Insurance Selection Wk 7 Reading Flashcards
Advantageous Selection
-
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
If high-risk individuals are less risk averse and the heterogeneity in risk aversion is sufficiently large…
advantageous selection may emerge
What kind of MC and AC curve occurs in adverse selection?
An upward sloping MC and AC curve.
When there’s advantageous selection, as price is lowered and more individuals opt into the market…
the marginal individual opting in has higher expected cost than infra-marginal individuals.
With insurance loads advantageous selection generates…
the mirror image of the adverse selection case, also leading to inefficiency, but this time due to over-insurance rather than under-insurance
From a public policy perspective, advantageous selection calls for…
the opposite solutions relative to the tools used to combat adverse selection
One way to examine whether adverse selection is present in a particular insurance market
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)
Advantageous Selection is defined by…
a negative relationship between insurance coverage and average costs
With adverse selection, individuals who have private information that they are at higher risk…
(Why does positive correlation confound adverse selection)
self-select into the insurance market, generating the positive correlation between insurance coverage and observed claims
With moral hazard, individuals are..
Why does positive correlation confound moral hazard
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.
In a positive correlation graph, the vertical difference between MCinsured and MCuninsured is a graphical way to quantify…
moral hazard in terms of expected cost
To apply the positive correlation test how can condition out the…
set of covariates
A proper implementation of the positive correlation test requires that we examine…
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.
If selection is empirically detected
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
A finding that the MC curve is downward sloping suggests
the existence of adverse selection
The finding that the MC is upward sloping suggests
the existence of advantageous selection
The “cost curve” test is not affected by…
the existence (or lack thereof) moral hazard
