Moral hazard in insurance claiming: Evidence from automobile insurance

This article provides new evidence on moral hazard in insurance markets by analyzing the frequency of automobile bodily injury liability (BIL) claims. We conduct cross-sectional regressions of statewide BIL claims frequency rates on variables representing state economic, demographic, and legal characteristics that affect the marginal costs and benefits of filing claims. As an indicator of moral hazard, we use survey data on consumer attitudes toward various types of dishonest behavior relating to insurance claims. The results provide strong support for the hypothesis that attitudes toward dishonest behavior are related to BIL claims frequency, and thus provide evidence of significant moral hazard in automobile insurance markets.     

An Evolutionary Analysis of Buyer Insurance and Seller Reputation in Online Markets

Applying an evolutionary framework, we investigate how a reputation mechanism and a buyer insurance (as used on Internet market platforms such as eBay) interact to promote trustworthiness and trust in markets with moral hazard problems. Our analysis suggests that the costs involved in giving reliable feedback determine the gains from trade that can be obtained in equilibrium. Buyer insurance, on the other hand, can affect the trading dynamics and equilibrium selection. We find that, under reasonable conditions, buyer insurance crowds out trust, and trustworthiness. Ockenfels gratefully acknowledges the support of the Deutsche Forschungsgemeinschaft. Mengel’s research was supported by the Spanish Ministry of Education and Science (grant SEJ 2004-02172).     

Experimental markets for insurance

This article extends the large amount of research on double-oral auction markets to hazards that produce only losses. We report results from a series of experiments in which subjects endowed with low-probability losses can pay a premium for insurance protection. Insurers specify the price at which they are willing to assume the risk of a loss. Insurance prices approach expected value for a large range of probabilities and loss amounts. Subjects seem to realize losses are statistically independent. Prices are not affected by ambiguity about the probability of loss.     

Catastrophic responses to catastrophic risks

Socializing risks from catastrophic losses is difficult even in an ideal political environment, owing to different estimates of low probability risks, solvency constraints, dangers of moral hazard, and high loss correlation. However, these intrinsic contracting problems do not justify invalidating ordinary insurance contracts or forcing insurers to cover catastrophic losses. Yet, political pressures forcing insurance subsidies now induce inefficient decisions in siting and construction, with high expected social losses. Ordinary contract solutions are always imperfect, but superior to the regulatory maze. Unfortunately, patterns of legislation and court decisions are running in the wrong direction.     

Risk,ambiguity, and insurance

In a series of experiments, economically sophisticated subjects, including professional actuaries, priced insurance both as consumers and as firms under conditions of ambiguity. Findings support implications of the Einhorn-Hogarth ambiguity model: (1) For low probability-of-loss events, prices of both consumers and firms indicated aversion to ambiguity; (2) As probabilities of losses increased, aversion to ambiguity decreased, with consumers exhibiting ambiguity preference for high probability-of-loss events; and (3) Firms showed greater aversion to ambiguity than consumers. The results are shown to be incompatible with traditional economic analysis of insurance markets and are discussed with respect to the effects of ambiguity on the supply and demand for insurance.University of Chicago Graduate School of BusinessUniversity of Pennsylvania The Wharton School     

Replacement Cost Endorsement and Opportunistic Fraud in Automobile Insurance

Traditional insurance contracts do not offer protection against the replacement value of a vehicle. A replacement cost endorsement gives the opportunity to get a new vehicle in the case of a total theft or in the case of total destruction of the car in a road accident. This type of protection was introduced in Canada in the late 1980's. It is also offered in France and many insurers in the United States are going to move in that direction. We propose tests that separate moral hazard from adverse selection in the analysis of the effect of this additional protection on car theft. We show that holders of car insurance policies with a replacement cost endorsement have a higher probability of theft near the end of this additional protection (usually 24 months following the acquisition of a new car). Our tests indicate that this result is a form of ex post moral hazard or opportunistic insurance fraud.     

Insuring September 11th: Market Recovery and Transparency

The terrorist attacks on the World Trade Center caused unprecedented economic and structural ramifications in the insurance markets, resulting in considerable uncertainty and informational asymmetry. We test several theoretical models of how markets respond to and recover from extreme capital shocks. Using the capacity constraint, post-loss investment and implicit insurance contract models, we develop testable hypotheses predicting the temporal and cross sectional variation in insurance company stock prices following September 11th. We find evidence consistent with the models' predictions, in particular, the predictions regarding relations between net losses and leverage and stock price performance after the shock.     

Loss aversion leading to advantageous selection

Some insurance markets are characterized by “advantageous selection”, that is, ex-post risk and coverage are negatively correlated. We show that expectation-based loss aversion as in K?szegi and Rabin (Quarterly Journal of Economics, 121(4), 1133–1165, 2006; The American Economic Review, 97(4), 1047–1073, 2007) provides a natural explanation for this phenomenon in environments in which risk aversion models do not, e.g., when agents face modest-scale risks and/or in absence of moral hazard. More exposure to risk has two competing effects on an agent’s willingness to pay for insurance: a positive effect, as in standard expected utility models; and a negative one, due to a reference effect. We determine conditions under which an insurance provider optimally sets a high price at which only low risk agents buy.     

Adverse Selection,Bequests, Crowding Out,and Private Demand for Insurance: Evidence from the Long-term Care Insurance Market

Adverse selection, moral hazard, and crowding out by public insurance have all been proposed as theoretical reasons for why the market for private long-term care insurance has been slow to evolve in the U.S. Using national samples of the elderly and near elderly, this study investigates which is most important. The data contain direct measures of risk aversion, expectations of future nursing home use and living to old age, and the bequest motive. For both groups, we find evidence of adverse selection, and, for the elderly, crowding out of private long-term care insurance by Medicaid. However, we do not find that demand for such insurance is motivated either by bequest or exchange motives.     

Two-sided intergenerational moral hazard,long-term care insurance,and nursing home use

Two-sided intergenerational moral hazard occurs (i) if the parent’s decision to purchase long-term care (LTC) coverage undermines the child’s incentive to exert effort because the insurance protects the bequest from the cost of nursing home care, and (ii) when the parent purchases less LTC coverage, relying on child’s effort to keep him out of the nursing home. However, a “net” moral hazard effect obtains only if the two players’ responses to exogenous shocks fail to neutralize each other, entailing a negative relationship between child’s effort and parental LTC coverage. We focus on outcomes out of equilibrium, interpreting them as a break in the relationship resulting in no informal care provided and hence high probability nursing home admission. Changes in the parent’s initial wealth, LTC subsidy received, and child’s expected inheritance are shown to induce “net” moral hazard, in contradistinction to changes in child’s opportunity cost and share in the bequest.     

Behavioral insurance: Theory and experiments

“Risk and insurance” provides an illustrative set of decisions made in the presence of uncertainty. As behavioral models become more integrated into economics and finance, many of their effects are illustrated quite well within insurance markets. Especially noteworthy are the complementary roles of theory and experiments. This article reviews the interactive role of experiments and theory in analyzing insurance demand from a behavioral perspective. We pay special attention to several models of underinvestment in insurance or in other risk-mitigation markets.     

Insurance buying gamblers

The puzzling coincidence of gambling and insurance has often been analysed by taking recourse to utility functions with convex and concave regions. In this paper we show that it may be optimal for utility maximizing risk seekers to engage in insurance and gambling activities simultaneously. A possible reason for this behavior is that these individuals try to take advantage of a moral hazard situation.     

Adverse selection and equilibrium in liability insurance markets

Models of asymmetric information in insurance markets typically consider insurance buyers with Bernoulli loss distributions differing in expected loss. This article analyzes markets where buyer loss distributions are characterized by mean-preserving spreads and insurers can classify applicants in terms of expected values but not by risk. Because liability losses are characterized by skewed continuous probability distributions, both discrete and continuous loss distributions are considered. In contrast to the single separating equilibrium in the classic Rothschild-Stiglitz insurance market, multiple separating equilibria are identified in this article: three in the discrete case and four in the continuous case. The possibility of extreme discontinuities in insurer policy offers provides a new explanation for crises in liability insurance markets.The support of the National Association of Insurance Commissioners is gratefully acknowledged.     

Arrow’s theorem of the deductible: Moral hazard and stop-loss in health insurance

The logic of Arrow’s theorem of the deductible, i.e. that it is optimal to focus insurance coverage on the states with largest expenditures, remains at work in a model with ex post moral hazard. The optimal insurance contract takes the form of a system of “implicit deductibles”, resulting in the same indemnities as a contract with full insurance above a variable deductible positively related to the elasticity of medical expenditures with respect to the insurance rate. In a model with a predefined ceiling on expenses, there is no reimbursement for expenses below the stop-loss amount. One motivation to have some insurance below the deductible arises if regular health care expenditures in a situation of standard health have a negative effect on the probability of getting into a state with large medical expenses.     

Social protection in the Republic of Korea: Social insurance and moral hazard

Abstract As reported in numerous studies, the system of social protection in the Republic of Korea long remained underdeveloped because of the priority given instead to economic growth. The past few years have seen major changes, however. The government decided to apply the theory of “productive welfare”, thereby committing itself to introducing a system of universal statutory social insurance which is intended to set the seal on a new social compact and which may, ultimately, impact on the model of socioeconomic development itself. This article outlines the recent changes in insurance against sickness, unemployment and old age and goes on to describe the moral hazard facing the new system of social insurance and the need for a form of joint management in order to minimize this hazard.     

Adverse selection,moral hazard and propitious selection

We propose a simple model with preference-based adverse selection and moral hazard that formalizes the cherry picking/propitious selection argument. This argument assumes that individuals differ in risk aversion, potentially resulting in more risk averse agents buying more insurance while being less risky. The propitious selection argument is summarized by two properties: regularity (more risk averse agents exert more caution) and single-crossing (more risk averse agents have a higher willingness to pay for insurance). We show that these assumptions are incompatible with a pooling equilibrium, and that they do not imply a negative correlation between risk and insurance coverage at equilibrium.

Reforming health insurance: A question of principles?

Most industrialized countries have financed health services through health insurance. Two systems prevail: private, or public (social) health insurance. The theoretical differences between them are reviewed. It is argued that most health systems are, however, hybrids and that health insurance reform in Europe and the United States has accentuated this trend because the principles distinguishing the two systems have often been ignored. This is illustrated through the evolution of voluntary vs. compulsory affiliation, coping with moral hazard, and provider regulation.     

Unemployment Insurance or Individual Savings Accounts: Can Chile'S New Scheme Serve as a Model for Other Developing Countries?

In 2002 the Chilean government implemented new legislation for an unemployment insurance scheme. It has been presented at both national and international levels as a model for other developing countries, because it provides protection against unemployment, avoids issues of moral hazard associated with traditional unemployment insurance systems, and has a relatively low public finance requirement. The insurance combines a system of individual savings accounts with a publicly financed contingency fund. This article examines how it will work in practice, and whether it can indeed serve as a model.     

Incentives and government relief for risk

Government relief is offered for a wide range of risks-natural disaster, economic dislocation, sickness, and injury. This article explores the effect of such relief on incentives and the allocation of risk in a model with private insurance. It is shown that government relief is inefficient, even when its level is less than the private insurance coverage that individuals would otherwise have purchased and even when private insurance coverage is incomplete due to problems of moral hazard.Harvard University and National Bureau of Economic Research (Cambridge, MA 02138; 617-495-4101). I am grateful for comments from Lucian Bebchuk, Martin Feldstein, John Parsons, Michael Rothschild, Steven Shavell, Lawrence Summers, and a referee, and for support from the John M. Olin Foundation.     

The government, the market, and the problem of catastrophic loss

This article addresses the comparative advantage of the government to the private property/casualty insurance industry for the provision of insurance coverage for catastrophic losses. That the government can play an important role as an insurer of societal losses has been a central public policy principle since at least the New Deal. In addition, our government typically automatically provides forms of specific relief following unusually severe or unexpected disasters, which itself can be viewed as a form of ex post insurance. This article argues that, for systemic reasons, the government is much less effective than the private property/casualty insurance market in providing coverage of losses generally, but especially of losses in contexts of catastrophes.