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Jun 2022

Think Tank: The Geneva Association - Switching motivation and moral hazard

Source: Asia Insurance Review | Apr 2020

Empirical results from automobile physical damage insurance in Taiwan show that policyholders who switch to a new insurer early before their prior policy expires are more likely to file a claim in the last policy month – known as the expiration effect - than those who switch upon expiration of their policy and those who renew their contract with the same insurer. This research paper, published by the Geneva Association and authored by Mr Chun-Ting Liu, Ms Jui-Yun Wu and Mr Chi-Hung Chang investigates policyholders’ moral hazard from the perspective of switching motivation and determines whether switching behaviour is associated with the expiration effect.
Moral hazard in the insurance market arises from information concealment by the insured. Intentional concealment of information by the insured violates the principle of utmost good faith, which harms the insurer’s interests and causes all insureds to bear the cost induced. Moral hazard could lead to insurance malfunctioning. Furthermore, it has been a central issue in the insurance market and has been intensively investigated in academic literature, most of which has focused on automobile insurance.
Previous research showed that an insured who purchases high coverage is highly likely to incur a claim because of the reduced incentive to prevent accidents; this is known as an ex ante moral hazard. Dozens of works have investigated moral hazard in the context of the automobile insurance market. However, no study has explored this issue from the perspective of the motive to change the insurer upon insurance policy expiration, which we call ‘switching motivation’. Our study examines the moral hazard induced by policyholders’ switching motivation and contributes to the literature on moral hazard from two different aspects.
Gaming the system
Policyholders who purchased automobile physical damage insurance may buy a new policy from other insurers ahead of the expiration month of the old contract and file a claim on the last policy month to avoid a surcharge for claims records. The new insurer is unable to take the claims records into account when computing a fair premium via a bonus-malus coefficient, because the claim is filed with the prior insurer after the new contract has taken effect.
This allows a potentially high-risk insured to obtain identical insurance coverage at a low premium, and this unfair situation is less likely to arise when the insured renews the contract with the same insurer or switches to a new insurer only upon policy expiration. Thus an insured who switches to a new insurer prior to policy expiration may have a high claim rate in the last policy month because the insured believes that filing a claim with the old insurer after changing to a new insurer would not lead to a surcharge for the new contract. 
The switch therefore constitutes an opportunistic motive and the insured may be accustomed to this opportunistic behaviour and take similar actions thereafter. Thus the question whether the opportunistic motive elicits an expiration effect warrants investigation.
The motor insurance market in Taiwan
Automobile insurance in Taiwan includes compulsory liability insurance as well as voluntary insurance covering automobile physical damage, automobile theft and liability. Automobile physical damage insurance, which accounts for a substantial share of the automobile insurance business in terms of premium revenue, consists of three types of policies differentiated by their scope of coverage.
The Form A physical damage insurance policy provides the most comprehensive coverage, because it covers almost all perils except for some specifically defined events. The Form B policy is mostly identical except for third-party malicious behaviour and unknown perils and provides the insured with a choice of an increasing deductible or no deductible. The Form C policy covers only the collision between vehicles with no deductible. Premiums vary in the difference in coverage scope and extended coverage.
The market is highly regulated, because authorities intensively supervise insurers’ operations from the business and financial aspects, such as competition among insurers and pricing of policies. Premiums for automobile physical damage insurance are determined based on the insured’s gender, age, and claims record. Men have a higher gender-age coefficient and are charged at a higher premium than women at a given age. The coefficient of claims record called the bonus-malus coefficient is evaluated based on claim points on a three-year horizon.
No claim scenarios
A claim point decreases by one point if the insured did not file a claim in the previous year, and the decrease in one claim point corresponds to a claim coefficient decrease of 0.2 points, which results in a 20% discount on basic premium. Not filing a claim for three successive years results in a maximum of a 0.6 point decrease in the claim coefficient and a maximum discount of 60% on basic premium. 
However, the claim coefficient rises by 0.2 points for each subsequent claim beyond the first claim during the previous three years, and basic premium rises similar to a no-claim case. Insurers share information on the claims record of the insured.
One special characteristic of Taiwan’s automobile insurance market is the significance of a distribution channel, that is, the dealer-owned agents. In most other countries, clients rarely purchase insurance via car dealers when buying a new car, whereas in Taiwan the car is usually sold with car insurance by an insurance agency closely related to or even owned by car dealers. 
Insurers are highly competitive in terms of commission, given that automobile insurance accounts for a substantial proportion (more than 50%) of the non-life insurance market by premiums revenue in Taiwan and that dealer-owned agents are the dominant distribution channel in this line. 
Car dealers may encourage clients to file a claim around the policy expiration date to obtain a partial return of premiums, which could increase clients’ willingness to renew the contract through the dealer. This sustains the investigation on the expiration effect induced by dealer-owned agents pursued in this article.
The findings show that the expiration effect is more serious for policyholders who switch to a new insurer before the policy expires than for those who switch upon the expiration of the old contract and for those who renew the contract with the same insurer. 
Moreover, the expiration effect is more serious for the dealer-owned agent channel where the expiration effect is caused mostly by the encouragement of dealer-owned agents than for the direct underwriting channel where the expiration effect emerges from the insured’s opportunistic motive. The expiration effect is also more serious for the early switcher than for the normal switcher or renewer via the direct underwriting channel.
Our findings have practical implications for insurers’ underwriting strategies. For example, for the direct underwriting channel, the insurer could inform a client who transfers from other insurers early before the policy expires that a surcharge for claims records will be imposed even if the claim is filed after the new contract becomes effective. This could deter the opportunistic motive of policyholders.
Attention to detail
Moreover, the insurer could review the claims records of the physical damage insurance and third-party liability insurance in previous policy years. Particular attention should be paid to policyholders who did not purchase physical damage insurance but filed a claim with a high amount of third-party liability insurance in the last policy year. 
These policyholders have a high incentive to purchase physical damage insurance when transferring to a new insurer. Insurers should also analyse whether a client’s switch is caused by rejection by the former insurer. Finally, under a rating deregulation, insurers could consider policyholders’ switching behaviour to establish underwriting guidelines and mitigate potential moral hazard. A 
The Geneva Association
Professor Chun-Ting Liu is from the department of insurance and finance, National Taichung University of Science and Technology in Taiwan.
Professors Jui-Yun Wu and Chi-Hung Chang are from the department of risk management and insurance, Feng Chia University in Taiwan.

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