4.1Insurance companies

We need rstly to recognise that insurance companies as a group are engaged in two

quite distinct forms of business: long term and general. So distinct are these forms of

business that many insurance companies specialise in one or the other. Some of the

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largest rms, however, deal in both. Long-term insurance is also sometimes referred

to as life insurance, although it includes activity which is not strictly life-related, and

the rms that specialise in long-term insurance are often called ‘life ofces’.

We shall see in a moment why their activities are quite distinct. What they have in

common, however, and the reason that they are treated together, is the fact that they

all provide insurance against nancial loss. They do this by collecting premiums or

contributions from large numbers of people in return for an agreement to compensate

the policyholder in the event of a specied event occurring within a specied time.

Such an event might be theft, re, illness or even death; within the next year, the next

many years or even within a lifetime. The level of premium paid to insure against an

event depends obviously upon the likelihood or risk of the event occurring and the

level of compensation or benet to be paid when it does. Alternatively, we may say

that for a given level of benet, the premium will be determined by the risk, or more

briey still, that the premium : benet ratio is a function of risk. However, the payment

of premiums creates a pool of funds at the companies’ disposal, awaiting claims to

be made against it. Provided sufcient funds are available or can be easily recovered

in order to meet unexpected claims, this pool of funds can be invested in earning

assets by the companies to provide a further source of income. Thus their investment

success is a second factor which inuences the ratio of premium : benet levels.

Asymmetric information:A situation where one party to a nancial transaction has

better information than the other about factors relevant to the transaction.

Since the premium : benet ratio is one of the main criteria on which clients

are likely to choose an insurance company, the management of risk is clearly very

important for insurance companies. It is also quite difcult for reasons arising out of

asymmetric information. There is often an inequality in the information available to

the two parties in any nancial transaction. In section 3.1.4, for example, we noted

that intermediaries (banks in that case) often have better knowledge about the risk

to which they are going to put funds than do the savers who lend them. This is

a major reason for regulating the behaviour of nancial institutions. In the case

of insurance, however, the more obvious asymmetry arises between the insurance

company itself and the insured. Typically, and especially in general insurance, it is

the insured who has the better information since he knows his activities and the

risks involved in much greater detail than the insurance company does.

This particular asymmetry gives rise to two specic problems. The rst is moral

hazard. This arises when an insured person becomes less careful about her actions

precisely because she is insured. Since safety measures typically have a cost, it might

be tempting to some people to cut down on these measures, knowing that the

insurance company will have to pay in the event of an accident. The other prob-

lem is described as adverse selection. This arises when the riskiest clients express the

strongest demand for insurance products. The insurance company does not normally

have the information to distinguish very accurately between customers of different

degrees of risk. It has thus to set a price for its contracts (the premiums) which it hopes

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