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What is an actuarially fair insurance premium? How might adverse selection and moral hazard lead to inefficiency in insurance markets? What actions may insurance companies take to reduce these problems?

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Introduction

1. What is an actuarially fair insurance premium? How might adverse selection and moral hazard lead to inefficiency in insurance markets? What actions may insurance companies take to reduce these problems? K&R 179 Adverse selection: K&R 564,567-572 Frank 213-4, Lecture notes 24/11/03 Moral Hazard: K&R 577-582, Frank 214, Lecture notes 28/11/03 Plan: Introduction Definition of actuarially fair insurance premium, complete with diagram Definition of adverse Selection Why does A'S' lead to inefficiency? Definition of Moral Hazard Why does M'H' lead to inefficiency? What actions may insurance companies take to reduce these problems? Conclusion (m'h' & a's' both first studied in insurance mkt) Definition of actuarially fair insurance premium, complete with diagram Actuarially fair insurance is insurance where the premium is equal to the expected payout of the insurance provider. For an actuarially fair insurance policy, the premium for $1 worth of insurance is simply the probability of the bad state of the world occurring.

Middle

We assume the company issues insurance to a population of different groups:- High Risk - h People Low Risk - l People Ph> Pl, but the Insurance Company cannot tell the difference. So the Insurance Company offers a weighted premium Low risk clients refuse to pay. High-risk clients will say insurance is a bargain. Low Risk drop out of market. High-risk enter market. Claims ?, Premiums ?, More L'R' drop out of the market. Causes welfare loss in insurance market, markets could cease to exist in extreme cases. Definition of Moral Hazard Hidden actions problems when a policyholder may take unobservable actions that affect the probability that he or she will suffer loss and file an insurance claim. Because the informed may take a wrong action (i.e. not do enough to prevent a hazard) these situations are known as Moral Hazard.

Conclusion

However some argue banning sex-based rates would discriminate against women by ignoring actuarial facts. Group health plans are a successful tool for avoiding A'S'. Since insurance is mandatory for all employees, there is no adverse selection problem, and employees who are likely to collect benefits have no opportunity to buy more insurance than those who are not likely to collect. Moral Hazard Co-insurance- a provision in an insurance policy whereby the policyholder picks up a percentage of the bill for damages when there is a claim. For example, in many health insurance policies there is a 20% co-insurance rate. Deductibles are a provision in the insurance policy under which the person buying the insurance has to pay the initial damages up to a set limit. Deductibles and Co-insurance give incentive to care for the subject of the insurance policy while still covering the policyholder in the event of a major loss. No claim bonuses are another method of providing an incentive to care.

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