ASYMMETRIC INFORMATION IN INSURANCE 2

Asymmetric Information in Insurance

Asymmetric information occurs when one party in an economic transaction, either a
seller or a buyer, possesses more material knowledge than the other party (Hubbard & O’Brien,
2017). Even though present in almost all economic transactions, asymmetric information may
lead to market failure if the party with more material knowledge about the transaction uses it to
their advantage. In the insurance industry the problem of asymmetric information is a fairly
common one.

Causes of Asymmetric Information in Insurance Industry

There are many reasons why information asymmetry may exist in insurance market. The
main one, however, is failure of policy holders to adhere to the principle of utmost good faith
(Sullivan, 2016). This principle requires that persons entering a transaction present all the critical
information relevant to the transaction.
Examples of adverse selection and moral hazard problems in insurance companies
There are two main negative outcomes that asymmetric information generates. These are
adverse selection and moral hazard. Adverse selection occurs when a business cannot determine
the risk level of an individual or group of individual buying their services or goods (Hubbard &
O’Brien, 2017). Moral hazard, on the other hand, is the risk that one party in a business or
economic transaction will act in a manner that negatively affects the other party (Hubbard &
O’Brien, 2017). Both of these outcomes involve one party in the transaction making or
facilitating making of worse economic decisions than they would have made if they had also
possessed the information the other party had.
In the insurance industry an example of adverse selection is when heavy smokers, who
are at risk of contracting cancer and dying prematurely, purchase life insurance premiums at the

ASYMMETRIC INFORMATION IN INSURANCE 3
same rate as the general population (Choi, Chen & Sawada, 2015). Since they are know that their
smoking puts them at risk of early death, they have more incentive to purchase life insurance
covers than the general population. Thus, insurance companies end up with disproportionately
higher smokers with life insurance covers than non-smokers. With their higher mortality rates,
insurance companies end up using a lot of their resources making life insurance policy pay-outs.
They are left with no option but to increase premiums. Higher premiums, however, discourage
non-smokers from taking life insurance covers. The result is that insurance companies end up
mostly with smokers which leads to regular high pay-outs and eventual collapse of the firm.
Moral hazard is also a common problem in insurance. An example is when a mild smoker
or non-smoker begins smoking heavily after purchasing life insurance cover. By engaging in
such behavior they assume extra risk that harms the insurer since they increase the likelihood of
a claim being made much earlier than the insurer had planned for (Einav & Finkelstein, 2018).

Impact of adverse selection and moral hazard in insurance industry
Adverse selection and moral hazard present a serious problem in the insurance industry.
Adverse selection lead insurance firms to deal with customers that are riskier and less profitable
than the general population (Sullivan, 2016). In the worst case scenario such clients may lead to
collapse of a firm. Moral hazard also reduces profits of insurance companies as customers
significantly increase their exposure to loss (Einav & Finkelstein, 2018).
Principal agent problem in insurance market

Principal agent problem occurs when one entity called the agent acts on behalf of another
entity called the principal, or makes decisions or takes actions that affect the principal but their
interests are not aligned (Hubbard & O’Brien, 2017). In the insurance market the principal is the
insurer and the agent could be the policy holder. Assuming the policy holder has fire insurance.

ASYMMETRIC INFORMATION IN INSURANCE 4
The principal (insurer) hopes that the agent (policy holder) will do their best to limit their
exposure to the insured risk (fire). If the policy holder is operating a failing business, they may
be interested in having the business destroyed so that they can make their claims before it
completely fails. There is, therefore, a principal agent problem because the interests of the
insurer are not aligned with those of the policy holder. One method of solving this kind of
agency problem is having the insurer and the policy holder share cost of damages through having
deductibles in the policy (Sullivan, 2016).
How insurance companies reduce the problem of adverse selection and moral hazard
In the insurance industry the problem of adverse selection can be reduced by classifying
customers based on their risk levels (Sullivan, 2016). The more risky individuals or groups are
then charged higher premiums or avoided altogether if they are too risky. In health insurance this
process of assigning risk levels to customers is done through underwriting. After examining their
current health records, lifestyle, and other factors that may have an impact on their health,
underwriters identify individuals that are high risk to the company and, therefore, liable for
higher premiums.
Adverse selection can also be reduced by strictly adhering to the principle of utmost good
faith. This principle requires that insurance applicants provide accurate information pertaining to
the policy that they are applying for. Failure to provide such information may lead to the insurer
not honoring their obligations when the risk occurs.
Insurance companies also use many methods to reduce moral hazard problem. One of
them is including deductibles in their policies (Einav & Finkelstein, 2018). When there is a
deductible, an insurance buyer pays out of pocket a portion of the claim and the insurance

ASYMMETRIC INFORMATION IN INSURANCE 5
company pays the rest. The goal of this cost sharing is to reduce the possibility of the insurance
buyer engaging in risky behavior because they have an insurance cover.

References

Choi, Y. J., Chen, J., & Sawada, Y. (2015). Life insurance and suicide: Asymmetric information
revisited. The BE Journal of Economic Analysis & Policy, 15(3), 1127-1149.
Einav, L., & Finkelstein, A. (2018). Moral Hazard in Health Insurance: What We Know and
How We Know It. Journal of the European Economic Association, 16(4), 957-982.
Hubbard, R. G., & O’Brien A. P. (2017). Money, banking, and the financial system (3rd ed.).
Boston: Pearson.
Sullivan, S. P. (2016). Why wait to settle? An experimental test of the asymmetric-information
hypothesis. The Journal of Law and Economics, 59(3), 497-525.