Insurance Overview Flashcards
Insurance
an agreement/contract between two parties that deals with adverse events
adverse event
a bad thing that has some chance of happening
insurer
the party that provides the insurance
insured
the party that buys the insurance
the 2 components of insurance contracts
1) insured party makes a payment (a premium) to the insurer
2) insurer gives a benefit to the insured if an adverse event occurs
insurance can be provided
by either the private sector or the gov
Retirement & Disability Insurance
– 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
social insurance
insurance that’s heavily influenced by the gov
social insurance comes in two forms
1) directly provided by the gov
2) provided by private firms under strict gov. regulation
Healthcare insurance types
– Medicaid: gov.-provided health insurance for children & the poor
– Medicare: gov.-provided health insurance for the elderly
– Obamacare: regulatory framework for private health insurance
Unemployment Insurance
– run at the state level
– Workers pay in via taxes when they work
– Receive benefits if they lose their jobs
three categories of social insurance programs
healthcare, retirement & disability, and unemployment
Social insurance has ______ ____ over time
grown substantially (is now one of the core functions of the federal gov)
Why do people value insurance?
it reduces the damage from adverse events
What insurance does
lets people redistribute resources across states of the world (transfer from the good state to the bad state)
main advantage of insurance
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
bad state
an adverse event occurs, p
- Consumption = W - m * b - delta +b
good state
the adverse event does not occur, 1-p
- Consumption = W (income) - m (dollars per dollar of coverage) * b (insurance)
p
the fixed probability that the adverse event occurs/ the probability of the good state
Expected Utility
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
EU mathematically is
– 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)
Expected Utility Model
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
the model makes a major claim
– In situations of uncertainty, people maximize their expected utility
– Choose the option that gives the highest average utility over all states
Risk Aversion
the idea that people don’t like uncertainty
→ prefer a sure thing to an uncertain outcome with the same expected payout
Consumption exhibits
diminishing marginal utility
diminishing MU
The utility from an additional dollar ↓ as you have more resources
Diminishing MU implications
– 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)
The individual’s problem
Choose the amount of insurance b that makes her best off
Actuarially fair pricing
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
in real world, only two situations where insurance is actuarially fair
1) provided by a benevolent gov
2) provided by private companies that are subject to perfect competition
Expected profit
the difference between the premium the insurer receives and the benefit it expects to pay
– E[profit] = m · b − p · b
the individual should buy
an amount equal to her loss in the bad state (full consumption smoothing)
- assuming actuarially fair pricing & strictly concave utility functions
If the price is greater than actuarially fair
people will likely buy less than full insurance
strictly concave utility function
Expected utility is higher if consumption is smoothed than if it is not
