A large, well-established home insurance company writes insurance policies to co

Question

A large, well-established home insurance company writes insurance policies to cover losses from fire, theft, and vandalism. In a recent financial review, managers discovered that company performance was lagging behind projections. They examined pricing and claims history in more detail and identified a group of about 10,000 customers whose claims far exceeded the collected premiums. Members of the actuarial group, whose compensation was partially tied to profitability of the policies they priced, were particularly frustrated. How would you recommend the insurer address this problem?

Before continuing, first answer the following 3 questions to diagnose and solve the problem. Then, please elaborate in your answer to the question above.

1) Who is making the bad decision?

2) Do the actuaries have enough information to make a good decision?

3) Do the actuaries have the incentive to make a good decision?

Explanation / Answer

1. The insurer is making a bad decision. There is a moral hazard problem. The consumers in the market are those who know that the probability of theft, fire and vandalism is high in their cases. The insurer will need to reduce the price of the insurance policy so that it attracts genuine customers.

2. Actuaries may have to lower the price of the insurance so that the genuine customers are attracted to the insurance policy rather than the customers with moral hazard problem. The information may not be available with the actuaries as to which customers are acting as moral hazard and how many of them are genuine.

3.The actuaries are incurring losses as their compensation is tied to the profitability of these insurance policies. The actuaries have incentive to make a good decision as they have nowhere to go but to increase the profitability in their own interest.

As mentioned above the insurer needs to reduce the price so that it is affordable for the genuine insurance seekers. The reduction in price will attract more consumers towards the insurance policy.

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