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FRM Part I · FRM Exam Part I · Insurance Companies and Pension Plans

An insurer wants to reduce moral hazard on a property policy where the expected loss is 10,000 per year. Which design feature most directly aligns the policyholder's incentives with loss prevention?

A deductible and coinsurance feature is the most direct remedy. By making the policyholder bear part of each loss, it restores an incentive to take care. Uniform premium rises, reinsurance or a larger pool do nothing to change the insured's behavior after purchase.

  1. AIntroducing a deductible and coinsurance so the policyholder bears part of every lossCorrect
  2. BRaising the premium for all policyholders equally
  3. CReinsuring the full portfolio with a reinsurer
  4. DIncreasing the number of policyholders in the pool

Explanation

Deductibles and coinsurance leave the insured with a share of each loss, so care and prevention have a personal payoff. A uniform premium increase does not change the marginal incentive to prevent loss. Reinsurance and pool size address the insurer's risk bearing and diversification, not the insured's behavior.

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