Understanding Insurance

Reasons for Insurance

• Risk aversion drives people to seek insurance, as they prefer a certain outcome with lower gains over an uncertain one with the same expected value
• This stems form the idea of diminishing marginal utility; wealth means each additional euro contributes less to one's overall well-being
• Risk-averse individuals place greater importance on avoiding a substantial loss than on achieving an equivalent potential gain
• Insurance provides a way to spread risks, lessening the financial burden on individuals from adverse events
• Risk distribution yields a societal benefit in terms of pareto-improvement
• Risk distribution lets risk-averse individuals shift risks to insurers
• Risk distribution promotes economic activity and investments

Problems with Insurance

Moral Hazard

• Moral hazard arises when insured individuals behave less carefully because the insurer bears the financial consequences of damage
• Someone with theft insurance for their bike might not buy an extra lock, knowing they will be compensated if stolen
• Moral hazard results in more claims, which increases costs for insurers
• These costs lead to an increase in premiums, which insurers must pass on
• Moral hazards also reduces efficiency, since people no longer properly weigh prevention costs against potential damage

Adverse Selection

• Adverse selection happens when high-risk people are more inclined to secure insurance than low-risk individuals
• Insurer does evaluate risk differences
• If an insurer offers a fixed-premium health insurance, high-risk individuals are likelier to subscribe for it
• The result is excessive payouts and rising premiums
• Healthy people may opt out, leaving only high-cost clients and making the insurance unsustainable

Information Asymmetry

• Information asymmetry occurs when the insured has more knowledge about their own risk than the insurer
• Asymmetry leads to incorrect premium calculations and higher costs for the insurer
• For example failing to disclose a serious illness upon taking out health insurance results in the insurer unknowingly charging too little in premiums
• Information asymmetry results in incorrect risk assessments
• Information asymmetry leads to higher costs and rising premiums
• Insurers may then require strict questionnaires and medical examinations

Solutions for Moral Hazard

• Implement deductibles: The insured pays part of the damage themselves
• Deductibles retain a financial incentive to prevent damage
• Higher premiums apply to high risk groups so that lower risk people are not forced to subsidize them
• Enforce safety regulations that require a safety lock against theft during theft insurance
• Implement a bonus-malus arrangement. Those who file few claims pay less premium, while those who often file claims pay more

Solutions for Adverse Selection

• Premiums are calculated on the basis of risk profiles
• Required insurance (such as healthcare insurances) can prevent only people at high risk from getting insurance
• Offering insurance through employers may help insurers connect with a wider base of clients

Solutions for Information Asymmetry

• Duty of disclosure (art. 7:928 BW): Insured parties must provide relevant details when taking out insurance
• Insurer's duty of investigation: Insurers can ask questions on such topics as health condition, prior driving record etc
• Sanctions for misrepresentation: If the insured is found to have withheld information deliberately, the insurer has the authority to rescind the policy

Effects of Introducing No-Fault Insurances

Primary Costs

• No fault systems will reduce legal costs by diminishing legal disputes and costs associated with legal proceedings
• Faster payouts, due to claim approvals not being dependant on finding fault
• Higher premiums will lead to the insurance companies paying for all damages

Secondary Costs

• Less caution due to the perception of reduced risk of accountability and the knowledge that compensation payments will occur
• Higher activity level could lead to higher risks
• Study shows increased number of fatal traffic accidents

Tertiary Costs

• Lower transaction costs as claims process more quickly, allowing for an easier administration
• Reduced incentive to prevent damage due to diminished personal accountability
• Research shows no fault insurances may result to serious injuries
• Drivers may generally be less responsible

Practical Experiences with No-Fault

• Research indicates that no-fault systems may increase an accident rate
• Mixed evidence regarding the effect of driving behaviour and the impact upon caution
• No-fault insurance tends to lead to more serious accidents
• Liability is more clear

Hybride System in the Netherlands

• Article 185 Dutch Road Traffic Act: The owner of a motorized vehicle is liable for damage to non-motorized road users, barring force majeure
• Full compensation for children under 14 years of age
• Minimum 50% compensation for adults, unless intentional or reckless behaviour is involved