Taking chances

INSURANCE has been much in the news lately. But most people know little about two major problems that arise in the insurance business: adverse selection and moral hazard.

Suppose we know that one out of every 10,000 factories will catch fire in any given year; and that each fire will damage Rs.10,000 worth of property, this would suggest that insurance would work if you can get each factory owner to pay a premium of a little over one rupee a year. But this is not quite the way it works. What will happen is that those who are more at risk will be more likely to seek insurance than those who face low risks. Alternately, if smokers and non-smokers both seek life insurance cover, and if both pay premium at the same rate, this would mean that non-smokers would wind up getting less than their rupee's worth of insurance; since they are not as much at risk as smokers. This is the problem of adverse selection. To tackle this problem, insurance companies try to set different rates of premium for different groups of people who face different levels of risk.

Moral hazard is another kettle of fish altogether. Take the case of medical insurance. An insurance company examines the rate at which people fall ill, and the amount of money they spend on their illness as and when they do fall ill. On the basis of these calculations, they then decide how much premium to charge for policies that cover different kinds of medical risks. The problem that arises here is that someone who takes a medical insurance policy, might start "falling ill" more often, or seeking more expensive treatment than he would have done had he not taken a policy. It is because of this that it makes good sense for an insurance company to reimburse only a part of the costs, leaving a small part to be borne by the person concerned. By the same logic, it is not a good idea for companies to reimburse all the expenses that their employees incur on medical treatment. Indeed, this is a bad idea not only for the companies, but for their employees as well; since some of the "treatments" that fully reimbursable employees can so easily be tempted to go in for can harm them, and, indeed, at times even prove fatal.

But this is not a one way street. Adverse selection can also operate in reverse gear. I remember a case in which an insurance company insured a printer against the risk of fire. The workshop caught fire one night; but, luckily, he was able to get the fire extinguished before the whole thing was razed to the ground. Good move? Not quite. The insurance company later declared that it would reimburse only 20 per cent of the loss; most of the damage, it said, had been caused not by the fire, but by the efforts to put it out. Similarly, there was recently a news item saying that the Life Insurance Corporation (LIC) insists that insured persons notify them as soon as any life threatening situation arises; HIV for instance. And once the company is notified, it simply terminates the policy.

SUDHANSHU RANADE

Send this article to Friends by E-Mail

Section  : Features
Previous : Anarchic recipes for change?
Next     : Free(dom) software