Annex
PRIVATE INSURANCE
For a private insurance market to exist a number
of conditions must hold:
— Pure Risk—insurance is a risk
transfer mechanism and thus simply provides compensation for loss;
the insured is put back into the same position as they were before
the event occurred—they are "indemnified'. Thus, pure
risks involve a loss, or at best a break-even situation; there
must be no element of financial gain should the insured event
occur. Nevertheless, there are certain products available in the
market, such as Critical Illness Insurance, which pay out a lump
sum should a certain event occur. In the example given, to the
extent that such Critical Illness insurance covers the extra costs
associated with the sickness or disability, the product is an
insurance product covering a pure risk.
— Financial Value—the risk, which
is to be insured against, must be capable of financial measurement.
— Insurable Interest—there must
be a legally recognisable relationship between the insured (the
person taking out the insurance) and the financial loss. If this
principle is not in place, any such contract would be akin to
gambling.
— Particular Risk—defined as
a risk that is independent across individuals in the pool; risks
which arise from individual causes and affect individuals in their
consequences. In contrast to this form of risk are fundamental
risks, which are impersonal in origin and widespread in effect.
The indiscriminate nature of fundamental risks means that they
are not usually offered through the private insurance market.
Examples include protection against the risk of war (which affectsevery
single member of society), terrorism risks, and, in certain regions
of the world, natural disasters such as earthquakes and hurricanes.
Such risks are usually the remit of the state as "insurer
of last resort".
— Pool of Risks—the insurance
company must be able to attract enough policyholders for the risk
to be well spread.
— Fortuitous—the probability
of the insured incurring the loss must be less than one. The exception
to this is whole of life assurance, where it is the time
of the claim which is not known with certainty.
— Predictable—the probability
has to be to some extent predictable and foreseeable for the insurance
company to be able to set a price. Recent examples of where the
risk has not been predictable or foreseeable can be found in both
the private and social insurance market for industrial diseases.
Both the state system, Industrial Injuries Disablement Benefit,
and the private system, Employers' Liability, saw a dramatic increase
in claims following the ratification of Noise Induced Hearing
Loss as a prescribed industrial disease with adverse consequences
in both markets; notably large underwriting losses in the private
insurance market and unforeseen public expenditure in the social
insurance market.
— Public Policy—the insured event
must not be against public policy; that is contrary to what society
would consider to be the right and moral thing to do. For example,
it would be unacceptable to offer insurance against the risk of
a criminal venture going wrong.
— Insurance markets are also liable
to two particular problems, those of moral hazard and adverse
selection.
Moral hazard occurs when the existence of insurance
cover alters the behaviour of the person covered, usually in a
disadvantageous way to the insurer. For example, the subscriber
may take less care to avoid the loss that is covered, or may commit
fraud.
Adverse selection occurs when the company cannot
accurately identify individual risks, which leads to the risk
pool containing predominately bad risks. The reason for this is
that individuals who buy insuranceare likely to be those for whom
it is the best value i.e. those who are most likely to claim.
Insurancecompanies try to avoid this by rating premiums to reflect
the risk of claim for each individual, but if individual risks
cannot be identified then high-risk individuals will be offered
premiums below their actuarially fair rate.
Insurers try to minimise these problems. Moral
hazard can be reduced by a number of devices ranging from excesses
to insisting on security measures as a condition of insurance.
There are also some ways of alleviating adverse selection, depending
on the type of insurance. For example, exclusion clauses and waiting
periods. However, if the problems of adverse selection and moral
hazard are severe and there are no easy ways to overcome them,
then they may be enough to prevent the existence of a private
insurance market.
May 1999
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