Insurance Selection Wk 7 Reading

Question 1

Advantageous Selection

Answer 1

-

Question 2

Textbook Case of Insurance Demand and Cost

Answer 2

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.

Question 3

Text Book Case of Insurance Demand and Cost Graph Axes

Answer 3

The vertical axis indicates the price (and expected cost) of that contract, and the horizontal axis indicates the quantity of insurance demand.

Question 4

A risk-averse individual’s willingness to pay for insurance is …

Answer 4

the sum of the expected cost and risk premium for that individual

Question 5

If the marginal cost curve in an insurance graph is sloping downwards…

Answer 5

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.

Question 6

What is arguably the most impost distinction of insurance markets (or selection markets ore generally) from traditional product markets?

Answer 6

The link between the demand and cost curve. The shape of the cost curve is driven by the demand-side customer selection.

Question 7

The distinguishing feature of selection markets (i.e. insurance) is…

Answer 7

that demand and cost curves are tightly linked, because the individual’s risk type not only affects demand but also directly determines cost.

Question 8

The risk premium is shown graphically in the figure of textbook insurance market…

Answer 8

the vertical distance between expected cost (the MC curve) and the willingness to pay for insurance (the demand curve).

Question 9

Absent income effects, the welfare loss from not insuring a given individual…

Answer 9

is the risk premium of that individual, or the vertical difference between the demand and MC curves.

Question 10

The fundamental inefficiency created by adverse selection arises because…

Answer 10

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.

Question 11

The canonical solution to the inefficiency created by adverse selection is to…

Answer 11

mandate that everyone purchase insurance

Question 12

A lump sum subsidy toward the price of coverage would…

Answer 12

shift demand out, leader to a higher equilibrium quantity and less under-insurance

Question 13

Public policy intervention (Ex: “Community Rates”)

Answer 13

Regulation that imposes restrictions on the characteristics of consumers over which firms can price discriminate.

Question 14

• Central Issue - when insurance companies are allowed to price on gender …

Answer 14

Do consumers still have residual private information about their expected costs?

Question 15

What are two important features of actual insurance markets?

Answer 15

1. ) Insurance “loads” or administrative costs of providing insurance
2. ) Preference Heterogeneity

Question 16

The key implication of “loads”

Answer 16

is that it is now not necessarily efficient to allocate insurance coverage to all individuals

Question 17

If when there are “loads” when might it not be efficient to allocate insurance coverage to all individuals, even if they’re risk averse?

Answer 17

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.

Question 18

Under the textbook assumptions, private information about risk never produces..

Answer 18

over-insurance relative to the efficient outcome, and mandatory insurance coverage is always a (weakly) welfare-improving policy intervention

Question 19

individuals whom it is socially inefficient to insure

Answer 19

whose expect costs are above their willingness to pay

Question 20

Second Feature of real-world insurance markets that is not captured by the textbook treatment

Answer 20

preference heterogeneity

Question 21

Preference Heterogeneity

Answer 21

the possibility that individuals differ not only in their risk but also in their preference, such as their willingness to bear risk (risk aversion)

Question 22

The existence of unobserved preference heterogeneity opens up the possibility of….

Answer 22

advantageous selection

Question 23

Advantageous selection produces opposite results to the…

Answer 23

adverse selection results.

Question 24

All else equal, willingness to pay for insurance is increasing in …

Answer 24

risk aversion and in risk

Question 25

If high-risk individuals are less risk averse and the heterogeneity in risk aversion is sufficiently large…

Answer 25

advantageous selection may emerge

Question 26

What kind of MC and AC curve occurs in adverse selection?

Answer 26

An upward sloping MC and AC curve.

Question 27

When there’s advantageous selection, as price is lowered and more individuals opt into the market…

Answer 27

the marginal individual opting in has higher expected cost than infra-marginal individuals.

Question 28

With insurance loads advantageous selection generates…

Answer 28

the mirror image of the adverse selection case, also leading to inefficiency, but this time due to over-insurance rather than under-insurance

Question 29

From a public policy perspective, advantageous selection calls for…

Answer 29

the opposite solutions relative to the tools used to combat adverse selection

Question 30

One way to examine whether adverse selection is present in a particular insurance market

Answer 30

compare the expected cost of those with insurance to the expected cost of those without (or compare those with more insurance coverage to those with less coverage)

Question 31

Advantageous Selection is defined by…

Answer 31

a negative relationship between insurance coverage and average costs

Question 32

With adverse selection, individuals who have private information that they are at higher risk…
(Why does positive correlation confound adverse selection)

Answer 32

self-select into the insurance market, generating the positive correlation between insurance coverage and observed claims

Question 33

With moral hazard, individuals are..

Why does positive correlation confound moral hazard

Answer 33

identical before they purchase insurance, but have incentives to behave differently after.

The government typically has no advantage over the private sector at reducing the welfare costs of moral hazard.

Question 34

In a positive correlation graph, the vertical difference between MCinsured and MCuninsured is a graphical way to quantify…

Answer 34

moral hazard in terms of expected cost

Question 35

To apply the positive correlation test how can condition out the…

Answer 35

set of covariates

Question 36

A proper implementation of the positive correlation test requires that we examine…

Answer 36

whether, among a set of individuals who are offered coverage at identical prices, those who buy more insurance have higher expected cost than those who do not.

Question 37

If selection is empirically detected

Answer 37

it is natural to ask whether the welfare costs it generates are large or small, and what might be the welfare consequences of specific government policies

Question 38

A finding that the MC curve is downward sloping suggests

Answer 38

the existence of adverse selection

Question 39

The finding that the MC is upward sloping suggests

Answer 39

the existence of advantageous selection

Question 40

The “cost curve” test is not affected by…

Answer 40

the existence (or lack thereof) moral hazard