Insurance Overview

Question 1

Insurance

Answer 1

an agreement/contract between two parties that deals with adverse events

Question 2

adverse event

Answer 2

a bad thing that has some chance of happening

Question 3

insurer

Answer 3

the party that provides the insurance

Question 4

insured

Answer 4

the party that buys the insurance

Question 5

the 2 components of insurance contracts

Answer 5

1) insured party makes a payment (a premium) to the insurer
2) insurer gives a benefit to the insured if an adverse event occurs

Question 6

insurance can be provided

Answer 6

by either the private sector or the gov

Question 6

Retirement & Disability Insurance

Answer 6

– run by the Social Security Administration
– Workers pay into the programs via taxes during their working years
– Receive benefits when they retire or become disabled

Question 6

social insurance

Answer 6

insurance that’s heavily influenced by the gov

Question 6

social insurance comes in two forms

Answer 6

1) directly provided by the gov
2) provided by private firms under strict gov. regulation

Question 7

Healthcare insurance types

Answer 7

– Medicaid: gov.-provided health insurance for children & the poor
– Medicare: gov.-provided health insurance for the elderly
– Obamacare: regulatory framework for private health insurance

Question 7

Unemployment Insurance

Answer 7

– run at the state level
– Workers pay in via taxes when they work
– Receive benefits if they lose their jobs

Question 7

three categories of social insurance programs

Answer 7

healthcare, retirement & disability, and unemployment

Question 8

Social insurance has ______ ____ over time

Answer 8

grown substantially (is now one of the core functions of the federal gov)

Question 9

Why do people value insurance?

Answer 9

it reduces the damage from adverse events

Question 10

What insurance does

Answer 10

lets people redistribute resources across states of the world (transfer from the good state to the bad state)

Question 11

main advantage of insurance

Answer 11

allows for consumption smoothing
- consuming similar amounts regardless of state
- give up some consumption in the good state via premiums to be able to maintain their consumption in the bad state

Question 12

bad state

Answer 12

an adverse event occurs, p
- Consumption = W - m * b - delta +b

Question 13

good state

Answer 13

the adverse event does not occur, 1-p
- Consumption = W (income) - m (dollars per dollar of coverage) * b (insurance)

Question 14

p

Answer 14

the fixed probability that the adverse event occurs/ the probability of the good state

Question 15

Expected Utility

Answer 15

the expected value of a person’s utility across states of the world – the utility that the person expects to obtain before she knows which state will occur

Question 16

EU mathematically is

Answer 16

– weighted average of a person’s utility in each state, where the weights depend on the probabilities of the states
– EU = Pr(good state) * U(good state) + Pr(bad state) * U (bad state)

Question 17

Expected Utility Model

Answer 17

a model that deals with decision-making under uncertainty
– the framework that economists use to model how people make decisions when they don’t know which state will occur

Question 18

the model makes a major claim

Answer 18

– In situations of uncertainty, people maximize their expected utility
– Choose the option that gives the highest average utility over all states

Question 19

Risk Aversion

Answer 19

the idea that people don’t like uncertainty
→ prefer a sure thing to an uncertain outcome with the same expected payout

Question 20

Consumption exhibits

Answer 20

diminishing marginal utility

Question 21

diminishing MU

Answer 21

The utility from an additional dollar ↓ as you have more resources

Question 22

Diminishing MU implications

Answer 22

– Utility ↓ from lower consumption in bad state > utility ↑ from extra consumption in good state
— a utility function is strictly concave (increasing in consumption but at an ever decreasing rate)

Question 23

The individual’s problem

Answer 23

Choose the amount of insurance b that makes her best off

Question 24

Actuarially fair pricing

Answer 24

The insurer charges an amount that is equal to its expected payout & the insurer makes zero expected profits
- common assumption in economic theory
– m = probability of the adverse event p

Question 25

in real world, only two situations where insurance is actuarially fair

Answer 25

1) provided by a benevolent gov
2) provided by private companies that are subject to perfect competition

Question 26

Expected profit

Answer 26

the difference between the premium the insurer receives and the benefit it expects to pay
– E[profit] = m · b − p · b

Question 27

the individual should buy

Answer 27

an amount equal to her loss in the bad state (full consumption smoothing)
- assuming actuarially fair pricing & strictly concave utility functions

Question 28

If the price is greater than actuarially fair

Answer 28

people will likely buy less than full insurance

Question 29

strictly concave utility function

Answer 29

Expected utility is higher if consumption is smoothed than if it is not