Below is the Budget constraint with actuarially fair insurance, were the slope of the budget constraint is = p/(1-p)
In the diagram above where A is the endowment point and B the preferred consumption, insurance is actuarially fair. Equilibrium occurs where Cs= Cn.
By making this expenditure on insurance, risk is eliminated. In the event of a lawsuit or no lawsuit her consumption is the same- she is fully insured.
Definition of adverse Selection p 564
Adverse selection is the phenomenon under which the uninformed side of a deal gets exactly the wrong people trading with it. (ie/ it gets an adverse selection of the informed parties). It is caused by hidden characteristics.
E.g. Company selling Fire insurance. 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. In the case of insurance- Storm damage – hire firm to fix it. Ask if it is an insurance job, as if it is they can charge more (insurance companies should monitor this better). Insurance company can’t control actions of claimer, who may make decisions out of line with insurance company’s interests. The insurance company is exploited by the consumer.
What actions may insurance companies take to reduce these problems?
Adverse Selection
P572-573
AIDS testing takes place in the health insurance market. The insurance company wants to avoid insuring people who will be collecting soon. Testing tells the company who is a high-risk consumer. While it solves the A’S’ problem other problems arise. The test has social implications, and for those with AIDS the ability to reduce risk by purchasing insurance is lost.
Targeted insurance rates are often placed on indirect measures where there is no direct observation of risk. Men are charged higher life insurance rates. Sex-based rates are extremely controversial; some argue they constitute unfair discrimination as some men clearly live longer than women. 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.