Question

Life insurance policies typically have clauses stipulating the insurance company will not pay claims arising from suicide for a specified term—typically two years from the date the policy was issued. Use precise economic terminology to explain the likely impact on an insurance company’s bottom line if it were to eliminate such a clause.

Short answer

This case put the insurance company in a risky financial situation. It may run into solvency problems and be unable to meet the client’s commitment.

Step-by-step solution

Define Asymmetric Information

The term asymmetric information implies that in a deal between two groups, one group cheats another because it has more information. This phenomenon is common in insurance deals.

Step 2: Explaining the likely impact on an insurance company’s bottom line if it were to eliminate such a clause

Insurance firms are in charge of insuring different risks to other people or businesses, protecting or securing their property, health, and lives from the hazards they are exposed to.

An insurance company's profitability stems from the need to enter into many contracts to insure a large number of clients. It must maintain a significant cash reserve to maintain a solvency margin against future payments inherent in its business.

The company establishes a policy of not paying claims for suicide case that occurs two years after the contract. This situation reflects an adverse selection situation in which the insurance company does not have information about the mental state of each individual who purchases a policy. Thus, people may commit suicide after purchasing an insurance policy to leave the money for the family.

Such cases take the insurance firm to a precarious financial position since it might face solvency issues and be unable to satisfy customer obligations.

Therefore, the insurance company might be in a risky financial situation since it might run into solvency problems and be unable to meet client commitments.