Information, Risk, and Insurance. Chapter 16
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1 + Information, Risk, and Insurance Chapter 16
2 + Chapter Outline n The Problem of Imperfect Information and Asymmetric Information n Insurance and Imperfect Information
3 + Imperfect information and asymmetric information n Asymmetric information: where both parties involved in an economic transaction have an unequal amount of information (one party knows much more than the other) n E.g. Buying a used car n Imperfect information: either the buyer, the seller, or both, are less than 100% certain about the qualities of what is being bought and sold
4 + Imperfect vs asymmetric Imperfect Information n buyers and/or sellers do not have all of the necessary information to make an informed decision about the price or quality of a product n Lacking Asymmetric Information n one party, either the buyer or the seller, has more information about the quality or price of the product than the other party. n Unequal
5 + Lemons Used Car Market n even with imperfect information, prices still reflect information n used cars are more expensive on some dealer lots because the dealers have a trustworthy reputation to uphold (signal) n individual seller has no reputation to defend (Craigslist)
6 + Imperfect information Labor markets n How can a potential employer screen for certain attributes, such as motivation, timeliness, ability to get along with others, and so on? 1. Trade schools and colleges to pre-screen candidates. 2. Only interview a candidate with a degree and, sometimes, a degree from a particular school. 3. View awards, a high grade point average, and other accolades as a signal of hard work, perseverance, and ability. 4. References for insights into key attributes such as energy level, work ethic, and so on.
7 + Imperfect information - impacts n Equilibrium Price and Quantity n Thin markets (few buyers and sellers) as each is hesitant due to uncertainty as opposed to thick markets (many buyers and sellers) n Price as a signal of quality n E.g. Expensive restaurants
8 + Imperfect Information - Fixing n Product quality assurance n Reputation, guarantees, warrantees, and service contracts n Guarantees assure quality (promised) n Warranty promise to fix defect over a limited time n Service Contract pay extra to assure repairs n Labor Markets n occupational licenses and certifications to assure competency; probationary periods n Financial Markets n cosigners and collateral n Federal Trade Commission against advertisers making false claims as truth
9 + Insurance and Imperfect Information Section 16.2
10 + Insurance n Insurance: a method that households and firms use to prevent any single event from having a significant detrimental financial effect. n Premiums: Regular payments made by households or firms with insurance n Based on probability of event occurring n Pooled and paid out to those affected by the covered event if it occurs n E.g. Health insurance, Life insurance, Auto insurance etc.
11 + How insurance works n 100 people insured; three risk groups; three possible outcomes n Total damage = (60 $100) + (30 $1,000) + (10 $15,000) = $600 + $30,000 + $150,000 = $186,000 n If each of the 100 drivers pays a premium of $1,860 each year, the insurance company will collect the $186,000 needed to cover the costs of the accidents that occur. Average premiums and average insurance payouts must be approximately equal. n approximately equal.
12 + How insurance works n Risk group: a group that shares roughly the same risks of an adverse event occurring. n Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks n If could classify people according to risk group, then each group can be charged according to its expected losses high risk, pay higher premiums
13 + Imperfect information in insurance markets n Moral Hazard : when people engage in riskier behavior with insurance than they would if they did not have the insurance. n E.g. with car insurance, drivers drive less careful than without n Cannot be eliminated, but insurance companies can attempt to reduce it: 1. Monitor behavior to manage risk security system lowers premiums 2. Deductibles - amount that the insurance policyholder must pay out of their own pocket before the insurance coverage starts paying 3. Copayment - policyholder must pay a small amount 4. Coinsurance - insurance company covers a certain percentage of the cost n When faced with copays and deductibles, studies find reduction in moral hazard (less consumption of covered service)
14 + Moral Hazard health insurance n Fee for service: medical care providers are paid for the services they provide and are paid more if they provide additional services. n Traditional way of providing health care in the US n Lately more shift to health maintenance organizations (HMOs) n Health Maintenance Organization (HMO) provides healthcare that receives a fixed amount per person enrolled in the plan regardless of how many services are provided n Consumer still has incentive to demand more services; provider has incentive to limit it.
15 + Adverse Selection n Adverse selection - the problem in which the buyers of insurance have more information about whether they are highrisk or low-risk than the insurance company does. n Asymmetric information problem for insurers n E.g. With $1860 premium cost from previous example, only high risk group will get insurance (expected loss greater than $1850, while others have expected cost less than $1860, so insurance company can not pool risk, i.e. take from lower risk and pay to higher risk n May refuse high risk individuals, or offer insurance at very high rates as was the case with healthcare in US before 2010
16 + Affordable Care Act 2010 n If insurance premiums are set at actuarially fair levels, people end up paying an amount that accurately reflects their risk group, certain people will end up paying a lot or not offer it to those with pre-existing conditions not allowed under ACA n High premiums not all get insurance (adverse selection) mandated now (50+ employees must offer insurance) n State insurance exchanges for competition of plans n Paid for by higher taxes, annual fees on providers
17 + Review Questions
18 + Review Questions n Q6. What are some of the ways a seller of goods might reassure a possible buyer who is faced with imperfect information? n Solution: Offering warrantees or a period of time in which to return the product for a full refund might correct for the buyer s lack of information. n Q7. What are some of the ways a seller of labor (that is, someone looking for a job) might reassure a possible employer who is faced with imperfect information? n Solution: The worker may offer to work for a trial period for little or no wages so that the employer can verify his value before signing a longterm contract. n Q8. What are some of the ways that someone looking for a loan might reassure a bank that is faced with imperfect information about whether the loan will be repaid? n Solution: People looking for loans typically have to show evidence of a steady income or the possession of collateral, such as a property owned, so that the bank can be assured of collecting on its loan.
19 + Review Questions n Q 11. What is an actuarially fair insurance policy? n Solution: An actuarially fair policy is one in which the average benefits paid out equal the average cost to the policy holder. n Q 12. What is the problem of moral hazard? n Solution: Moral hazard is the observation that people behave in more risky ways when the cost of risky behavior is decreased. n Q 13. How can moral hazard lead to insurance being more costly than was expected? n Solution: When people are insured, they engage in more risky behavior, leading to higher costs for the insurer and thus higher premiums for the policy holder.
20 + Problem - # 24 Imagine that 50-year-old men can be divided into two groups: those who have a family history of cancer and those who do not. For the purposes of this example, say that 20% of a group of 1,000 men have a family history of cancer, and these men have one chance in 50 of dying in the next year, while the other 80% of men have one chance in 200 of dying in the next year. The insurance company is selling a policy that will pay $100,000 to the estate of anyone who dies in the next year. n a. If the insurance company were selling life insurance separately to each group, what would be the actuarially fair premium for each group? n b. If an insurance company were offering life insurance to the entire group, but could not find out about family cancer histories, what would be the actuarially fair premium for the group as a whole? n c. What will happen to the insurance company if it tries to charge the actuarially fair premium to the group as a whole rather than to each group separately?
21 + Solution n a. For the high risk group, the premium would be the probability of dying 0.02 times the benefit payment $100,000 = $2,000. For the low risk group this would be x $100,000 = $500. n b. We weight the premiums for the two groups by frequency in the population and add the results together. $2,000 x $500 x 0.8 = $800. n c. The high risk group will recognize that they are getting a good deal, since $800 is less than their actuarially fair rate of $2,000, so they will enroll in high numbers. Meanwhile, the low risk group will be less likely to enroll, since the rate is higher than their actuarially fair rate of $500. This adverse selection problem will cause the insurance company to either lose money or have to raise rates still higher.
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