4.1 Insurance companies

will provide a positive return for the average level of risk to which it is exposed. But

potential customers, seeing the uniform price, will divide into those who will take

the contract because they think the premium is good value (knowing themselves to

be high-risk) and those who will reject the contract because the premium is too high

(knowing themselves to be low-risk). The average risk that the company actually

faces is thus increased because the contracts that are actually written are dominated

by high-risk (relative to the premiums) clients.

Moral hazard:The situation where being insured encourages someone to behave more

recklessly than they would have done without the insurance.

Adverse selection:The situation where those who pose the highest risks are the ones

most likely to take out insurance.

Both problems can be tackled to some degree by risk screening. Typically, this involves

the study of past statistics on client characteristics and outcomes. It may be possible

to identify groups of clients as having differing degrees of risk and then charging them

risk-based premiums. Where screening is difcult or impossible, moral hazard-type

behaviour can be discouraged by imposing a deductible amount (commonly referred

to as an ‘excess’) which the insured has to pay for himself. This gives the insured a

nancial incentive to behave with caution. Similarly, restrictive covenants can be imposed

which make the contract void if the insured behaves in a completely inappropriate

way. Motor insurance provides a good example of these responses to the asymmetric

information problem. Age, past record and type of car are used to screen drivers for

risk, to the level of which premiums are then related; motor policies often pay for

damage only in excess of a certain value and they also contain clauses forbidding the

use of the vehicle for anything other than normal or ‘domestic’ use.

General insurance covers such things as accident, vehicles, goods in transit, dam-

age to property, various forms of liability, re and natural forces, and legal expenses.

Classes of long-term insurance include life and annuity, permanent health, marriage

and birth. One class of long-term business is pension fund management. This does

not in itself involve companies undertaking insurance risks but acknowledges that

the skills required for the operation of the life insurance business are similar to those

needed to run pension funds. Thus, over the years, many life assurance companies

have taken on the management of pension funds on behalf of rms and other

institutions. When we come to consider the activities of insurance companies as a

form of nancial intermediation, this distinction between the two types of business

will be crucial.

Firstly, though, let us get some idea of the size of the insurance business. As with

all nancial magnitudes, we can consider both ows and stocks.In the course of

2004, net investment by insurance companies was approximately £33bn. Long-term

insurance companies received the greater part of this inow: roughly £25bn com-

pared with £8bn received by general funds. Later, in Table 4.1, we shall look further

at what assets insurance companies acquired and compare these acquisitions with

those of other NDTIs.

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Chapter 4 • Non-deposit-taking institutions

When we look at stocks, we can see from Figure 4.1 (by adding up all the assets in

both pie charts) that total assets/liabilities at the end of 2004 amounted to £1079bn.

Of these, £112bn were held by general insurance companies and £967bn belonged

to long-term funds.

Figure 4.1Insurance companies’ asset holdings at end 2004 (£bn)

(a) general (b) long term

Source: Adapted from ONS, Financial Statistics, April 2006, Tables 5.1A, 5.2A

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