Effective Underwriting Reduces Information Problems


   Insurance markets may fail to work effectively when differences in the risks faced by policyholders cannot be incorporated in insurance premiums. To see why, consider again the example of homeowners pooling risk. Suppose now that there are two types of homeowners: those who live in coastal areas that are at relatively high risk for windstorms and floods, and those who live in inland areas at lower risk for these hazards. If all homeowners were charged the same insurance premium, and if premiums were set equal to the average loss rate for all homes, then homeowners in inland regions would rightly feel that they were being overcharged. They face less risk from windstorms and floods than owners in coastal regions, yet they are asked to pay a premium equal to average losses for a pool that includes houses in both regions. Owners living in coastal areas would be attracted to the pool because it offers insurance at a premium that does not reflect their homes higher risk. If the insurance policy were offered to all homeowners, a disproportionate share of those in coastal regions would accept the policy, while a disproportionate share of those living inland would seek insurance elsewhere or would choose to go without insurance. As a result, the average loss for those who chose to participate in the pool would be higher than the premium charged.

   This example illustrates a general property of insurance contracts which economists call adverse selection. When premiums do not reflect differences in risk that are known to potential policyholders, insurance pools tend to attract members who are at greatest risk for the hazards covered. The solution to this problem is to charge policyholders with different risk exposures different premiums. In the example above, adverse selection could be avoided if homeowners in inland areas were charged lower premiums than those in coastal regions. Insurance providers generally try to set premiums commensurate with risk, but this is not always possible. In some cases it may simply be too costly for an insurance provider to identify differences in risk, but, as discussed later in this chapter, efforts by policymakers and insurance regulators to keep premiums for some high-risk policyholders low can also play a role.

   Inefficiencies can also arise when insurance discourages those who are insured from taking actions to reduce potential losses. Consider the incentives faced by a homeowner thinking about how best to prepare for future windstorms. Many homeowners can reduce the damage caused by windstorms by installing storm shutters, but storm shutters are costly. If a homeowner is fully insured against the economic losses arising from future windstorms, she may be less likely to purchase shutters. The tendency of those who are insured to work less hard to avoid losses is called moral hazard.

   Insurance providers are well aware of the potential for moral hazard, and they attempt to address it through effective underwriting. Many insurance policies only cover losses in excess of a specified amount called a deductible, or they require that policyholders pay a fixed share of any losses incurred. By insuring some, but not all, economic losses, these types of policies strengthen policyholders incentives to work to reduce the risks they face. Insurers may also require that specific action be taken as a precondition for receiving coverage, or they might provide pricing incentives for risk-reducing investments. For example, an insurer might refuse to cover windstorm risks for homes without storm shutters, or it might charge those homeowners a higher premium.

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