No Medical; Moral Hazard

Going through material for Accounting Theory class. Always getting something new on the reread, irrespective of number of times article used previously. Concept of “moral hazard”, as discussed by Daniel B. Thornton in a 1984 article on Agency Theory (“Agency Theory for the Novice – Part 1”), written for a professional journal, CA Magazine (November, 1984):

I believe this term [moral hazard] was first used by Kenneth Arrow in “Uncertainty and Medical Care”, American Economic Review (Vol. 53, 1963). In that article, “moral hazard” referred to the incentive to misrepresent one’s health when applying for medical insurance, so that one might pay a premium equal only to what a person of “average” health would pay. Often, this would be possible, since a person is better informed about his own health than the doctor assessing his application, at first. If medical insurance firms did not examine prospective insurees, they would have to charge higher premiums. Seeing this, only sicker people would wish to apply for the insurance. But then, the premium would have to be raised again, to account for the now lower average health in the group. In the next round, only the very sick would apply, lowering the average again. This “dropping out” of the healthier people Arrow called “adverse selection”. Without medical examinations, adverse selection would ruin the market for health insurance…

Thought about all the “no medical” life insurance that has been offered over the past several years. Would seem to be predicted by Arrow as impossible, in that the insurance company supposedly need healthier people as part of the mix, in order to avoid ever-increasing premiums and the dropout “adverse selection”?

In terms of the “no medical” life insurance currently on offer, they advertise that they ask only a couple of questions, but don’t require a medical examination. The insurance amounts are comparatively small: $25,000 to perhaps $200,000. Also, in many such plans, it seems that there is no payout possible during the first two years that the insurance is in place. If one dies during this period, one gets a refund of premiums only.

Seems that the “no medical” life insurance market must be reasonably profitable, given the proliferation of ads for this type of insurance. Maybe at the time Arrow was writing, term insurance was not that common. The more common insurance was “whole life”, which was more expensive, but involved a savings component. The insurance policy had a cash surrender value at any point. No cash surrender value with term insurance, plus no insurance payout if you stop paying the premiums. So if one can target a market where they will start to pay the premiums, but where a high proportion will stop paying the premiums at some point before death, could be quite profitable. People more inclined to stop paying premiums would seem to be people of modest or highly variable financial means. If the monthly premium is high enough to prejudice other obligations unless one stops paying…

Wonder how, if at all, Arrow’s theory has been tested empirically, or does it end up being a highly-cited theory for fifty some years, that becomes more and more distant from…

About brucelarochelle

http://www.lmslawyers.com/bruce-la-rochelle
This entry was posted in Accounting Issues, Economics, Life Insurance. Bookmark the permalink.

1 Response to No Medical; Moral Hazard

  1. On January 26, 2014, Neil Remington Abramson, who sold life insurance at one point, commented as follows (email correspondence reproduced with permission):

    I don’t really believe that your medical health isn’t an issue. They don’t have to do a medical in advance. They can ask you if you suffer from… Or ever had… You say no, but they don’t pay out till they check your medical records. They collect your premiums and don’t have to pay out if you lied.

    You hear all kinds of stories about checking after, and stories about benefits denied.

    The policy advertised incessantly on CBC here ends at age 85 ,so its not whole life.

    But whole life policies had three values: (1) what they would lend you on it; (2) what would accrue just from the premiums paid; (3) what it would be worth if the market kept going up through the roof and beyond. (1)&(2) weren’t much but (3) always looked very impressive. London Life’s Freedom 55 was based on (3) projections which didn’t pan out, I heard, for most people.

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