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Nicole Seaman

Director of FRM Operations
Staff member
Learning outcomes: Describe moral hazard and adverse selection risks facing insurance companies, provide examples of each, and describe how to overcome these problems. Evaluate the capital requirements for life insurance and property-casualty insurance companies. Compare the guaranty system and the regulatory requirements for insurance companies with those for banks.


21.5.1. Insurance is the quintessential risk transfer product. The customer pays premiums to the insurance company, who provides coverage by making a promise to pay (aka, the contingent payout) in the event of a covered loss. In addition to risk transfer, another key element of insurance is the pooling of the premium dollars: the insurance company is diversified with respect to the loss event type. Insurance is a legal contract and very broadly, the FRM categorizes insurance contracts as one of three types: life; property and casualty (P&C); or health insurance. (Although sub-categories of insurance dynamically emerge, to be sure!). In regard to the key risk types, each of the following statements is true EXCEPT which is false?

a. Moral hazard is the primary risk for life insurance companies
b. Adverse selection occurs before insurance is purchased and is a risk that is enabled due to an asymmetric information problem
c. Moral hazard occurs after insurance is purchased and is a material risk for heath and property-casualty (P&C) insurance companies
d. Insurance companies reduce their moral hazard risk with policy deductibles

21.5.2. Given their obligations (insurance is a legal contract), insurance companies have internal and external (i.e., regulatory) capital requirements. In regard to regulations, capital, and capital requirements at insurance companies, which of the following statements is TRUE?

a. In the European Union (EU), Basel IV regulates the capital requirements for international (i.e., cross-border) insurance companies
b. The leverage ratio, as defined by assets-to-equity, is likely to be higher for a life insurance company than a property-casualty company (ceteris paribus)
c. On the insurance company's balance sheet, the unearned premiums are assets that are matched by liabilities such as investments in corporate bonds
d. In the United States, regulation of insurance companies is primarily conducted at the Federal level and the Federal (U.S.) government maintains a permanent fund to protect the policyholders of chartered insurance companies

21.5.3. Customers of insurance companies do not like to see their premiums increase, obviously. At the same time, most customers care about the claims process and quality: if the insurance doesn't pay out when it is needed, so the cheapest policy is not always the best! In regard to an increase in the premium(s), which of the following is MOST LIKELY to be TRUE?

a. A whole life insurance premium increases in the middle of the policy because the insurance company's shareholders have demanded an increase in the dividend
b. A variable life insurance premium increases because new genetic information (i.e., family tree insights) reduces the policy holder's life expectancy
c. A health insurance premium increases due to a higher cost for physician services, new technologies and/or hospital upgrades
d. A health insurance premium increases because the policyholder develops unexpected health problems that were unanticipated when the policy was written

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