Question

A) A large insurance company offers group disability insurance products to businesses, which in turn offer the product to their employees. Pricing policies to prevent a loss is difficult. Since it is difficult to know exactly which employees are more prone to file claims, it is hard to price policies accurately. If policies are priced too low, high-risk clients will be attracted and losses incurred. If policies are priced too high, not enough clients will be attracted. Compounding this factor is the fact that companies are motivated to exaggerate their safety in order to negotiate a lower price.  

What problem is being described in this scenario?  

What types of activities can the insurance company undertake to distinguish between customers with a low probability versus a high probability of claiming?

B)The large accommodation chains like Marriott, Accor do not run individual hotels themselves but rather lease the naming rights to a franchisee who leases the building from a property trust. What are the main advantages for hotel chains of not directly operating the hotel? What are the main disadvantages of the franchisee not owning the building?   

Answer 1

Ans1 The problem they are talking about here is adverse selection. This happens due to asymmetric information. Under asymmetric information, one party to a contract has more information than the other party. Since the information is not complete with the other party it might choose a risky alternative.

In such situations, the insurance company can do field inspections to gather information about high risks and low risks clients.

It can also ask for medical certificates from the clients. They can also ask clients to undertake certain medical tests.  

Lastly, they could use the help of underwriters which help them to charge different premiums to different clients on the basis of associated risks.

Ans 2  The main advantages for hotel chains of not directly operating the hotel

It reduces the investment to buy the building, run operations, pay the salaries to the employee.

It reduces the need for the franchisor to deal with government regulations of different countries.

Quality of service is ensured as support of the franchisor is provided to run the operations.

Franchisee will be able to use the benefits of an already existing brand name.

The associated brand name also gives a high chance of success because of a better reputation and management.

The franchisor will earn fees for giving the franchisee the right to use its name. It will also earn a share in profits

Main disadvantages of the franchisee not owning the building

The franchisee does not actually hold an asset. You might lose the gain you could have got on capital.

The lease agreement could get expired, which might cause you to move the operations.

The franchisee creativity will get subsumed because the agreement dictates while running the operations. The franchisee won't be able to carry out any modifications in the building.

Bad performances by other franchisees may affect your franchise's reputation