Freemont insurance sells homeowners insurance. In a recent financial review, managers discovered that company performance was lagging behind projections. They examined pricing and claims history in more detail and identified a group of about 20,000 homeowners insurance customers whose claims far exceeded the collected premiums. Members of the actuarial group, whose compensation was partially tied to profitability of the policies they priced, were particularly frustrated.
a. Who is making the bad decision?
b. Does this group have enough information to make a good decision?
c. Does this group have an incentive to make a good decision?
d. Suppose moral hazard is at play. What is one thing that Freemont could do to reduce the problem of moral hazard?
e. Suppose adverse selection is at play. What is one thing that Freemont could do to reduce the problem of adverse selection?
The company hired a consultant to do a deep dive into the 20,000 customers whose claims far exceed the collected costs. The consultants noted that a significant number of these customers were far more likely to have had prior claims with their prior insurer. They took this information to the actuaries, but the actuaries said they were already taking into account the number of prior claims into their pricing.
f. How can we reconcile the fact that the actuaries were taking into account the number or prior claims into the pricing, but still under pricing these policies?