Topic 7: Market Failures to Managing Risk, Risk Pooling+Optimal Risk Pools

Risk Pools

-Need to be large and homogeneous

-COV will continue to decrease until it comes close to 0

-As the risk pool gets larger and larger the risk faced by the insurer falls and approaches zero

Insurance Definition

a device that:

-pools exposures to loss of individuals/firms into a group

-uses funds paid by members of the group (premiums) to pay for losses as they occur

-Group is engaged in a loss/risk sharing engagement

Wealth transfer using loss premiums (refund of premium to the people with losses) and no loss premiums (using the premiums of people without a loss to support those with a loss)

Income/Wealth Transfer in Risk Pool

All risk pools shift money around

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

Heterogeneous Pool

Income transfer is from those who do not have a loss to the who do have loss

Low risk individuals to high risk individuals

Pools are not perfect

Social Security

Largest risk pool ion the US (heterogenous)

This has an intergenerational risk/wealth transfer

Why do firms/individuals buy insurance? What is the commodity purchased?

-Certainty

-Peace of mind

-Security

-Enhances credit worthiness

-Protection of assets

Insurance involves:

Pool and transfer, transfers from the Insured to the Insurers

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

Obtain lots of data, info is power?

Predictions more accurate=less risk

Insurance company invests money until they pay claims

Insurance contract- Idemnification

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

-Idemnify=to compensate

Full Idemnification

All losses paid no matter how big or small

Place the insured in the same financial position after the loss

Partial idemnification

Cost sharing and partial insurance

Ex. deductible/copay/coinsurance

Forms of idemnification

-Replace/repair asset

-Cash-reimbure of pay $

-Provide services (ex attorney-liability)

Principle of Idemnity

insurance will pay no more or less than the actual cash value (ACV)

Limit the 'amount of recovery' to no more than ACV

ACV formula

Replacement cost (RC) - Depreciation = ACV

purpose of principle of indemnity

To control moral hazard, prevent insured from making a profit

Violations of idemnity

Life insurance

Insurance for rare items (antique cars, artwork)

Insurance supply

insurers are willing to sell insurance at a particular price

Insurance demand

Pi

Why might Pi > Pmax?

-EL too high

-P* is too high

-risk charge is too high

-loading costs are too high

Pmax is too low

-individuals underestimate the severity or frequency of the loss

-moral hazard created by disaster relief (floods)

---where insurance like benefits exist

Five Characteristics of Insurable Risk

Large number of similar objects

Losses are accidental or unintentional

Losses can be determined and 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

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 (ex. harassment)

What are losses?

-how do we measure "pain & suffering"?

Losses are not catastrophic to insurer

When one random event results in many many losses (earthquake, flood, hurricane)

Creates risk of insolvency

Large loss principle

Max possible loss needs to be sufficient (do not insure small things!)

Small losses paid through savings

Insurance Contract issues

Misrepresentation(lie)

Concealment (not providing all relevant info)

Principle of Subrogation

substitution of the insurer in place of the insured for the purpose of claiming indemnity from a third party for a loss covered by insurance

Public policy issue 1- Terrorism

Introduction of TRIA 2002

Insurance companies absorb some risk

Public policy issue 2- Flood

Insurance company does NOT bare any risk

gov. funded (gov accepts risk)

1) Homogeneous Risk Pool

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