Moral Hazard

Definition of Moral Hazard as mentioned in Wikipedia is "Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk."This definition is self explanatory; further clarification can be added using following examples. Burglary Insurance:-- Taken a burglary insurance , insurer keeps more costly products at home moreover he might not invest more in securing his house( use of inexpensive locks) . Or become careless ( ignore to recheck if house is lock properly in doubt). Health Insurance:-- Just say an itch with an Insurance is a severe allergy. Actuaries while pricing product needs to take care of Moral Hazard as an important phenomenon. While pricing the product he has to keep in mind the effects of various change in policy conditions might have on Moral Hazard. For example:-- pricing a Health insurance policy which was earlier has an deductable but was withdrawn later might have much more effect in claims because of triggering of Moral Hazard claims. Underwriters and Actuaries work together in such cases to price these effects as effectively as possible.

Adverse Selection
Wikipedia states that "a situation where an individual's demand for insurance (either the propensity to buy insurance, or the quantity purchased, or both) is positively correlated with the individual's risk of loss (e.g. higher risks buy more insurance), and the insurer is unable to allow for this correlation in the price of insurance".

A few examples will make things clear.

Health Insurance :-- An individual knows best about his or her health. If he feels that there is very high probability that he will fall sick than he is tend towards taking health insurance. This is ANTI SELECTION or adverse selection if an insurer is not able to differentiate this risk from rest of the pool.

Lets see a bit more exhaustive example.

Motor Insurance :-- Suppose we have only two cars in market ( SANTRO and INDICA ). Company A insures 50 santro cars and 50 indica cars. Company collects Rs 1000 per car. Hence total revenue for the company is Rs 100000. Company recorded a total 16 claims and average claim size being Rs 5000. Therfore total claims is of Rs 80000 and Company makes a profit of Rs 20000. A more detail analysis shows out of these 16 claims 11 came from Indica and 5 came from Santro. ( for simplicity lets keep avg claim cost constant ). Company B when looked at the scenario priced its product in different fashion. Prices for indica was Rs 1500 and prices for Santro as Rs 750. Company A sticks to their old pricing. All the Santro holders shited from company A to company B and all Indica holders taken policies from company A. Aftereffects :-- Company A has 150 policies ( cars ) all Indica. Collected Rs 150000 as Premium . There were 33 claims of Rs 5000 and totalling Rs 1,65,000 . Company makes a loss of Rs 15000.

This is the effect of Adverse Selection.

Actuaries and Underwriters combine their skills together to eliminate this kind of effect to take place. Actuaries have the mathematical skills to identify the bad and good areas. Underwriters have knowledge of Market and competitors.

We ( actuaries ) have to price our product in such a manner that such effect does not take place in Market. Constant monitoring is also necessary to identify such Burning spots and to remove them with immediate effect.

Hazards
Risk professionals refer to hazards as conditions that increase the cause of losses. Hazards may increase the probability of losses, their frequency, their severity, or both. That is, frequency refers to the number of losses during a specified period. Severity refers to the average dollar value of a loss per occurrence, respectively. Professionals refer to certain conditions as being hazardous. For example, when summer humidity declines and temperature and wind velocity rise in heavily forested areas, the likelihood of fire increases. Conditions are such that a forest fire could start very easily and be difficult to contain. In this example, low humidity increases both loss probability and loss severity. The more hazardous the conditions, the greater the probability and/or severity of loss. Two kinds of hazards physical and intangibleaffect the probability and severity of losses.

Physical Hazards We refer to physical hazards as tangible environmental conditions that affect the frequency and/or severity of loss. Examples include slippery roads, which often increase the number of auto accidents; poorly lit stairwells, which add to the likelihood of slips and falls; and old wiring, which may increase the likelihood of a fire. Physical hazards that affect property include location, construction, and use. Building locations affect their susceptibility to loss by fire, flood, earthquake, and other perils. A building located near a fire station and a good water supply has a lower chance that it will suffer a serious loss by fire than if it is in an isolated area with neither water nor firefighting service. Similarly, a company that has built a backup generator will have lower likelihood of a serious financial loss in the event of a power loss hazard. Construction affects both the probability and severity of loss. While no building is fireproof, some construction types are less susceptible to loss from fire than others. But a building that is susceptible to one peril is not necessarily susceptible to all. For example, a frame building is more apt to burn than a brick building, but frame buildings may suffer less damage from an earthquake. Use or occupancy may also create physical hazards. For example, buildings used to manufacture or store fireworks will have greater probability of loss by fire than do office buildings. Likewise, buildings used for dry cleaning (which uses volatile chemicals) will bear a greater physical hazard than do elementary schools. Cars used for business purposes may be exposed to greater chance of loss than a typical family car since businesses use vehicles more extensively and in more dangerous settings. Similarly, people have physical characteristics that affect loss. Some of us have brittle bones, weak immune systems, or vitamin deficiencies. Any of these characteristics could increase the probability or severity of health expenses.