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294 PA R T I I I Financial Institutions Based on this information, the insurer can decide whether to accept you for the insurance or to turn you down because you pose too high a risk and thus would be an unprofitable customer Risk-Based Premiums Charging insurance premiums on the basis of how much risk a policyholder poses for the insurance provider is a time-honoured principle of insurance management Adverse selection explains why this principle is so important to insurance company profitability To understand why an insurance provider finds it necessary to have risk-based premiums, let s examine an example of risk-based insurance premiums that at first glance seems unfair Harry and Sally, both college students with no accidents or speeding tickets, apply for auto insurance Normally, Harry will be charged a much higher premium than Sally Insurance companies this because young males have a much higher accident rate than young females Suppose, though, that one insurer did not base its premiums on a risk classification but rather just charged a premium based on the average combined risk for males and females Then Sally would be charged too much and Harry too little Sally could go to another insurer and get a lower rate, while Harry would sign up for the insurance Because Harry s premium isn t high enough to cover the accidents he is likely to have, on average the insurer would lose money on Harry Only with a premium based on a risk classification, so that Harry is charged more, can the insurance company make a profit.2 Restrictive Provisions Restrictive provisions in policies are an insurance management tool for reducing moral hazard Such provisions discourage policyholders from engaging in risky activities that make an insurance claim more likely For example, life insurers have provisions in their policies that eliminate death benefits if the insured person commits suicide within the first two years that the policy is in effect Restrictive provisions may also require certain behaviour on the part of the insured A company renting motor scooters may be required to provide helmets for renters in order to be covered for any liability associated with the rental The role of restrictive provisions is not unlike that of restrictive covenants on debt contracts described in Chapter Both serve to reduce moral hazard by ruling out undesirable behaviour Prevention of Fraud Insurance providers also face moral hazard because an insured person has an incentive to lie to the insurer and seek a claim even if the claim is not valid For example, a person who has not complied with the restrictive provisions of an insurance contract may still submit a claim Even worse, a person may file claims for events that did not actually occur Thus an important management principle for insurance providers is conducting investigations to prevent fraud so that only policyholders with valid claims receive compensation Cancellation of Being prepared to cancel policies is another insurance management tool Insurers can discourage moral hazard by threatening to cancel a policy when the insured Insurance person engages in activities that make a claim more likely If your auto insurance company makes it clear that coverage will be cancelled if a driver gets too many speeding tickets, you will be less likely to speed Note that the example here is in fact the lemons problem described in Chapter