The direct advantage of an insurance contract is the exchange, for a fixed fee, of the uncertainty concerning a potential loss, for the certainty of indemnificationin the case the insured suffer a loss. Indemnificationor compensation is the primary reason why an individual or a firm would buy an insurance contract.
The reduction of uncertaintyis the other motivation because individuals are risk averse. The certainty concerning the outcome of a risky situation is, in the case of a pre-loss financing arrangement, one of the risk management objective of the firm.
The Costs Generated ByInsurance Contracts
Insurance contracts also generate direct and indirect costs that may have an impact on the offer of optimal contracts and the efficient allocation of the risks to the insurer.
Transaction costsare important and they reflect the costs of distributing and servicing the contracts to the insured. For property and liability insurancecontracts, in terms of premium income, these expenses account on average for about 30 to 35 percent (excluding taxes) but vary greatly in different countries according to the organization of the market, as well as among the different types of insurance coverages and insurance companies. The percentages in the life insurancebusiness are usually lower but vary also greatly according to the same kind of factors.
Moral Hazardis a condition that increases the expected frequency or severity of a loss. It is an intentional act inspired by the possibility of recovering an amount of money from an insurance contract in force. Arson, for example, is a cause of fire. Increasing the amount of a loss by making a false claim (property insurance), by overutilizing the services (health insurance), by charging excessive costs to repair the damage (automobile insurance) or by granting excessive awards in a judgment (liability insurance), generate a higher cost than expected and must be taken into account in the premium that is paid by all insured for any kind of coverage.
For K. Borch (1990, p. 325) there is no doubt that the concept of moral hazard has its origin in marine insurance.An insurance contract is based on good faith and fair dealing between the underwriter and the insured. The concept is subjective and the discrimination sometimes associated with particular countries or flags of convenience. It is easy to find other examples. Moral hazard can clearly occur in any kind of insurance. In a paper on moral hazard, Professor Stiglitz stressed the importance of incentives, and argued that insurance contracts should be designed so that they induce the insured to take good care ofhis property.4
Similarly, a morale hazardis a condition that causes an individual to be, consciously or unconsciously, less careful because of the elimination of the uncertainty concerning the financial consequence of a risk. The probability and size of a loss is almost always influenced by an individual's actions. It is often recognized that insurance reduces the incentive for loss prevention and control.
The importance of moral hazard extends beyond the context of insurance to the entire paradigm of agency theory. It includes any inefficiency in the decision of a contractual party that results from externalities whenever one party is not assigned the full costs and benefits of a decision that affects other parties to the contract.5
Utmost good faith(Uberrima Fides), means that the parties to the contract would disclose to each other all the material facts about the risk and cover, fully, truly and faithfully. Any breach in the duty of disclosure whether by way of concealment, innocent misrepresentation or fraudulent misrepresentation, renders the contract voidable at the hands of the aggrieved party, usually the insurer.
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