Study Guide

Question 1

1. Why buy insurance and the logic behind health insurance

Answer 1

Health insurance is effectively sacrificing money earned in good times for protection during bad times. By paying an insurance premium, you are protected in the event some sort of health event happened to you. The amount paid might be more or less than real medical costs. Theoretically, a pool of insurance premiums diversifies the risk in a large group of individuals. Additionally, the sum of premiums exceeds the sum of medical expenses, leading to both strong health coverage and profits for the insurance company.

Question 2

2. Risk Aversion

Answer 2

Risk aversion describes a person’s preference for a certain outcome over an uncertain outcome. A risk averse person will prefer a certain outcome to an uncertain one with the same expected income.

Question 3

3. Risk Premium (Check the numerical examples on PPT slides)

Answer 3

Risk premium describes the total amount of money a person pays for insurance. This incorporates expected medical benefits (E(B)) and a loading fee which represents the difference between expected utility and the utility function. The horizontal distance between the chord and the utility function represents the loading fee.

Question 4

In a utility function diagram, what is typically on the x axis and what is typically on the y axis?

Answer 4

The x axis represents income, and the y axis represents utility.

Question 5

Describe the steps for calculating total risk premium

Answer 5

1. calculate the difference between expected income and full income, this is E(B). Find the corresponding Expected utility.
2. Determine the certain income associated with that level of utility, and incorporate the difference into a calculation of the total risk premium

Question 6

4. Describe the factors affecting demand for insurance

Answer 6

Include: patterns of insurance coverage, probability of illness, price of insurance, insurance demand elasticity, tax penalty
income + degree of risk aversion

Question 7

5. Moral Hazard and Adverse Selection

Answer 7

Moral hazard is the phenonenom where individuals are less incentivized to engage in safe behavior because risk behavior will be covered. Adverse selection describes the oversupply of low-value goods or contracts in a market due to information asymmetry. Adverse selection has the power to destroy an insurance market through an “adverse selection death spiral.”

Question 8

6. Expected Value

Answer 8

Expected value is a formula, which follows the pattern:
(proportion out of 1)(value) + (proportion out of 1)(value) + (proportion out of 1)(value)
All proportions theoretically add up to 1.

Question 9

7. Job Lock

Answer 9

Job lock describes the phenomenon where a person stays in the job they have because they do not want to lose their benefits. This process hinders social mobility and leads to modest social welfare losses.

Question 10

8. Compare and contrast experience rating and community rating

Answer 10

Experience rating describes the way in which insurance companies could rate potential customers with perfect information (i.e. by incorporating their full medical history). In a community rating system, everyone in a community must receive the same premium, and medical history cannot be considered.

Question 11

9. What are factors that determine the premium for health insurance?

Answer 11

Premiums for health insurance are context-dependent, but they also rely on the identifying factors for the person. For instance a person’s age, gender, lifestyle will help determine their premium, as will government regulations, the company they are applying for, and employer contributions.

Question 12

10. What does an ideal insurance contract look like?

Answer 12

According to demand theory, an individual seeking to maximize their utility will select a plan with full coverage above a deductible.