Screening
To reduce adverse selection, insurance companies try to screen out poor insurance risks
from good ones. Effective information collection procedures are therefore an important
principle of insurance management.
Risk-Based Premium
Charging insurance premiums on the basis of how much risk a policyholder poses for the
insurance company is a time-honored principle of insurance management.
Restrictive Provisions
Restrictive provisions in policies are another insurance management tool for reducing
moral hazard. Such provisions discourage policyholders from engaging in risky activities
that make an insurance claim more likely.
Prevention of Fraud
An important management principle for insurance companies is conducting investigations
to prevent fraud so that only policyholders with valid claims receive compensation.
Cancellation of Insurance
Being prepared to cancel policies is another insurance management tool. Insurance
companies can discourage moral hazard by threatening to cancel a policy when the
insured person engages in activities that make a claim more likely
Deductibles
The deductible is the fixed amount by which the insured’s loss is reduced when a claim is
paid off. A deductible thus makes a policyholder act more in line with what is profitable for
the insurance company; moral hazard has been reduced. Another function of the
deductible is to eliminate the administrative costs of small losses by forcing the insured to
bear these losses.
Coinsurance
-when a policyholder shares a percentage of losses with the insurance company.
- Reduces Moral Hazard & Controls Cost
- Balances risks
Example: In a medical insurance plan with 80% coverage, the insured pays 20% after meeti
ng the deductible.
Limits on the amount of Insurance
- to prevent excessive payouts and reduce moral hazard.
- Avoids Overcompensation
-Encourages Responsibility
Example: If a car is insured for more than its value, the owner may neglect theft prevention,
knowing they could profit from a claim.
CREDIT DEFAULT SWAT
-
a financial instrument that acts as insurance against the default of debt, usually related to
bonds.
How CDS works
-to transfer the risk of default to a third party, like an investment or insurance company.
- When default risk is low, the cost of the CDS is low, which can increase the market price o
f the underlying bond.
Growths & Risks
- Between 1995 and 2009, the CDS market grew exponentially, reaching $62 trillion by 2008
.
- The growth was driven by the securitization of mortgages, and many did not foresee the co
llapse of the real estate market.
-
AIG, a major issuer of CDSs, faced near bankruptcy during the 2008 financial crisis and req
uired a $182 billion bailout.
Regulatory Issues: CDSs were not heavily regulated, and the market grew without sufficient
oversight, leading to massive risks for issuers and investors.
Monoline Insurance
-in providing credit insurance for bond repayments.
- offer insurance to guarantee the timely repayment of bond principal and interest if a debt i
ssuer defaults.
Key Features
-
Specialization : focus on credit insurance, unlike other insurers with multmultiple lines of b
usiness.
Municipal Bond Market : A municipal bond with a lower credit rating (e.g., A rating) can recei
ve a higher rating (e.g., AAA) when insured by a monoline insurer. This reduces the interest c
ost for municipalities.
-
High Credit Rating Requirement : Monoline insurers must maintain a high credit rating to off
er these guarantees.
Risks
Credit Downgrades : During the subprime financial crisis, monoline insurers faced credit d
owngrades, which negatively impacted both the insurers and the municipal bond market, r
aising concerns about the stability of these bonds.
Monoline Insurance
-
Monoline insurers specialize in credit insurance, guaranteeing bond principal and interest p
ayments in case of issuer default.
- enhance bond credit ratings (e.g., from A to AAA), reducing borrowing costs for municipali
ties.
- effectiveness depends on maintaining a high credit rating.
2008 Financial Crisis Impact: Exposure to mortgage-
backed securities led to downgrades, destabilizing the municipal bond market.
Pensions
- a financial pool that accumulates during an individual’s working years and is paid out duri
ng retirement.
Reasons for rapid Growth
Urbanization : Families became more dispersed, reducing reliance on children for financial
support in old age.
Longevity & Early Retirement: People are living longer and retiring earlier, increasing the nee
d for retirement funding.
Economic Role: Pension plans have become the fastest-
growing financial intermediary, helping individuals secure financial stability in retirement.
