of my neighborhood but the implicit cost to my neighbors is not something I reimburse and may not concern me Extemalities also can occur in risk and insurance If I drive recklessly without auto insurance I extemalize risk to other drivers if I can escape paying the full cost of any damages I cause Conversely if I insure my business others may bene t from that insurance if it allows me to stay in operation whenI sulTer a loss Extemalities are important because they can result in an inef cient allocation of resources If it is possible for individuals and firms to extemalize some risls to others then society may be burdened by more risk than what is optimal For example drivers might drive more safely and cause fewer auto accidents if every driver was forced to pay the full cost of any accidents they cause However extemalities can be intemalized with insurance if insureds pay riskbased premiums While riskbased pricing is imperfect because of limited information insurers can employ pricing techniques that reward safe behavior and punish risk behavior A good illustration is merit rating in auto insurance in which drivers pay higher premiums if they are cited for traf c violation or cause accidents This encourages unsafe drivers to improve their behavior As explained above the attempt to reduce extemalities is re ected in compulsory insurance requirements although these requirements may not be fully effective B Principal Agent Con icts Principalagent con icts can occur when a principa has dif culty monitoring and controlling the behavior of his agent and the agent s interests dilTer from those of the principal A classic example in insurance is the potential con ict between the interests of the owners of an insurance company the agent and its insureds the principal Owners of insurance companies may have diminished incentives to maintain a high level of safety to the extent that their personal assets are not at risk for unfunded obligations to policyholders that would result from insolvency9 It is costly for consumers to properly assess an insurer s nancial strength in relation to its prices and quality of service Insurers also can increase their risk a er policyholders have purchased a policy and paid premiums These incentive con icts information asymmetries and imperfect control mechanisms could cause some insurers to incur greater nancial risk than what would be optimal for policyholders and society This is a primary reason why the government regulates insurer solvency to mitigate such con icts and limit the nancial risk of insurers Principalagent con icts can be found in various aspects of insurance and help to explain some of problems that develop as well as the devices that diiferent parties employ to control them Synopsis of Key Points Utility theory provides a framework for understanding individuals demand for insurance Risk averse people will be willing to pay a risk premium above the expected payout on an insurance policy This makes insurance feasible when the risk premium consumers are willing to pay exceeds the loading for expenses that insurers must add to expected loss costs in calculating an adequate premium 2 Insurance serves an essential role in diversifying risk and reducing uncertainty by pooling losses among a group of individuals and firms E Social welfare is maximized when insurance markets function ef ciently and the costs of diiferent activities are equal to their bene ts 4 Equity can be de ned in diiferent ways but it is consistent with economic ef ciency when individuals pay insurance premiums commensurate with their relative risk of loss 9 This is the case with the corporate form of organization where the owners or stockholders of the corporation are protected by limited liability ie creditors of the corporation cannot go after the personal assets of stockholders V39 0 gt1 9 5 There Adverse selection arises when highrisk individuals are more likely and lowrisk individuals are less likely to buy insurance Riskbased pricing proper underwriting selection and policy design can diminish adverse selection Moral hazard arises when insureds stand to gain from causing a loss or have diminished incentive to prevent losses Insurers combat moral hazard by having insureds bear a portion of their losses and declining to olfer insurance in situations where the insured would gain nancially from having a loss Insurance contracts embody various concepts including the principles of indemnity and insurable interest Under the principle of indemnity in the event of a loss insureds should not gain nancially from insurance and should be restored to no better than their prior position Under the principle of insurable interest the insured must sulfer some harm or loss if the insured event occurs The supply of insurance is determined largely by the cost of providing coverage and should be relatively price elastic over the long run The demand for insurance is determined principally by consumers risk and degree of risk aversion and will be somewhat less sensitive to price particularly for essential or mandatory insurance coverages The concepts of perfect and workable competition provide a benchmark for evaluating the structure and performance of insurance markets A competitive market structure leads to competitive conduct and good market performance that maximizes the value of insurance to consumers Many insurance markets may be characterized by a monopolistically competitive structure where insurers compete on both price and product features This structure will generally be ef cient assuming that consumers value the product diiferentiation provided by insurers are instances where insurers may engage in excessive competition underpricing and cyclical pricing Underpricing should be a shortrun phenomena but may require regulatory intervention if it persists and threatens insurers solvency Suggested References Baumol William J John C Panzar and Robert D Willig 1982 Contestable Markets anal the Theory of Industry Structure New York Harcourt Brace Jovanovich Cummins J David Scott E Harrington and Robert W Klein eds 1991 Cycles anal Crises in PropertyCasualty Insurance Causes anal Implications for Public Policy Kansas City Missouri NAIC Martin Stephen 1988 Industrial Organization New York MacMillan Rejda George E 2001 Principles of Risk Management anal Insurance Reading Mass Addison Wesley Rothschild Michael and Joseph E Stiglitz 1976 Equilibrium in Competitive Insurance Markets Quarterly Journal of Economics 90 629649 Scherer F M and David Ross 1990 Industrial Market Structure anal Economic Performance 3rd ed Chicago Rand McNally Varian Hal R 1992 MicroeconomicAnalysz39s 3rd ed New York WW Norton amp Co 12506 Shopping for Insurance A General Guide by Robert Klein Georgia State University 1 Determine Your Coverage Needs and Options General Guidelines The rst step in shopping for a particular type of insurance is determining what coverage you need in relation to the coverages offered by insurers What do you have at risk Risk assessment involves valuing your assets and income that are subject to losses from various perils Certain losses also might generate expenses or nancial obligations that you will want to cover in whole or in part by insurance You may choose to not cover every possible contingency or potential loss or choose to retain some potential losses However you should try to insure large potential losses that you could not afford to pay from your nancial assets or expected income Below are some of the typical risks that individuals and households face Risk Insurance Product Comment Legal obligations to others for damages you cause from owning driving auto Minimum state requirements may not be sufficient to cover your liability or assets Auto Liability Insurance Market value of your vehicle Auto Phys Damage Ins Unnecessary for old cars Replacement cost or market value of your home and other property Also includes 100000 of Homeowners Insurance personal habrhty coverage Value of your personal property for renters Also includes 100000 of Renter s Insurance personal habrhty coverage Flood and earthquake risks to home amp personal property Flood Insurance Farthauake Insurance Flood amp earthquake risks not covered under homeowners ins Personal Liability Umbrella Liability Ins Additional liability coverage beyond auto and home coverage Premature death 7 loss of future income to dependents Life Insurance Term life offers max death protection for given premium Other products have savings component Income needs during retirement Annuities Save amp invest in working years Potential medical expenses from illness or accident Health Insurance Important to buy if you don t have coverage through employer Loss of income from nonwork caused illness or disability Disability Insurance Workcaused losses covered by employers work comp insurance Potential custodial care expenses not covered by health insurance LongTerm Care Ins Range of coverage options and prices Deductibles anal Limits You also need to value the amount of risk protection you receive in relation to its cost Generally low amounts of insurance are more expensive in terms of the loading factor you pay in relation to the amount of insurance protection you receive As a general rule you will derive greater value from spending your money on protection against large potential losses you cannot afford to retain eg a 1 million liability judgment or medical bill and less value from spending money on protection against small losses you can afford to retain eg a 500 auto collision loss or medical bill Hence choices concerning deductibles and limits are very important Generally speaking you can obtain better risk protection and greater value by spending your money on higher limits for essential coverages rather than spending your money on low deductibles and extraneous coverages that provide small benefits e g towing coverage or credit insurance Coverage Gaps anal Duplicate Coverages Additionally you should consider how the coverages under your insurance policies interact Ideally you want to cover all significant risks and avoid gaps in coverage Correspondingly you don t want to waste your money on buying duplicate coverages Changing Needs anal Risk Status Also be aware that your coverage needs will change as your economic and family circumstances change Hence you should review your insurance coverages periodically to ensure they continue to meet your needs and make appropriate adjustments as your needs change You should shop shortterm coverages such as auto and home insurance periodically even if your needs do not change as you may be able to obtain better terms from a different insurer The limits on your homeowners insurance should be revised periodically for in ation or enhancements of your home Additionally in purchasing health and life insurance you must consider how your needs and risk characteristics will change in the future and the exibility you wish to have in your policy to adjust to changing circumstances Another consideration is that the younger you are when you buy life insurance the less expensive it is Renewability and level premium provisions can lower the cost of this insurance over the time period you need it Information Various national organizations and state insurance departments publish brochures that explain various insurance coverages and offer tips on shopping for insurance Books are also available that provide advice on buying insurance You should obtain any brochures published by the insurance department in your state as they will provide pertinent information specific to your state as well as general information Most insurance departments also have tollfree consumer inquiry telephone lines and Internet web sites where you can obtain information and ask questions What Types of Insurance Should I Be Concerned About Health You should have some form of health or medical insurance if at all possible If your income is limited you can economize by buying HMO coverage or a policy with higher deductibles that still protects you against catastrophic expenses If you wait until you develop a serious medical condition it will be too late You should take full advantage of any health insurance coverage as well other coverages offered through your employer You should carefully evaluate your options when you begin employment as your ability to make changes may be limited after your enrollment period expires Also you will want to continue health insurance coverage through special federal COBRA provisions during temporary periods of unemployment so you will not be subject to preexisting conditions exclusions when you reenter a new employer s health plan Disability Many employers also provide some form of disability insurance coverage but some do not You should consider buying disability coverage if your employer does not provide it or buying additional supplemental coverage to what your employer provides Disability insurance covers a significant portion of your wage losses if you are unable to work because of an injury or illness that is not workrelated workrelated injuries and illnesses are covered by workers compensation insurance Typically the coverage provided by employers is limited in terms of duration generally less than two years but you can purchase supplemental coverage for longer periods up to age 65 Long Term Care Health insurance typically does not cover extended nursing home or home health care Longterm care insurance has been developed to provide such coverage but the extent and cost of the coverage varies considerably among policies and insurers This is a difficult consumer decision that you need to consider carefully Some people rely on Medicaid to cover them if they need longterm care but this requires you to deplete most of your assets and those of your spouse and the federal government has been tightening the rules on this The financial condition and prospects of longterm care insurers is very important as you may not need your benefits until far in the future Also the older you are when you buy this coverage the more costly it is Auto Home and Liability You should buy auto insurance if you own an auto and homeowners insurance if you own a home Renters and condo insurance is a good buy for people who do not own a home These policies also provide 100000 in nonauto liability coverage Further umbrella liability coverage is a good buy for people with significant income and assets to protect against tort judgements Q Your need for life insurance depends on your circumstances You probably should buy life insurance if you have dependents who rely on your income Also if you buy life insurance when you are young and in good health you will be in a better position to maintain and enhance this coverage as you get older and your economic and health circumstances change Term insurance offers the most coverage for the least premium Whole life and universal life products are more expensive but offer tax favored savings accumulation which you can evaluate against your other investment options Retirement The purchase of life insurance and annuities and other investments for retirement and estate planning purposes is a more complex decision that will be affected by a number of considerations that will vary among people Most people will find it desirable to supplement the retirement benefits that they will receive from Social Security and their employers The earlier you begin a retirement savings plan the more exibility you will have and the smaller the portion of your income you will need to set aside to achieve your financial goals The more you can save and invest in your working years the better the options you will have in shaping your future work and retirement plans Taxfavored retirement savings plans such as 401k and related plans IRAs etc can be very efficient ways to increase your savings for retirement This is something that you need to study carefully ideally with the assistance of an independent certi ed financial planner Social Security Most working and retired people are eligible for Social Security insurance coverages which encompass health disability and retirement insurance but various eligibility requirements determine when you can receive benefits and how much those benefits will be The amount of insurance coverage and benefits provided is limited they are intended to provide a minimum oor of coverage rather than the amount of coverage most people would prefer to have Hence most people will find it desirable to buy additional insurance and make additional financial provisions for their retirement years Other There are other types of insurance you may need to purchase or consider purchasing that are not discussed above You also will likely encounter insurance coverages that you do not need or are not a good use of your money Books on insurance and financial planning discuss other insurance coverages You would be well advised to read both and enlist the services of an independent certi ed advisor in developing an overall insurance and financial plan for you and your family 2 Determine Your Risk Factors When you apply for insurance and seek a price quote the agent or insurer will ask you various questions to determine whether you meet the insurer s underwriting guidelines and what price they will quote you As your application proceeds the agent andor insurer may seek additional information from you or other sources and may attempt to verify some information from documents you provide inspections or official sources You should answer all questions as truthfully as you can to the best of your knowledge to avoid jeopardizing your application or the enforceability of your insurance policy It is helpful to anticipate the types of questions you will be asked to expedite your application and receive an accurate price quote The questions you will be asked will vary depending on the type of insurance Also insurers may offer discounts for certain characteristics and it is helpful if you can anticipate these items so you can obtain any discounts to which you are entitled You may also be able to take steps to decrease your risk eg avoid driving violations install safety devices etc and obtain insurance on better terms Depending on your characteristics and circumstances you may be considered a high risk or a special risk by some insurers This could affect their willingness to offer you coverage the type of coverage they are willing to offer you and the price they will charge you If you fall into this category you may wish to broaden your search to include insurers who would be more willing to write you andor would be willing to offer you more favorable terms than preferred or standard insurers Conversely if you are considered to be a low risk you are likely to obtain the best terms from a preferred insurer Also you can take actions to improve your risk profile avoid smoking obey traffic laws improve your credit rating etc that could expand your insurance options and lower its cost 3 Contacting Agents and Insurers In shopping for insurance you should remember that insurers use different distribution systems and you should utilize all of them Ideally you want to make your search as broad as possible mindful of the effort required to obtain price quotes from various insurers As a general rule you should try to contact insurers who use 1 direct writing or direct response mechanisms 2 exclusive agents and 3 independent agents Direct writers and exclusive agents can provide you with quotes for companies within their corporate group Independent agents represent multiple insurers but a given independent agent will not represent all insurers who use independent agents Also independent agents typically do not represent direct writers and insurers that use exclusive agents Hence you should contact several insurers and agents to survey the market The Internet is increasingly becoming a better vehicle for obtaining information on insurance insurers products prices and other things Some insurers may enable you to purchase insurance on line but most will at least give you some pricing information and refer you to an agent or sales representative to purchase a policy 1 This is starting to change as some insurers moved to mixed distribution systems that involve some combination of direct response exclusive agent and independent agent approaches Some insurance departments also publish price surveys for commonly purchased insurance coverages These surveys are typically based on certain hypothetical policiesinsured characteristics and cannot cover all possible situations However they may provide you with some indication of the insurers that might offer you the best prices for the coverages you wish to buy Also there are several vendors who provide pricing information for a number of insurers particularly for life and auto insurance It could be cost effective to contact some of these vendors to obtain a broader survey of the market and determine those insurers most likely to offer you the best terms for the coverage you wish to purchase Typically these services are designed to give you pricing and coverage information that is based on the coverages you wish to purchase and your specific characteristics Some vendors charge a fee for their services Keep in mind that the initial price quote you receive may change after an insurer reviews and verifies all the information relevant to issuing a policy Hence if you receive a final quote that is substantially higher than the initial quote you may wish to reshop your insurance 4 Quality of Service and Financial Strength Should you always go with the lowestpriced insurer Not necessarily Insurers vary in terms of quality of service andor financial strength and you may wish to consider these dimensions Also you need to consider whether an independent agent will provide additional services to you that you value and that you would not necessarily receive from a direct writer or exclusive agent Unfortunately it is difficult for consumers to obtain information on insurers quality of service The experience of relatives friends and neighbors may be useful Some insurance departments publish complaint ratios on insurers but this is a somewhat imprecise and potentially misleading measure of quality of service Consumers Reports publishes consumer satisfaction surveys on insurers and other sources have begun offering consumer ratings of insurance companies Financial strength information is easier to obtain Most insurers are rated by one or more commercial rating services Agents typically provide the ratings of insurers you are considering but you can also obtain this information from public libraries or directly from the rating services Financial strength is particularly important for longterm policies such as life health and longterm care insurance State guaranty funds will provide you with some protection if your insurer becomes insolvent but there are limits on this coverage and there may be delays in getting your claims paid or gaining access to your funds At a minimum you should ensure that an insurer is licensed to do business in your state and determine if the insurer has committed any regulatory violations that would cause you to be concerned The same advice also applies to agents that you work with You can obtain this information by contacting your state insurance department Most insurers and agents are reputable but there are a minority that may attempt to take unfair advantage of you 5 Be An Informed Consumer Insurance can be a complex and tedious subject but consumers must do everything they can to inform themselves and look after their own interests You cannot rely on insurers agents and regulators to ensure that you make the best decisions or prevent you from being a victim of fraud or market abuses Hence you should read information about the insurance you are purchasing carefully consider the coverages you purchase shop intelligently for the best terms check the standing of your insurer and agent and read insurance policies before you purchase them Your insurance purchase decisions are some of the most important decisions you will make and you should make them carefully ASIAN EARTHQUAKE AND TSUNAMI An Insurance Perspective Insurance Information Institute December282004 While the economic losses from the Asian tsunami are expected to be high the insurance losses arising from this event are likely to be modest Here s why BACKGROUND A magnitude 90 earthquake centered about 100 miles west of the Indonesian island of Sumatra 62 miles underthe Indian Ocean struck at around 7AM local time Sunda December 26 2004 7PM ET Saturday December 25 The earthquake triggered a series of tsunamis tidal waves that sent walls of water crashing into at least half a dozen countries across Southern Asia Several powerful aftershocks followed the initial quake one of magnitude 72 More than 40000 are reported dead and thousands injured after extensive flooding that has swamped the coastal areas ofcountries including Bangladesh India Indonesia Malaysia the Maldive Islands Myanmar Somalia Sri Lanka and Thailand Hundreds of thousands more are reported to be missing and millions homeless Property damage to residential and commercial buildings is reported to be extensive The earthquake is the fourth largest in the world since 1900 and the strongestsince the 1964 magnitude 92 earthquake in Prince William Sound Alaska The most powerful earthquake on record occurred in Chile in 1960 The magnitude 95 quake caused 550 million in damage 35 billion in current dollars killed more than 2000 people and injured more than 3000 ltalso caused a tsunami which caused additional destruction in Hawaii Japan the Philippines and the west coast of the United States Tsunami a Japanese term is a series of waves generated by largescale seafloor displacements associated with large earthquakes M r H I N A PAKISTAN NEPAL r VEHLJIAN Arabian aANeLAbEsm 5 r N D r A Sauli BURMA L AOS China I Bar ui Be ngal THAlLAND cmsoum V E N M SFII EIFIUNEI mm M A L n y 5 r A Eplcmlerofquaks SINGAPORE INDAN 4 OCEAN s r INSURANCE COVERAGE IN DISASTERAFFECTED REGION While the loss of life is enormous and economic losses are expected to be large the insurance losses arising from this event are likely to be modest Nonlife ie propertycasualty insurance penetration rates tend are low in the countries affected by this disaster see table below In other words relatively little insurance is purchased in the affected countries Although overall insurance premium volume in South and East Asia continues to grow penetration and growth rates for insurance products vary significantly between individual regions and markets NonLife Insurance Premiums 2003 Thailand 1 276 119 Source Swiss Re Sigma No 32004 World Insurance in 2003 Insurance Industry on the Road to Recovery As the table above indicates there is relatively little penetration of nonlife insurance products in the countries worst affected by this earthquake and associated tsunamis India Indonesia Sri Lanka In Indonesia for example just 8 per capita was spent on nonlife insurance in 2003 Measured in terms of GDP Indonesia has an insurance penetration rate of 083 percent for nonlife business in 2003 Penetration of nonlife insurance in Sri Lanka the country perhaps suffering the most severe impact from the tsunamis is even lower By comparison a total of 1 980 per capita was spent on nonlife insurance in the US in 2003 nearly 250 times as much as in Indonesia and more than 280 times that in Sri Lanka Measured in terms of GDP nonlife insurance premiums as a percentage of GDP ie penetration rate in the United States were equal to 523 percent of GDP in 2003 more than six times that of Indonesia and seven times that of Sri Lanka Property Coverage Insurance coverage for earthquake and tsunami damage will vary by country and region Typically property policies offer coverage as follows Standard Fire Policy covers perils such as fire lightning explosion only Extended Coverage standard fire policy plus additional coverage purchased separately The extended coverage may include earthquake fireexplosion following an earthquake tsunami and volcanic eruption All Risks Policy typically covers unforeseen sudden and accidental physical lossdamagedestruction to the insured s property subject to standard exclusions Flood risk may be covered under this policy The extent of insured losses will depend on the takeup of coverage by insureds Policy terms can vary considerably from country to country INSURED LOSS ESTIMATES It is still too soon to assess the total damage and losses associated with the December 26 earthquake and accompanying tsunamis Economic losses will be in the tens of billions of dollars if not more and the scale of human suffering enormous However as the table above indicates relatively little insurance is sold in the affected countries meaning that insured losses are likely to be modest relative to the scale ofthe disaster Depending on the level of property damage and amount of coverage in play there could be significant losses to local insurers See attached data for the leading nonlife insurance companies in Bangladesh India Indonesia Malaysia Sri Lanka and Thailand Foreign insurers operating in the region primarily European and Asian could experience some potentially large claims These claims are most likely to arise from hotel and resort properties as well as facilities owned or operated by foreign multinationals However it is important to recognize that large multinationals tend to have large retentions often in addition to a captive insurer Many may have purchased highlevel catastrophe coverage Claims associated with damage to infrastructure port facilities marine interests ships cargo oil platforms offshore facilities are also possible Travel personal accident and life insurers will also be impacted 2004 A RECORD YEAR FOR DISASTER LOSSES In a preliminary report published December 16 2004 Swiss Re Sigma estimated that about 300 natural and manmade catastrophes worldwide in 2004 caused approximately 42 billion in insured losses 105 billion in total economic losses and claimed the lives of 21 000 people Note that the recent disaster in Asia with at least 40000 deaths reported will increase disaster related deaths to more than 60000 in 2004 Swiss Re noted that the 42 billion in insured losses would make 2004 another record year in terms of insurance claims after 1992 1999 and 2001 About 95 percent ofthe claims were attributable to natural catastrophes it said By comparison in 1992 insured losses adjusted for inflation were in the region of 38 billion including Hurricane Andrew in 2001 they reached 37 billion including the September 11 terrorist attack and in 1999 they totaled 36 billion including the Lothar and Martin winter storms The trend towards higher losses is due in part to rising population densities and value concentrations as well as growing urbanization of exposed areas Swiss Re said POPULATION Bangladesh 138448210 est July 2003 GDP 2382 billion 2002 est LEADING NONL39FE ASSOCIATION Bangladesh Insurance Association INSURANCE COMPANIES 2000 Rupah Bima Bhaban Written premiums 7 Rajuk Avenue Com gan BDT Mn USD Mn Dhaka 1000 Bangladeh Tel 880 29557330 Sadharan Bima Corporation 8174 118 Fax 880 29557330 9211 301 4 58 Green Delta 3013 58 CURRENCY taka EDT Re39iance 2550 4399 EXCHANGE RATES taka per US dollar 5789 2002 EL 2002 38 5581 2001 5214 2000 4909 Phoenix 1982 38 1999 4691 1998 Peoples 1951 37 Bangladesh REGULATORY BODY Chief Controller of Insurance General 1841 35 Department of Insurance Prime 1803 35 Ministry of Commerce Federa 171 1 33 Sadharan Bima Bhaban 2 Gross written premiums 139 Mothijheel Commercial Area Dhaka 1000 Bangladesh Tel 880 29565548 Fax 880 29565056 DIRECT PREMIUMS WRITTEN 2003 LEADING LIFE INSURANCE COMPANIES Total premiums 297 US millions Data not available Nonlife premiums 102 Life premiums 194 Sources Swiss Re premium data Axco Insurance Information Service leading cos US Central Intelligence Agency economicdemographic data III International Insurance Fact Book 2004 wwwinternationalinsuranceorg wwwiiiorg or wwwinsuranceinfo POPULATION 1049700118 est July 2003 GDP 2664 trillion 2002 est LEADING NONLIFE ASSOCIATION Insurance Institute of India INSURANCE COMPANIES 2003 Universal Insurance Building P Mehta Road Written premiums Murnbai 400 001 India Company INR Mn USD Mn Tel 91 222872923 New India 382124 8087 United India 288806 8108 CURRENCY Indian rupee INR National 288358 5881 Oriental 280344 5757 EXCHANGE RATES Indian rupees per US dollar ECGC 317478 774 4861 2002 4719 2001 4494 Baa Allianz 219848 81 0 2000 4306 1999 4126 1998 Tata NS 2 339393 48391 REGULATORY BODY Insurance Regulatory amp Development IFFCOTokio 21 332 433 Authority ICICI Lombard 20348 41 8 Pasisrarna Bhavanarn Reliance 13537 332 5958b Basheer Bagh Gross written premiums Hyderabad 500 004 India Tel 91 406820964 Fax 91 406823334 LEADING LIFE INSURANCE COMPANIES 2003 DIRECT PREMIUMS WRITI39EN 2003 Gross written premiums Companzz INR Mn USD Mn Total premiums 17302 US millions LIC 5432343 112331 I mme Pfem39ms 3 7 mm premlums 13590 ICICI Prudential 41782 858 HDFC Standard 14882 808 Birla Sunlife 14382 298 Sources Swiss Re premium data Axco Insurance Information Service Max New York 9859 199 leading cos US Central Intelligence Agency economicdemographic data SBI Life 7288 148 Tata AIG 7177 148 Allianz 83339 8817 142 OM Kotak 4032 83 ING Vysya 2118 44 III International Insurance Fact Book 2004 wwwinternationalinsuranceorg wwwiiiorg or wwwinsuranceinfo POPULATION I d 234893453 est July 2003 n ones39a GDP 7142 billion 2002 est ASSOCIATION Insurance Council of Indonesia LEADING NONL39FE Jll Nlajemahit 34 Blok V29 INSURANCE COMPANIES 2002 Jakarta 10160 Indonesia Written premiums Tel 62 213454387 Company IDR Mn USD Mn Fax 62 213454307 T P t 1 809 3 172 8 httpwwwdaiorid Ugu Fa ama 39 39 39 Jasa Indonesia 81 54 883 CURRENCY Indonesian rupiah IDR Cemral ASia 7921 851 Astra Buana 8804 731 EXCHANGE RATES Indonesian rupiahs per US dollar Sinar M83 5380 885 931119 2002 102608 2001 Allianz Utama 5584 800 842177 2000 785515 1999 AIU I d 500 5 53 8 100136 1998 Ones39a 39 39 Wahana Tata 4824 51 8 REGULATORY BODY Directorate of Insurance MitSUi Sumit0m0 3881 393 Ministry of Finance Tokio Marine 3087 328 Dr Wahidin Street No1 Gross written premiums Building A 8th Floor Jakarta 10710 Indonesia Fax 62 213509118 INSURANCE COMPANIES 2002 DIRECT PREMIUMS WRITI39EN 2003 W Company IDR Bn USD Mn Total premiums 3107 US millions Bumiputera 1912 20550 2207 N quotf mm 1733 AIG Lippo Life 17188 1844 Life premiums 1373 Jiwasraya 8585 1028 Indolife Pensiontama 7827 851 Sources Swiss Re premium data Axco Insurance Information Service Manulife Indonesia 8878 71 7 leading c0s US Central Intelligence Agency economicdemographic data Jiwa Seguis Life 5917 835 Prudential Life 4788 51 2 AIA Indonesia 441 4 474 Allianz Life 41 72 448 Brin in Jiwa Se39a tera 3840 423 Ifo wwwiiiorg or wwwinsuranceinfo wwwinternationalinsuranceorg III International Insurance Fact Book 2004 M I POPULATION a aySIa 23092940 est July 2003 GDP 1984 billion 2002 est LEADING NONLIFE ASSOCIATION General Insurance Association of INSURANCE COMPANIES 2002 Malaysia 3rd Floor Wisrna PIAM Written premiums 150 Jalan Tun Sambathan Company MYR Mn USD Mn 50782 Kuala Lumpur Malaysia Kurnia 9217 2428 Tel 60 322747399 39V39Nl 4317 1138 Fax 60 322745910 Allianz General 4189 1097 httpwwwpiarnorgrny MAA 3983 1043 UniAsia General 3320 874 CURRENCY ringgit MYR American Home 3111 819 EXCHANGE RATES ringgits per US dollar Honq Leonq 3089 808 38 2002 38 2001 38 2000 Aviva 2840 895 38 1999 392 1998 Mitsui 2351 819 Longac 2233 589 REGULATORY BODY Insurance Supervision Department Gross written premiums 13th Floor Block A Jalan Dato Onn 50480 Kuala Lumpur Malaysis Tel 60 326988044 Fax 60 326970597 LEADING LIFE INSURANCE COMPANIES 2002 Gross written premiums Companx MYR Mn USD Mn DIRECT PREMIUMS WRITTEN 2003 Great EaStem 30505 8028 Total premiums 5609 US millions NA 1 537399 404397 Nonlife premiums 2154 Prudential 11590 3050 Life premiums 3455 ING 901 2 2372 MAA 5528 1454 Honq Leonq 4348 1144 Sources Swiss Re premium data Axco Insurance Information Service leading c0s US Central Intelligence Agency economicdemographic data Asia Life 3009 792 MCIS Zurich 2788 733 John Hancock 2700 711 MNI 2088 544 III International Insurance Fact Book 2004 wwwinternationalinsuranceorg wwwiiiorg or wwwinsuranceinfo POPULATION SI I LHDka 19742439 est July 2003 GDP 737 billion 2002 est LEADING NONL39FE ASSOCIATION Insurance Association of Sri Lanka INSURANCE COMPANIES 2003 do Union Assurance Ltd Written Eremiums Union Assurance Centre Company SLR Mn USD Mn 20 St Mlchaels3d S L k 4 888 1 54 4 Colombo 3 Sri Lanka r39 a a 39 39 39 Tel 94 1343061 Ceylinco 37212 41 B JanaShakthi 1 14073 157 CURRENCY Sri Lankan rupee LKR Union 12850 142 Eagle 1 10737 120 EXCHANGE RATES Sri Lankan rupees per US dollar Asian Alliance 2711 30 9566 2002 8938 2001 7701 2000 7064 1999 6445 1998 National 2547 28 HNB Assurance 2434 2397 REGULATORY BODY Insurance Board of Sri Lanka Haylevs AIG 1855 21 Level 11 East Tower Clooperative 181 1 1 8 World Trade Centre Gross written premiums Echelon Square Colombo 1 Sri Lanka LEADING LIFE Tel 94 1437086 INSURANCE COMPANIES 2003 FaX 94 1439449 Gross written premiums DIRECT PREMIUMS WRITrEN 2003 Company SLR Mn USD Mn Sri Lanka 32390 339 Total premiums 239 US millions C 3 042 7 31 8 Nonlife premiums 137 eVmCO 39 39 Life premiums 102 Eagle 21898 227 Union 10981 115 Janashakthi 4152 44 Sources Swiss Re premium data Axco Insurance Information Service Asian Alliance 274 5 2 9 leading cos US Central Intelligence Agency economicdemographic data National 1575 18 HNB 1044 11 Clooperative 441 05 ATL 400 04 III International Insurance Fact Book 2004 wwwinternationalinsuranceorg wwwiiiorg or wwwinsuranceinfo Th 1 d POPULATION all an 64265276 est July 2003 GDP 4458 billion 2002 est LEADING NONIquot5 ASSOCIATION General Insurance Association INSURANCE COMPANIES 2002 223 801 Ruam Rudee Wireless Road Written premiums Bangkok 10330 Thailand Company THB Mn USD Mn Tel 66 25660328 M 74309 1730 Fax 66 256603940 DhipaVa 815729 1530 httpwwwgaiforg Bangkok 54223 1282 Deves 29131 878 CURRENCY baht THB The Safety 22451 523 Synmunkong 20848 485 EXCHANGE RATES baht per US dollar 4296 2002 4443 2001 Sa m nth 30894 482 4011 2000 3781 1999 New Hampshire 18148 448 4136 1998 Aviva 17845 411 Thai Zurich 1 13339 31 D REGULATORY BODY Department of Insurance Gross written premiums Ministry of Commerce 44100 Sanambinnam Road Nonthaburi 1 1000 Thailand Tel 66 5474565 Fax 665474571 LEADING LIFE INSURANCE COMPANIES 2002 Gross written premiums Compann THB Mn USD Mn DIRECT PREMIUMS WRITTEN 2003 NA 58 758394 1 387397 Total premiums 4932 US millions Thai Life 183840 4278 Nonlife premiums 1711 Avudhya CMG 88842 2088 Life premiums 3222 Bangkok 88485 1584 Ocean 88375 1545 Nationwide 24188 583 South East 18882 388 Zurich National 14424 338 Siam Commercial 13887 328 III International Insurance Fact Book 2004 wwwinternationalinsuranceorg wwwiiiorg or wwwinsuranceinfo