Topic 6: Market Failures Related to Managing Risk, Risk Pooling, & Optimal Risk Pools

Definition of Insutance

A device that pools exposures to loss of individuals into a group, uses funds paid by members of the group to pay for losses as they occur, and the group is engaged in a loss of risks haring arrangement.

Income/wealth transfer in risk pool

All risk pools shift money around

Homogenous Risk Pool

Income transfer is from those who do not have loss to those who do have a loss with similar risk

Heterogenous Risk Pool

Income transfer is from those who do not have a loss to those who do have a loss, from low risk to high risk.

Largest Risk Pool in the U.S.

Social Security

Why do firms and individuals purchase insurance

Certainty/peace of mind, serve other contracts, enhances credit worthiness/protect assets, regulation/comply with the law

Characteristics of an Insurable Risk

Large number of similar objects, Losses are accidental or unintentional, Losses can be determined & measured, Losses not catastrophic to insurer, Large loss principle

Large number of similar objects

Life insurance, automobiles, nature of objects similar so reliable statistics can be formed is key, also need to be concerned with adverse selection

Adverse Selection

Anti or negative selection

Demand Correlates to risk

Information is only known to insured

Impact on price could lead to collapse of insurance pool, product, or market

Losses are accidental or unintentional

-need to be fortuitous in nature

-must be some uncertainty or no risk

-insured should have no control over increasing frequency or severity

-must be accidental

-avoid moral hazard & gambling

Losses can be determined and measured

Did loss occur?

-not always easy for insurer to determine

What are losses?

-how do we measure "pain & suffering"?

Losses not catastrophic to insurer

- catastrophic to insured is ok

- 1 random event, 1 or a few claims

- When 1 random event results in many losses, its a big problem

- Earthquake, Flood, Hurricane - Risks that are difficult to diversify

- Avoid having all members of a group suffer to a loss at the same time

- Creates the risk of insolvency for insurer

- Difficult for insurer to predict overall cost

- Law of large numbers assumes that random events in question are independent

Large loss principle

- maximum possible loss needs to be sufficient

- administrative/loading costs too high for it to be affordable

- Small losses better paid off through savings

Insurance contract issues

misrepresentation (A false statement made by applicant when buying insurance) and concealment (must provide important or relevant info to the insurer)

Insurance involves

-pooling & transfer

-risk transfer from the insurED to the insurER

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

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

- obtain data over the years of offering insurance - info is power and their predictions are more accurate - less risk

- Invests money until they pay claims

Indemnification

Compensation

Insurer agrees to indemnify the insured in the event of a covered loss

insurance is a contract of indemnity

Full Indeminification

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

insured is not always fully indemnified

Partial Indemnification

- Cost sharing and partial insurance

- Cost sharing: Deductible/copay coinsurance - auto, homeowners, health insurance

- Forms of indemnification: Replace or repair an asset, cash reimburse or pay $, Provide services such as an attorney (liability)

Principle of indemnity

- The insured should not collect more than the actual cash value of the loss (ACV)

- To control moral hazard

- Prevent the insured from making a profit from the loss

ACV =

Replacement cost - depreciation based on replacement cost

Violations to the principle of indemnity

Life insurance (ACV rule has no meaning), insurance for rare items ("one of a kind," specify the amount of the loss before it occurs)

What tool do we use & when?

Hard to tell sometimes, depends on frequency and severity

Insurance supply

- insurers are willing to sell insurance at a particular price

- GP = Price of insurance or = EL + Risk Charge + Admin