What’s trust got to do with it?

Information asymmetry

Studying the phenomenon of insurance fraud, the concept of information asymmetry seems to be within its core. To be specific, it is the asymmetry of information between the parties of the insurance contract, i.e. the insurer, the insured and the policyholder, that is of relevance. The parties do not share the same level of knowledge regarding the insurance subject matter, the risks related thereto and the circumstances of an insured event.

For example, an insured person witnessing an insured event has the information advantage over the insurer regarding the circumstances of the event. This exposes him or her to the ex-post moral hazard. The described information advantage provides an opportunity for the insured to commit fraud. He or she can decide to deceive the insurer when describing the circumstances of the insured event with an intent of obtaining a higher compensation.

On the other hand, the information asymmetry quite regularly works in favour of insurers, as well. Namely, it is the insurers who draft the seemingly never-ending terms and conditions of insurance contracts and define their coverages. Their knowledge and understanding of the terms and coverages are incomparable to what a regular policyholder knows and understands about his or her policy. This information advantage is rather negatively reflected in a proverbial public belief that the insurers are the real fraudsters, as they are perceived to use the loopholes and/or refer to small print when avoiding to settle claims.

 

Closing the gap

The information asymmetry cannot be completely eliminated. At least not in a cost-effective manner (see Towsend, 1979). The gap may be narrowed by using new technologies which are increasing the availability of relevant and independent information sources to insurers (shameless moment: we contribute with our (abc) search) app). Nevertheless, the insurers still considerably rely on information provided by insureds themselves. Similarly, the insureds rely on insurers that they will truly cover the risks that matter to them the most, as not many are prepared to spend hours studying terms and conditions.

And this is what’s trust got to do with it. It helps the parties overcome the information asymmetry described above. Relying on each other is much easier when there is mutual trust between the parties. When an insurance contract is concluded and exercised in good faith, it is more likely that the disclosed information will be credible and reliable. The trust between the parties is being built. In contrast, insurance fraud erodes the trust. Information asymmetry reclaims significance and opportunity for further fraud (moral hazard) raises.

It clearly constitutes a breach of trust when an insured abuses a promise given by an insurer to pay the damages for an insured event. However, insurers can additionally aggravate the erosion of trust by remaining passive. Rather than actively pursue fraud prevention programmes, they may choose to pass on the costs of insurance fraud to all policyholders in the form of higher insurance premiums. In consequence, the insurance market becomes less efficient and the customers (policyholders) are no longer treated equally. As insurance fraud becomes pervasive, the level of public tolerance towards insurance fraud increases. The vicious circle is complete.

 

Referenced literature:

Townsend, R. M.: Optimal Contracts and Competitive Markets With Costly State Verification. Journal of Economic Theory 21(2), 1979, 265–293.

Tennyson, S.: Moral, Social and Economic Dimensions of Insurance Claims Fraud. Social research Vol. 75: No 4, 2008, pp. 1181–1204.