Solutions ( Risk ) - Dealing with insurance problems

Insurance Policy

When an individual, say a farmer, is insured by an insurance company, the farmer basically pays a premium ( pre-decided amount to be paid periodically) to the company , in return for which, the company agrees to compensate him for a chance damage like a godown burn. The company deals with this by insuring , say, 200000 farmers threby ensuring that even if 200 farmers ask for claims the insured ask for claims, the total amount of premium money collected is more and the company is in profit. Plus, the company usually also invests the premium money into profitable ventures, thereby increasing the profit.
The distinct advantages for the farmer over reciprocal insurance are that the uncertainty of timing in reciprocal insurance is eliminted as the premiums are to be paid at known times and are usually a small fraction of the total claim money. Plus, there is the backing of the capital of the insurance company.




Types of Insurance Risks - Actuarial and Non-actuarial

Insurance policies would generally cover risks of known probability or estimable probability. These are called Actuarial risks. These include property-liability insurance ( homes, cars, automobiles ) and life insurance ( illness, death ).
However, there are Non-actuarial risks, whose probability calculation is totally a shot in the dark, eg : whether a satellite launch would fail or not. In such cases, the financial system offers external insurance. A number of Insurers, themselves not exposed to the risk agree to bear part of the claim for a premium. If there is a loss, they pay their share and if not, they are ahead by the premium amount. This is somewhat like gambling.



Dealing with incentive problems

Problems of moral hazard and adverse selecion are more serious for insurance companies than in the case of reciprocal insurance. To solve the problem of moral hazard ( slack behavious of an insured person ) , the insurance policy is such that a small agreed fraction of the loss is to be paid by the insured person himself. This puts him under the compulsion of being careful. The company can also make care a compulsive condition of the coverage policy ( eg: a farmer cannot store combustible material in his godown ).
Problem of adverse selection (high-risk is pro-insurance and low-risk is against it ) might lead to the claims beiung too many in number and the insurance company will go into a huge loss. The only way to solve this problem is a careful assessment of the risks that an insurance company covers to distinguish risks properly and also to tailor its premiums to reflect the risk so that the premiums for low-risk persons are less than those for high-risk persons.