Lecture 4

Question 1

What is an insurance?

Answer 1

Insurance is a promise to make some payment in case of a particular event, in exchange for a payment,
called a premium.

Question 2

What are insurance premiums?

Answer 2

Insurance premiums: Money that is paid to an insurer so that an individual will be insured
against adverse events

Question 3

What is consumption smoothing

Answer 3

Consumption smoothing: The translation of consumption from periods when consumption is high, and
thus has low marginal utility, to periods when consumption is low, and thus has high marginal utility.

Question 4

Why do individuals Value Insurance

Answer 4

Always a moderate amount of consumption for sure is better than a 50–50 chance of having a lot or
nothing.
* Individuals will demand full insurance in order to fully smooth their consumption across states of the world

Question 5

Expected utility model calculation?

Answer 5

• Suppose an adverse event occurs with probability 𝑝𝑝. Expected utility is
  𝐸𝐸𝑈𝑈=(1−𝑝𝑝)×𝑈𝑈(consumption with no adverse event)+𝑝𝑝×𝑈𝑈(consumption with adverse event)

Question 6

What is the expected utility model?

Answer 6

Expected utility model: The weighted sum of utilities across states of the world, where the weights are
the probabilities of each state occurring.

Question 7

The Role of Risk aversion in Insurance

Answer 7

Risk aversion: The extent to which individuals are willing to bear risk.
* Risk-averse people may still want to buy some insurance even if it is not actuarially fair.

• People may differ in their risk aversion, and if insurance premiums are extremely unfair, then only the most risk averse will want it.

Question 8

What is Information Asymetry?

Answer 8

Information asymmetry: The difference in information that is available to sellers and to
purchasers in a market.

• In the insurance market, buyers may know more about their insurable risks than the seller (insurer) does.

Question 9

Adverse Selection

Answer 9

Adverse selection: The fact that insured individuals know more about their risk level than does the insurer might cause those most likely to have the adverse outcome to select insurance, leading insurers to lose money if they offer insurance.

Question 10

What happens when adverse selection is present?

Answer 10

Selling to both requires that low-risk people subsidize high-risk people.
* Low-risk people may not want to do this.
* Sometimes, only high-risk people end up with insurance.

Question 11

Does Asymetric Info necessarily lead to market failure?

Answer 11

If low-risk people have a high enough risk premium, they will subsidize high-risk people in a pooling
equilibrium.

Question 12

What is Risk Premium?

Answer 12

The amount that risk-averse individuals will pay for insurance above and beyond the
actuarially fair price.

Question 13

What is pooling Equilibrium?

Answer 13

: A market equilibrium in which all types of people buy full insurance even though it is
not fairly priced to all individuals

Question 14

What is a seperating equilibrium?

Answer 14

A market equilibrium in which different types of people buy different kinds of
insurance products designed to reveal their true types.

Question 15

Other reasons other than adverse selection that the goverment should intervene in the market?

Answer 15

Externalities: Vaccines have positive spillovers, car crashes negative ones.
* Administrative costs: Government-run Medicare has much lower administrative costs than private
insurance.
* Redistribution: Governments may want to redistribute from the healthy to the sick.
* Paternalism: Governments may feel that people would choose to buy too little insurance for themselves.
* irrational agents and lazy choice makers

Question 16

What is the samaritans dilema?

Answer 16

Compassionate governments want to bail out hard-hit citizens.
* But, knowing this, citizens may not buy insurance, making bailouts expensive.
* This is especially important for floods

Question 17

What is self Insurance?

Answer 17

• Self-insurance: The private means of smoothing consumption over adverse events, such as through one’s own savings, the labor supply of family members, or borrowing from friends.

Question 18

How can people insure themselves against unemployment?

Answer 18

They can draw on their own savings.
* They can borrow, either in collateralized forms (such as borrowing against the equity they have in their
homes) or in uncollateralized forms (such as on their credit card).
* Other family members can increase their labor earnings.
* They can receive transfers from their extended family, friends, or local organizations.

Question 19

How much self-insurance is in place determines how effective social insurance is.

What 3 different things can happen?

Answer 19

• For an individual with no self-insurance, each dollar of unemployment insurance (UI) goes directlyto reducing the decline in consumption from unemployment.
• no crowd-out

For an individual with complete self-insurance, each dollar of UI replaces a dollar of selfinsurance.
* complete crowd-out

For an individual with partial self-insurance, each dollar is split between smoothing consumption
and reducing self-insurance.
* partial crowd-out

Question 20

The importance of social insurance for consumption smoothing will depend on two factors?

Answer 20

Predictability of the event: It is easier for people to self-insure against a predictable event, such as increasing their savings. More predictable risks reduce the benefits of providing social insurance.
* Cost of the event: It is more difficult to self-insure against high-cost events, such as becoming injured and unable to work. Costly risks increase the benefits of providing social insurance.

Question 21

Definition of Moral Hazard

Answer 21

• Moral hazard: Adverse actions taken by individuals or producers in response to insurance against
  adverse outcomes.

Question 22

Examples of Moral hazard

Answer 22

Tuna fisherman Paul Hebert
* Claimed a physical disability. Accepted $44,000 in Social Security over four years, two of which
were spent on the reality TV show Wicked Tuna, which required heavy physical labor.
* Construction worker Donald Ray Simmons Jr.
* Claimed a severe arm injury. Received $52,000 in insurance payments before investigators
discovered he was working as a tandem skydiving instructor.
* Office worker Sheyla Veronica White
* Hit herself on the head with a sprinkler that fell near her desk. She subsequently claimed that it
had fallen directly on her and filed a workers’ compensation claim. The whole episode was caught
on tape

Question 23

What 2 things determine Moral Hazard?

Answer 23

• How easy it is to observe whether the adverse event has happened.
• How easy it is to change behavior in order to establish the adverse event.

Question 24

In examining the effects of social insurance, four types of moral
hazard play a particularly important role.

Answer 24

• Reduced precaution against entering the adverse state.
• Because you have medical insurance, you reduce preventive activities to protect your health.
• Increased odds of entering the adverse state.
• Because you have workers’ compensation, you are more likely to claim that you were injured on the job.
• Increased expenditures when in the adverse state.
• Because you have medical insurance, you use more medical care.
• Supplier responses to insurance against the adverse state.
• Because you have workers’ compensation, firms aren’t as careful about protecting you against workplace
  accidents.

Question 25

In conclusion Optimal Social
Insurance

Answer 25

• Optimal social insurance systems should partially, but not completely, insure individuals against adverse
  events.
• The benefit of social insurance is the amount of consumption smoothing provided by social insurance
  programs.
• The cost of social insurance is the moral hazard caused by insuring against adverse events.

Question 26

Asymetric information in insurance has 2 important implications

Answer 26

• It can cause adverse selection.
• It can cause moral hazard.