It seems we hear about insurance all the time. We have to have car insurance, folks are worried about health insurance and you might be starting to think about life insurance. If you rent, you may want renters insurance. Wow, if everyone is doing it, it must be a good thing! Well, insurance can be a good thing. But, one size may not fit all, so we will study many details about insurance. The authors point out that insurance planning can be as fruitful as tax and investment planning. Insurance is another tool we can use to lead the good life, like right here in Nebraska.
Risk In the context of insurance, risk is the uncertainty of economic loss. We saw that the FDIC helps us by insuring our deposits in financial institutions up to $100,000. (Banks pay for it) Insurance companies pool resources from many and pay out the claims from the relative few who suffer losses. Any difference between the two would be the “profit” of the insurance company. You would hope that people who buy insurance do not take on risk that is easily avoidable and preventable. Some claim that once insured, people do not act in ways to prevent loss. This is called moral hazard.
Moral hazard Moral hazard is the situation where before we insure we have one set of risks, but after the insurance is purchased we have a different set of risks. For example, without fire insurance we take precautions to not have a fire. This leads to a certain probably of fire. After insurance we tend to not take as many precautions and thus have a higher probability of having the fire. The insurance company will soon see this and charge us the higher rates and this will drive the truly cautious from the market.
Insurance Underwriting refers to the notion that insurance companies have to decide who to insure and what to charge. The companies who offer insurance want information about you so they can decide what you will cost them. Information helps them figure out what to charge you. Before I work through some examples that are fun, I want to note that the authors point out that all life insurance policies contain an incontestability clause that gives the insurance company 1 to 2 years to investigate all information provided by the insured in the application. If false information is given, the insurance can be revoked.
Digression Say I flip a coin and if it comes up heads I give you a dollar. If it comes up tails I give you nothing. It costs you nothing to play. What, on average, can you expect to win? 50 cents, right. In the context of insurance we talk about the expected value or average outcome. We use a math formula to show the expect value. In the above example we have .5(1) + .5(0) = .5 or 50 cents. In general we take the product of each possible outcome and its corresponding probability and then we add across all possibilities.
adverse selection Let’s consider a world of used cars where there are good ones and there are bad ones - lemons. Let’s look at how buyers and sellers value each type of car: good car lemon seller values 100 50 buyer values 120 60. With perfect information both buyer and seller know about the type of car. There is a set of prices at which both types of cars call be sold. Good cars sell between 100 and 120 and lemons sell between 50 and 60.
adverse selection Say buyers and sellers do not know what type of car they are dealing, but they think the chances are 50-50 between a good one and a lemon. In the market sellers expect cars to be worth the expected value = .5(100) + .5(50) = 75, and buyers expect cars to be worth .5(120) + .5 (60) = 90. All used cars would likely sell between 75 and 90. Sometimes you get a lemon, sometimes you don’t.
adverse selection Now say only sellers know the type of car. At which price can cars sell for? -At prices above 100 sellers would offer all cars for sale. But when buyers do not know the type of car their expected value is 90 and thus would not pay 100 for the car. So prices above 100 would not exist for long. -Prices between 60 and 100 would have sellers sell only lemons because they would not sell something they value at 100 for less than 100. Buyers would soon find this out and then only offer 60 for cars. So prices above 60 would not last. -At prices below 50, no seller wants to sell.
adverse selection The only prices that can last are prices between 50 and 60 and then only lemons are offered for sale. In the presence of ‘asymmetric information’, trade in ‘high quality’ goods does not occur. So a lack of information on the part of some traders leads to less trade. This is an example of adverse selection. In the insurance world adverse selection means there is a tendency for only high risk groups to seek insurance.
Insurance Say you have 100 healthy people, people who have a 1 in 10 chance of being sick next period. Thus, next period you would expect 10 people from the group to be sick. We will talk about increments of $10 worth of doctor bills. Next period a person either pays 0 if they are not sick or $10 if they are sick. The expected payment per person is .1(10) + .9(0) = 1. So in any period the person can expect to pay out $1. Now this person wouldn’t pay more than $1 for insurance coverage of $10 because they would be buying more than they need.
Insurance Say the person would pay $2. Over the long haul they would find they pay in $2 per period but on average get out only $1 in benefits. These people wouldn’t do this for long. Insurance companies wouldn’t charge less than $1 because they would lose money over the long term. Now say there is another class of people called sicklies. They have a 9 in 10 chance of being sick next period. Their expected payment is .9(10) + .1(0) = 9.
Insurance By the logic similar to the healthies, insurance for the sicklies would cost $9 if insurance companies knew who they were. Now say the insurance company doesn’t know what group people fall into. Could it offer insurance to all at $1? NO!, it would lose money on the sicklies. If the insurance company offers $2 insurance some healthies drop out and it still loses money on the sicklies.
Insurance The insurance company would move toward insuring only the sicklies at $9. One group is ‘adversely’ selected to not participate in the market. So when the insurance company can not define the type of buyer, one type of buyer is driven from the market because the pricing structure has to cover the cost of doing business.
Summary In a world of perfect information, different classes of people pay different rates and all markets function. In a world where only buyers know their health risks only one market is formed - the sicklies market. Sickles end up paying the same either way, but healthies are driven from the market in a world of less than perfect information.