CIC 3019 INSURANCE AND RISK MANAGEMENT

Chapter 9: Limits to Insurability

Solutions

1. Explain why a business property insurance policy may have an exclusion for damages due
to a nuclear accident.
Answer: One explanation for an exclusion for damages due to a nuclear accident is that
damages from nuclear accidents are likely to be widespread. That is, damages will be correlated
across policyholders. Without an exclusion, insurers would need to hold more capital to keep
their insolvency risk from increasing, which would increase the premium loading on the policy.

2. You often hear people saying “Insurance companies are cheaters and always try to rip-off
customers, their insurance policies always have provisions that limit how much you can be
compensated and claim”. How would you respond to a person who has this view in mind?
Answer: I would tell my friend that people usually have this misperception because they
lack the proper information and knowledge about the role of insurance companies.
Insurance companies are in the business of managing risks. Thus, there are certain
provisions in the contract that limit the amount of compensation that policyholders can
claim. This is to limit the losses for the insurance companies. Without certain provisions
in the contracts, insurance companies may be at the risk of bankruptcy as they are also
exposed to the issue of adverse selection, moral and morale hazard. Thus, the provisions
are imposed to limit these risks to the insurer.

3. For the following types of risk exposures, explain why the amount of insurance coverage
may be significantly limited through contractual provisions such as exclusions, limits,
coinsurance, and deductibles) or in some cases, totally no coverage at all.
(i) Cough and cold – Answer: These are low severity risks but also high in frequency.
Personal health insurance usually does not cover cough and cold as these are
common to happen and the premium loadings will be much higher compared to the
expected losses. That is why common cough and cold (outpatient clinical visits) are
not covered under personal health insurance)
(ii) Pre-existing health condition – Answer: People with pre-existing conditions will
most likely be inclined to purchase medical or life insurance. This may cause an
adverse selection of risks from the perspective of the insurer. Thus, insurance
companies usually exclude pre-existing health conditions to eliminate the problem
of adverse selection and also moral hazard (i.e. people purposely purchasing
insurance with the intention to claim due to the known pre-existing health
condition).
(iii) Suicide in the first year of a life insurance policy – Answer: Suicide in the first year
of a life insurance policy can lead to severe moral hazard, i.e. the intentional act of
dishonesty with the intention to benefit from insurance proceeds. Usually life
insurance contracts will exclude this kind of risk.
(iv) Self-inflicted injury – Answer: Self inflicted injuries can lead to severe moral
hazard, i.e. the intentional act of dishonesty with the intention to benefit from
insurance proceeds. Losses as a result from self-inflicted injury are usually
excluded from insurance contracts.
 (v) Property loss due to political riot – Answer: Property loss due to political riot is
not a fortuitous loss and can lead to moral hazard, i.e. the intentional act of
dishonesty with the intention to benefit from insurance proceeds. These type of
losses are usually excluded from insurance contracts.
(vi) Your external drive worth RM300 – Answer: These are low severity risks but also
high in frequency. If insurance companies covered these kinds of small losses, the
premium loadings will be much higher compared to the expected losses. That is
why external drives are usually not covered under property insurance. However,
nowadays, some general life insurance companies cover this kind of digital
equipments.
(vii) Covid-19 – Answer: Covid-19 is a pandemic with high correlated risks. Life
insurance companies and health insurance usually exclude losses arising from
pandemic. The premium loadings will be high for these kinds of losses.

4. A tour bus company has experienced the following losses due to accidental damages on its
buses in a particular month:
Answer:
Bus Amount (i) RM2,000 (ii) 90/10 (iii) RM2,500 &
of loss deductible conisnruance 90/10 deductible
Bus A RM9,000 RM7,000 RM8,100 RM5,850

Bus B RM12,000 RM10,000 RM10,800 RM8,550

Bus C RM5,000 RM3,000 RM4,500 RM2,250

How much would the insurer pay in each of the above losses, assuming that the tour bus
company had insurance policies on each of its buses for sum assured of RM100,000 per
bus, with the following terms:
(i) A policy that has RM2,000 deductible
(ii) A policy that has coinsurance of 90/10, where the insurer will bear 90% of loss and
the insured will bear 10% of loss
(iii) A policy that has RM2,500 deductible and coinsurance of 90/10
5. Happy Time Day Camp has the following distribution for its annual liability costs:

$2,000,000 with probability .0001

$100,000 with probability .001

Loss =
$5,000 with probability .1

$0 with probability .8989

(i) What are the expected claim costs for Happy Time?
Answer: ($2,000,000)(.0001)+($100,000)(.001)+($5,000)(.1)=$800

(ii) If an insurer offered Happy Time a policy with 50% coinsurance, what are the
expected claim costs on this policy?
Answer: ($1,000,000)(.0001)+($50,000)(.001)+($2,500)(.1)=$400

(iii) If an insurer offered Happy Time a policy with a $5000 annual deductible, what are
the expected claim costs on this policy?
Answer: ($1,995,000)(.0001)+($95,000)(.001)=$294.50

(iv) If an insurer offered Happy Time a policy with a $500,000 limit, what are the
expected claim costs on this policy?
Answer: ($500,000)(.0001)+($100,000)(.001)+($5,000)(.1)=$650

6. For each of the following types of insurance, provide three common examples of moral
hazard that would be expected to impact the claim costs.

(i) automobile physical damage (collision) insurance

Answer: driving too fast, tailgating, failing to observe street signs, failing to lock car
doors, inflatingcosts of repair, etc. (Answer should not include actions that primarily
increase risk of injuryto persons, such as seatbelt usage and children’s car seats.)
(ii) health insurance
Answer: poor eating habits, failure to exercise regularly, alcohol consumption, etc.

7. Suppose that an insurer offered a small business owner a policy for theft insurance with no
deductible i.e. the insurance company would pay any and all claims for thefts of
merchandise or equipment at the insured’s place of business. Explain how moral hazard
might make the total claims higher than they would be if the policy required a deductible.
Answer:
Moral hazard refers to the effect of insurance on the insured’s incentives to reduce
expected losses. If there were no deductible, then the businesses would have no incentive
to take precautions against potential thefts, such as the installation of cameras, careful
inventory monitoring, locking the building, etc. Furthermore, there might even be
incentives to pass on some normal business expenses to the insurer such as those due to
damaged inventory.
8. For each of the following scenarios, indicate what law or legal principle prohibits the
scenario from occurring:

(i) You own two health insurance policies. One day you are hospitalized due to a minor
surgery and you make claims to both your health insurers in order to get double
recovery.
Answer: Principle of indemnity

(ii) You purchase life insurance on your sickly 90-year old neighbor with yourself as
the beneficiary. He dies and you make a claim.
Answer: Insurable interest

(iii) You fail to disclose information regarding your rheumatoid arthritis condition when
you apply for health insurance. You later request coverage for a hip replacement
surgery.
Answer: Principle of utmost good faith