Insurance Selection Wk 7 Reading Flashcards
Advantageous Selection
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Textbook Case of Insurance Demand and Cost
perfectly competitive, risk-neutral firms offer a single insurance contract that covers some probabilistic loss; risk-averse individuals differ only in their (privately-known) probability of incurring that loss; and there are no other frictions in providing insurance, such as administrative or claim-processing costs.
Text Book Case of Insurance Demand and Cost Graph Axes
The vertical axis indicates the price (and expected cost) of that contract, and the horizontal axis indicates the quantity of insurance demand.
A risk-averse individual’s willingness to pay for insurance is …
the sum of the expected cost and risk premium for that individual
If the marginal cost curve in an insurance graph is sloping downwards…
those individuals who are willing to pay the most for coverage are those that have the highest expected cost. Represents the well known adverse selection property of insurance markets.
What is arguably the most impost distinction of insurance markets (or selection markets ore generally) from traditional product markets?
The link between the demand and cost curve. The shape of the cost curve is driven by the demand-side customer selection.
The distinguishing feature of selection markets (i.e. insurance) is…
that demand and cost curves are tightly linked, because the individual’s risk type not only affects demand but also directly determines cost.
The risk premium is shown graphically in the figure of textbook insurance market…
the vertical distance between expected cost (the MC curve) and the willingness to pay for insurance (the demand curve).
Absent income effects, the welfare loss from not insuring a given individual…
is the risk premium of that individual, or the vertical difference between the demand and MC curves.
The fundamental inefficiency created by adverse selection arises because…
the efficient allocation is determined by the relationship between MC and demand, but the equilibrium allocation is determined by the relationship between AC and demand.
The canonical solution to the inefficiency created by adverse selection is to…
mandate that everyone purchase insurance
A lump sum subsidy toward the price of coverage would…
shift demand out, leader to a higher equilibrium quantity and less under-insurance
Public policy intervention (Ex: “Community Rates”)
Regulation that imposes restrictions on the characteristics of consumers over which firms can price discriminate.
- Central Issue - when insurance companies are allowed to price on gender …
Do consumers still have residual private information about their expected costs?
What are two important features of actual insurance markets?
- ) Insurance “loads” or administrative costs of providing insurance
- ) Preference Heterogeneity
The key implication of “loads”
is that it is now not necessarily efficient to allocate insurance coverage to all individuals
If when there are “loads” when might it not be efficient to allocate insurance coverage to all individuals, even if they’re risk averse?
The additional cost of providing an individual with insurance may be greater than the risk premium for certain individuals, making it socially efficient to leave such individuals uninsured.
Under the textbook assumptions, private information about risk never produces..
over-insurance relative to the efficient outcome, and mandatory insurance coverage is always a (weakly) welfare-improving policy intervention
individuals whom it is socially inefficient to insure
whose expect costs are above their willingness to pay
Second Feature of real-world insurance markets that is not captured by the textbook treatment
preference heterogeneity
Preference Heterogeneity
the possibility that individuals differ not only in their risk but also in their preference, such as their willingness to bear risk (risk aversion)
The existence of unobserved preference heterogeneity opens up the possibility of….
advantageous selection
Advantageous selection produces opposite results to the…
adverse selection results.
All else equal, willingness to pay for insurance is increasing in …
risk aversion and in risk