Topic 6: market failures related to managing risk pooling & optimal risk pools

Insurance

Insurance is a device that:

• pools exposure to loss of individuals into a group

• use funds paid by members of the group to pay for losses as they occur

• group is engaged or involved in a loss or risk-sharing arrangement

Income/Wealth Transfer in Risk Pool

all risk shift money around

homogenous risk pool

income transfer is from those who do not have loss to those who do have loss

heterogenous risk pool

• income transfer is a from a low-risk individuals to high risk individuals

• transfer between risk classes

• social security is the largest risk pool in the U.S. and has intergenerational risk/wealth transfer (heterogenous risk pool)

why do firms/ individuals purchase insurance?

• certainty/peace of mind

• enhances credit worthiness

• serve other contracts

• trade an unknown certain loss with a known and certain loss

• certainty in loss cost

• financial risk gets reduced

insurance involves

• risk and pooling

• risk transfer from the inured to insurer

• transfer the financial responsibility for payment of a loss to the insurer

How/why is the insurance company able to accept risk transfer

obtaining data over the years of offering insurance (info is POWER!) and their prediction is more accurate (less risk)

indemnification

• insurer agrees to indemnify the insured in the event of a covered loss (intentional acts are excluded! like getting in a fight and injuring someone)

• idemnify means to compensate

• insurance is a contract of idemnity

full indemnification

• all losses are paid for no matter how large or small

• place the insured in the same financial position after the loss as they were in prior to the loss

• is insured always fully indeminification? NO

partial indemnification

cost sharing and partial insurance

(cost sharing - deductible/copay/coinsurance

• ex: auto, homeowner, health insurance)

• insurer agrees to indemnify the insured in the event of a loss

• forms of indemnification

• replace or repair an asset

• cash - reimburse or pay dollars (before or after the loss)

• provide services - such as attorney (liability

principles of indemnity

in the event of a property loss, the insured should not collect more than the actual cash value of the loss (acv)

• acv is simply a way to value or measure a loss

• limit the ‘amount of recovery’ to no more than the ACV

• ACV = replacement cost - depreciation…? (fix this)

• purpose is to control moral hazard

• prevent the insured from making a profit from the loss

violations to the principle

• life insurance

• acv rule has no meaning

insurance for rare items

• “one-of-a-kind”

• specify the amount of potential loss payment before it occurs

what tools do we use and when?

• hard to tell sometimes

• depends on the frequency and severity

insurance supply?

• insurers are willing to sell insurance at a particular price

• GPC (Gross premium) = price of insurance

• GP = expected loss + risk charge + admin (loading)

Insurance Demand?

• will individuals pay for insurance at the stated premium?

• Pmax = must an individual will pay for insurance for particular rislk

• a risk is insurable if Pi <Pmax —> market exists (Pi = price insurance)

Why might Pi > Pmax

• Pi is too high

• expected losses are too high

• loading costs are too high

• Pmax is too low

• individuals underestimate the severity or the frequency of the loss

• moral hazard created by disaster relief (floods) —> where insurance like benefits exists

Characteristics of insurable risk

• 5 ideal situations that the insurable company seeks when determining if risk is insurable

• it is a wish-list —> not required that all are met

• guidelines

• what do we need for a market for insurance to exist so a risk is insurable

#1 - large numbers of similar objects

• life insurance

• automobiles

• nature of objects similar so reliable statistics can be formed (is key)

• also needs to be concerned with adverse selection (selection bias)

• how people select insurance and how much

Adverse selection

• AKA - anti-selection or negative selection

• demand correlates to risk

• info is only known to insured

#2 losses are accidental or unintentional

• need to be fortuitous in nature (by chance)

• must be some uncertainty or no risk

• insured should have no control over increased frequency or severity

• must be accidental

• avoid moral hazard and gambling

• why is it a problem? expected losses go up, Pi goes up, Pi > Pmax

• the solution is deductible or co-pay, claims investigation, and policy limits

#3- Losses can be determined and measured

• did loss occur

• not always easy for insurer to determine

• what are losses?

• how do we measure “pain and suffering”?

#4 - losses not catastrophic to insurer

• catastrophic to insured is okay

• normally 1 random event - 1 claim

• When 1 random event - results in many, many losses - big problems

• earthquake, flood hurricane - risks that are difficult to diversify

• avoid having all members of a group to suffer loss at the same time

• creates risk of insolvency for insurer

difficult for insurer to predict overall cost

• risk charge goes up

• Pi goes up

• Pi > Pmax

Solutions for catastrophic loss

• good underwriting

• diversifying risks

• reinsurance