Explain the problems that necessitate insurance management, and three methods insurance companies use to address these problems. Identify the problem that each practice addresses

Question

What will be an ideal response?

Answer 1

Insurance companies face the problems of adverse selection and moral hazard. Adverse selection is the problem that the highest risk individuals will be the most likely to purchase insurance. Moral hazard is the problem that, once insured, individuals will engage in risky behavior that increase the probability that a claim will be paid.

Insurance companies screen out good risk applicants from poor ones to reduce adverse selection. Risk-based premiums reduce adverse selection by charging higher premiums to higher risk individuals. Restrictive provisions reduce moral hazard by discouraging risky behavior. Investigation to prevent fraudulent claims also reduces moral hazard. Cancellation of insurance reduces moral hazard by discouraging risky activity. Deductibles and coinsurance require the insured to bear a portion of the cost of any claim, reducing moral hazard. Limiting the amount of insurance also reduces moral hazard.