LECTURE THREE

INSURNACE COMPANIES AS FINANCIAL

INTERMEDIREIES
FINANCIAL INTERMEDIARIES
 Without FI’s the cash flow between those with extra cash
(surplus) those who need cash (deficit) will be low due
to monitoring costs, Liquidity costs as well price risks.
 Banks

 Insurance companies

 Investment banks

 Finance companies

 Mutual funds
INSURANCE COMPANIES
 The primary function of insurance companies is to
protect individuals as well corporations from adverse
events.
 So they take premium to compensate policyholders when
specified event takes place.
 In return this premium will be reinvested in other
financial securities such as corporate bonds and stocks in
order to be able to pay the expected claims and achieve
profit as well.
PROBLEMS FACED BY INSURANCE
COMPANIES
 Adverse selection
 Moral hazard

 Selling insurance
ADVERSE SELECTION AND INSURANCE
 Insurance companies face the adverse selection problem.
 Adverse selection takes place when persons with higher-
than average chance of loss are seeking insurance at
standard rates which result in higher than expected loss
levels.
 Example: High risk drivers seeking auto insurance at
standard rates.
 Accordingly, if those with higher chance of loss succeed
in obtaining the coverage at standard rates, the insurer is
“adversely selected”
MORAL HAZARD AND SELLING
INSURANCE
 Moral hazard: when the insured fails to take proper
precautions to avoid losses because they are covered
(moral and attitudinal).
 Selling insurance

 Two types of agents: Independent agents (working for

many insurance companies) and exclusive agents ( loyal
for one company).
 Agents are compensated by being paid a commission so
they don’t care about the level or risk/loss.
 Insurance companies employ underwriters to review and
sign each policy and can turn down policies if they found
the risk unacceptable.
APPLIED TECHNIQUES TO DEAL WITH
ADVERSE SELECTION
 Screening: screening out poor insurance risk from good
ones so they can decide whether to accept it or reject it
by collecting all the required information.

 Risk based premium: charging the premium based on

how much risk a policy holder posses.

 Careful underwriting: the process of selecting and

classifying applicants.
APPLIED TECHNIQUES TO DEAL WITH
MORAL HAZARD
 Restrictive provisions: provisions discouraging any
undesirable behavior.
 Prevention of fraud: conducting enough investigations to
prevent fraud so only policy holders with valid claims take
the compensation.
 Cancellation of insurance: Ex. Receiving many speeding
tickets.
 Deductibles: amount that should be paid by the insured and
lower the premium paid.
 Coinsurance: When policyholders share a % of losses along
with the insurance company.
 Limits on the amount of insurance: Even if insureds are
willing to pay more.
TYPES OF INSURANCE COMPANIES
 Private insurance and government insurance.
 Private insurance:

1. life insurance

2. Health insurance

3. Causality insurance

4. Property and liability insurance

 Government insurance:

1. Social insurance programs