Asymmetric Information in

Insurance Market

INTRODUCTION

INTRODUCTION

Asymmetric InformationIt is defined as a market situation in which one party in a transaction has insufficient information about other party which leads to market failure

ASYMMETRIC INFORMATION GENERATE TWO TYPES OF OUTCOME :•ADVERSE SELECTION •MORAL HAZAD

ADVERSE SELECTION

When two (or more) individual are about to enter into an agreement , and one of them happens to have some information that others do not have , this state is referred to as adverse selection

ADVERSE SELECTION EXAMPLE

"THE MARKET FOR LEMON," written by George AkerlofThe purchase of a used car noted that the potential buyer of a used car cannot easily ascertain the true value of the vehicle.Lemon’s Car derive out peach cars from the market

ADVERSE SELECTION CORRECTED THROUGH

•SIGNALLING •SCREENING

ASYMMETRIC INFORMATION GENERATE TWO TYPES OF OUTCOME :•ADVERSE SELECTION •MORAL HAZARD

MORAL HAZARD

It refers to a market situation in which asymmetry occurs after an agreement is obtained between individual

PRINCIPLE AGENT PROBLEMIt refers to a market situation in which asymmetry occurs between the principle and the agent.

ADVERSE SELECTION• Adverse selection refers to a situation where sellers have information

that buyers do not, or vice versa, about some aspect of product quality. In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to get life insurance. To fight adverse selection, insurance companies try to reduce exposure to large claims by limiting coverage or raising premiums.

• To have better information to seller than a buyer about products and services being offered, keeping the buyer at a unfavorable condition in the transaction. For examples, Second-hand car market, a seller may not disclose the issue even if he knows the defect in the car. There exists asymmetric information in the market, doing business more with less profitability and market segment with more risk.

• Although substantial work has been carried out for adverse selection externality , adverse selection itself arise in the situation of insurance and the insurance market has been the locale for some of the earliest economic theorizing about it Arrow 1963, Pauly 1979, Rothschild and Stiglitz 1976. In presenting the Nobel Prize to Joseph Stiglitz, Professor Jörgen W. Weibull quotes the concept of adverse selection by noting that

[a]” prime example can be found in insurance, where companies usually offer alternative contracts, where higher deductibles may be traded off against lower premiums. In this way, their clients are, by their own choice of contract, effectively divided into distinct risk classes.”

• Why do individuals place different worth of coverage on insurance?

Much of the seminal theoretical work assumed that individuals only varied along on aspect, is their expected risk. Some who face greater risk and are willing to pay more for insurance. For example, all else equal, individuals with older and sicker groups would be willing to pay more for health and life insurance; individuals who travel long distances would be willing to pay more for auto insurance; and the group which includes retired persons’ have greater life expectancy would place their higher annuity value. Reason for the rise of adverse selection is by private information available to the individuals.

MARKET SIGNALLING• The ‘lemons’ proposition as elucidated by Akerlof (1970), claims that “bad

products drive good products” from the market place when there are asymmetric information between buyers and sellers.

• Various theories of “market signaling”, cited by Spence’s in 1973-78 predicts that sellers of products in market undertake costly activities that are designed clearly to signal buyers that they offer products of high quality. While adverse selection and market signaling is widely accepted as a result to hidden knowledge.

• Knowledge of asymmetric information about product quality originates in insurance markets where firms have difficulty in concluding the riskiness of those who need insurance coverage. Firms reply to the adverse selection externality through screening, sorting, categorizing.

LIFE INSURANCE COVERGE• Life insurance premiums rely on insured consumers’ age.

Because younger individuals are less likely to die than compare to older ones, younger people usually pay lower costs, whereas gender also plays a similar role because women tend to live longer than men, which allow them to pay a lower coverage.

• Engaging in risky activities tends to increase insurance costs. For example, a driver faces increased risk of death that prefer race car and, as a result, will pay high life insurance coverage or may denied coverage.

• A person pays more for insurance premium for a longer policy term and a larger death benefit. For example, the risk of dying for a person measure with a 30-year policy is higher than the risk of dying for a person with a 10-year policy.

CHALLENGES TO ADVERSE SELECTION• Producers in market are incapable of effectively differentiate between various types of

consumers and creating dissimilar goods and services on that basis.• Many economists argue that there is less reason to suspect this is true. In the automobile

and insurance markets, for example, differentiable products (policies and cars) are created for those with risk tolerance and risk history.

• Once the underlying asymmetric information is compensated for, the argument for adverse selection doesn't have much velocity. Empirical tests for the so-called ’lemon problem’ in car markets have earn unsubstantial results. The same is true for analysis of adverse selection in voluntary insurance markets.

• In fact, regulations which are imposed on the health and car insurance markets often subsidize rates that are paid by high-risk consumers; clearly implies that providers can discover various types of customers.

ADVERSE SELECTION

IN INSURANCE

• Because of adverse selection, companies who sell insurance observe people at higher risk of death are more willing to pay higher premiums for policies.

• If the charge by a company on consumer at average price and only high-risk consumers buy, the company holds a financial loss by paying out more benefits.

• However, the company can pay those benefits from more money by increasing premium for high risk policyholder.

• For example, a company of life insurance charges higher coverage for race car drivers. A car insurance company charges more for customers living in high crime areas. A company of health insurance charges higher coverage for customers those who smoke. In contrast, customers who do not involve in risky behaviors are likely to pay less for insurance due to increasing policy costs.

ADVERSE SELECTION SOLUTION

In case of insurance market, avoiding adverse selection involve identifying groups of people with higher risk than the general population and charging them higher money. For example, company of life insurance go through underwriting when examining whether to give an applicant a policy and what premium to charge. Underwriters generally evaluate an applicant’s height, weight, current health, medical history, family history, occupation, hobbies, driving record and lifestyle risks such as smoking; all such issues impact an applicant’s health and the potential of company for paying a claim. Though, the insurance company then regulates whether to give the applicant a policy and what premium to charge for taking on that risk.

MORAL HAZARD IN INSURANCE MARKET

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 problem 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.

Examples

fire insurance gives people an incentive to commit arson, especially if they are operating a failing business and decide that they'd rather have the cash from the insurance proceeds on the buildings than the buildings themselves.

Car insurance could make it safer for people to have accidents that cause injuries or property damage. Because, motor vehicle owners may drive more recklessly as their vehicle is insured.

In the Healthcare Insurance, there is probability that people take less care of their health once they have health insurance.

Why does moral

hazard occur?

In simple terms there is a cost involved in taking care and precautions to avoid a particular loss.

When a party has full insurance, they have no reason to incur these costs since their insurance will fully cover the loss.

Assumption 1.There is perfect competion in insurance market.

2.Insurer is risk neutral and there is no adminstartion cost.

3.The probablity (π) of loss (L) is depends on the cost of care a1, a0, where a1 > a0 .

For it to be worth spending a1 care rather than a0 care, it is necessary that; (π0 − π1)L > a1 or expressed another way; π1L + a1 < π0L .

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 B1α . • 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 B1α. • For the individual in Figure 1., 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 ).

Case under imperfect information The insurer will offer an insurance contract based on the break-even budget line B1α . The

associated premium for full cover is given by π1L.

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 unfavourable to the insurer since it makes a loss, the expected payments exceed the expected premiums : π0L > π1L .

A situation of moral hazard thus exists.

Prevention of Moral Hazard in Insurance Markets A deductible is "A provision in an insurance policy

under which the person buying insurance has to pay the initial damages up to some set limit.

A co-payment is "A provision in an insurance policy under which the policyholder picks up some percentage of the bill for damages when there is a claim.

An Example

• Suppose a professor is approached and is told that his students would be given the opportunity of buying grade insurance in class.• if a student wants to insure that he gets at least

a grade x in the class, he can purchase insurance that guaranteed him grade x as a minimum grade for a price px.• Assumptions:• The grade insurance market is perfectly

competitive.• 10% students earn A, 25% earn B, 30% earn C,

25% earn D and 10% earn an F.• The professors scruples are such that it costs a

minimum of c for him to raise a grade by one.

Adverse Selection Problem

• Assume that only A-insurance can be offered and that a student will behave the same whether or not he has insurance.

• Students who buy insurance at the beginning of the semester will thus study and work as hard in the class as they would have had they not purchased the insurance.

• Students themselves have a good idea whether they are capable of doing well or poorly in class but as an outsider an insurer will not know anything about any individual student and only know the distribution of grades that will emerge at the end.

• Now pA=0.1(4c)+0.25(3c)+0.3(2c)+0.25(c)=2c• The price of A-insurance is thus twice the cost of

paying the professor to raise a grade by 1 level. Thus if the cost is Rs 100 the premium would be equal to Rs 200 per student.

• Now suppose that all students are willing to pay as much as 2c to raise their grade by one level and 0.5c for any additional increase in the grade by another level.

• Now what would happen if all types of insurance policies were available i.e. A-insurance, B-insurance etc.

• Therefore under perfect competition conditions the insurer would have to charge a premium of 2.22c for the A-insurance.

• But at that price the B students would no longer be willing to pay for A-insurance because the price is above what they were willing to pay for a 1 letter grade upgrade.

• This means that the insurer would have to charge a premium of approximately 2.69c for the same insurance in order to break even if only C,D and F students nought insurance. But now C students will no longer want to pay for the insurance since they are willing to pay only 2.5c to raise their grades by two levels

• Thus only D and F students can be interested in the A-insurance. But if they are the only ones willing to buy insurance then the premium would have to go up to 3.29c which would ensure that only F students will be willing to pay which would then require premium amount to be 4c at which price not even F students will be interested.

• Therefore if students are given the opportunity to chooses or not choose A-insurance the company will not be able to sell any insurance in equilibrium if the student knows what kind of students they are and the insurer does not. This is an example of adverse selection problem that arises in the insurance market.

• Because of the adverse selection problem, students who line up to buy insurance therefore impose a negative externality in the market by raising the average cost of insurance

Moral Hazard Problem

• Throughout this example we have assumed that students will study as hard and diligently as they would have they not been offered any grade insurance. But would that be true?

• If, for instance, a random selection of half the class buys A-insurance, we calculated earlier that a premium of 2c would make the expected profit zero in the absence of moral hazard.

• But, if each of the students who bought insurance then changes behaviour sufficiently to end up with one letter grade below where he would have ended up otherwise, the insurer would have to charge a premium of 3c to have an expected profit of zero.

• The anticipation of moral hazard behaviour therefore implies that the insurer must charge more than he otherwise would, and it arises in insurance markets whenever individuals engage in riskier behaviour when insured.