This document provides an overview of basic insurance concepts and issues that can arise in insurance markets. It defines key terms like insurer, insured, premium, and policy. It also describes why people purchase insurance and outlines some problems like moral hazard, adverse selection, and information asymmetry that can occur. Specifically, it notes that moral hazard refers to policyholders taking less care due to having insurance. Information asymmetry can cause a market failure if insurers cannot correctly price policies based on policyholder actions. Overall ratings and risk pooling help address these issues.
2. BASIC CONCEPTS
Insurance is a means of protection from financial loss.
An entity which provides insurance is known as an insurer,
insurance company, or insurance carrier.
A person or entity who buys insurance is known as an insured
or policyholder.
The insurance transaction involves the insured assuming a
guaranteed and known relatively small loss in the form of
payment to the insurer in exchange for the insurer's promise to
compensate the insured in the event of a covered loss.
The insured receives a contract, called the insurance policy,
which details the conditions and circumstances under which
the insured will be financially compensated.
3. INSURANCE PREMIUM
In an insurance contract, the risk is transferred from the
insured to the insurer.
For taking this risk, the insurer charges an amount called the
premium.
Premium is an amount paid periodically to the insurer by the
insured for covering his risk.
The premium is a function of a number of variables like age,
type of employment, medical conditions, etc.
The premium paying frequency can be different. It can be paid
in monthly, quarterly, semiannually, annually or in a single
premium.
4. NEED OF INSURANCE
• LOOKING AFTER YOUR LOVED ONES
EVEN AFTER YOU'RE GONE.
• DEALING WITH DEBT.
• HELPS ACHIEVE LONG-TERM GOALS.
• LIFE INSURANCE SUPPLEMENTS YOUR
RETIREMENT GOALS.
• BUYING INSURANCE IS CHEAPER
WHEN YOU'RE YOUNGER.
• YOUR BUSINESS IS ALSO TAKEN CARE
OF.
• TAX-SAVING PURPOSES.
• A TOOL FOR FORCED SAVINGS.
• YOU MAY NOT BE QUALIFIED FOR IT
LATER.
• PEACE OF MIND.
5. MORAL HAZARD
In insurance the moral hazard may be defined
as the tendency of insurance policy holders’ to
make less effort protecting those goods which
are insured.
Moral hazard also refers to situations where
one side of the market can't observe the
actions of the other.
It is often called as problem of hidden action
i.e., actions taken by the insured affect the
probability of a loss but cannot be observed by
the insurer.
The insurer cannot apply correct prices
premium and indemnity that depend on the
actions of the insured, leading to a market
failure.
6. PRINCIPAL AGENT PROBLEM
For example, If you hire out a contractor to
fix your roof, you are the principal while
the roofer is the agent.
The principal-agent problem arises when
the incentives of the principal and agent
conflict. Both the principal and agent strive
to maximize their utility, but by doing so,
either the principal or the agent becomes
worse off as a result.
Let's say, you pay your roofer by the hour.
By doing so, the roofer realizes that, by
taking as much time as possible, he could
reap a higher reward in the form of money
Instead of paying the roofer by the hour,
you pay him by the project, a set fee. This
way, you have eliminated the roofers
incentive to extend the project as long as
possible.
It refers to a market situation in
which asymmetry occurs
between the principle and the
agent.
7.
8. THE MODEL
Assumptions:
Assumes insurance supplied by competitive, risk
neutral insurers, with no administration costs.
The probability (p) of loss (L) is endogenous and
depends on the level of expenditure on care a1, a0,
where a1 > a0.
Set a0 = 0, now probability of loss when a = 0 is
p0; and a = a1 by p1.
For it to be worth spending a1 care rather than a0
care, it is necessary that (p0 − p1)L > a1 or
expressed another way p1L + a1 < p0.
9. CASE UNDER PERFECT INFORMATION
When the individual chooses a0 = 0, the
insurance companies break even
budget line is the line B0y0.
The individuals budget line where they
spend a0 = 0 is B'y0. When they spend
a1 it is B1a.
Where there is perfect information (i.e.
no hidden action ) and the insurer can
observe that a1 care has been taken it
will offer full insurance anywhere along
the new insurer break even budget line
of B1a
For the individual in above Figure, it is
clearly better to spend a1 on care since
this will place them on a higher
indifference curve I' then if they choose
a0 (which places them on the lower
indifference curve I0).
10. CASE UNDER IMPERFECT
INFORMATION Consider the situation where they
assume that the insured party chooses a1
level of care.
The insurer will offer an insurance
contract based on the break-even
budget line B1a. The associated
premium for full cover is given by p1L.
But, the insured can choose their level of
care! They will choose a0 level of care as
this will place them at the point A'1. This
is on a higher indifference curve than
the perfect information situation. The
insured thus has an incentive to choose
a0 level of care.
This situation is clearly unfavorable to
the insurer since it makes a loss, the
expected payments exceed the expected
premiums: p0L > p1L .
A situation of moral hazard thus exists.
11. EQUILIBRIUM ANALYSIS:
Under moral hazard, when the insurer cannot observe the
actions of the insured which affect the risk of loss, the
equilibrium is of two types.
In one equilibrium the insured chooses to take no care and
have full cover at a fair premium based on his higher
accident probability.
In the other, the individual may be offered part cover at a
fair premium. The incomplete cover motivates the insured
to take care to reduce the probability of loss by making him
bear some of the consequences of the accident.
12. WHY IS RATIONING DONE?
The competitive equilibrium is
unusual in that it involves
rationing:
The insurer fixes the quantity of
cover it is willing to provide
despite the fact that the insured
would be willing to buy more
cover at a fair premium.
The reason the insurer does not
meet the demand is that it knows
that if the cover is increased the
insured will accept the increased
cover and reduce his care.
13. AN EXAMPLE TO DEMONSTRATE INSURANCE
PREMIUM UNDER ASYMMETRIC INFORMATION:
Cost to Insurer
17. Most healthy people will not buy Insurance since the cost is
greater than benefit.
18.
19.
20.
21.
22.
23. Here we assume that people who exercise, eat vegetables, buckle their seat
belt will not buy Insurance but people who smoke, mountain climbers,
motorcycle riders will buy Insurance. But is this TRUE ??
24. Mostly NO!! those who try to avoid risk by eating well also try to avoid risk by
buying health insurance. People have different tolerance for risk, and hence the
healthier people end up buying health insurance. This is called PROPITIOUS
SELECTION. This can keep cost low and prevent the death spiral.
25.
26.
27. A check up will
allow the
insurance firms to
have almost equal
information as the
buyers.
28.
29. But if too much
of Information
has already been
rendered, it is no
more a
Insurance.
Because
insurance is
done to protect
us in unexpected
states of affair
and it is a kind
of risk pooling.
30.
31. The employer purchases insurance for all his
employees without having much knowledge about
their health. Thus the adverse selection problem
becomes much weaker with group insurance.
But if you loose job, you even loose your
insurance and hence MEDICARE schemes by the
government is introduced.
32. Under this act, if you don’t buy health insurance you’ll be fined by law.
The idea is to pool healthy people into buying an insurance and that will
moderate the cost of health insurance and avoid the death spiral.
34. Relation between Premium
volume to GDP and Density
0.920.960.961.031.061.11.171.3
1.54
1.981.962.06
2.24
2.47
3.13
3.58
3.423.41
3.24
2.84
2.542.51
2.26
2.93
3.413.53
3.75
3.91
4.084.214.08
3.92
3.633.723.863.94
3.6
3.4
3.573.67
3.343.343.42
Chart Title
India United States
Year India US
1996 1.03 2.93
1997 1.06 3.41
1998 1.1 3.53
1999 1.17 3.75
2000 1.3 3.91
2001 1.54 4.08
2002 1.98 4.21
2003 1.96 4.08
2004 2.06 3.92
2005 2.24 3.63
2006 2.47 3.72
2007 3.13 3.86
2008 3.58 3.94
2009 3.42 3.6
2010 3.41 3.4
2011 3.24 3.57
2012 2.84 3.67
2013 2.54 3.34
2014 2.51 3.34
2015 2.26 3.42
35. Relation between country’s GDP and
Premium paid
Year Total Premium GDP
2005-2006 8643.29 9.20317E+11
2006-2007 156075.86 1.20111E+12
2007-2008 201351.41 1.18695E+12
2008-2009 221785.48 1.32394E+12
2009-2010 265447.25 1.65662E+12
2010-2011 291638.63 1.82305E+12
2011-2012 287072.11 1.82764E+12
2012-2013 287202.49 1.85672E+12
2013-2014 314301.66 2.03539E+12
2014-2015 328101.14 2.11175E+12
2015-2016 366943.23 2.26352E+12
Regression Statistics
Multiple R 0.933729832
R Square 0.8718514
Adjusted R
Square 0.857612667
Standard
Error 1.64341E+11
Observations 11
36. CONCLUSION
Insurance generates significant impact on the economy
by mobilizing domestic savings and turning accumulated
capital into productive investments.
It enables to mitigate loss, financial stability and
promotes trade and commerce activities which results
into economic growth and development. Thus,
insurance plays a crucial role in sustainable growth of an
economy. Therefore it is essential to prevent market
failure in insurance market for development of nation.