THE MARKETS FOR INSURANCE

One way to deal with risk is to buy insurance. The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk There are many types of insurance. Car insurance covers the risk of your being in an auto accident, fire insurance covers the risk that your house will burn down, health insurance covers the risk that you might need expensive medical treatment, and life insurance covers the risk that you will die and leave your family without your income. There is also insurance against the risk of living too long For a fee paid today, an insurance company will pay you an annuity–a regular income every year until you die. In a sense, every insurance contract is a gamble. It is possible that you will not be in an auto accident that your house will not burn down, and that you will not need expensive medical treatment. In most years you will pay the insurance company the premium and get nothing in return except peace of mind. Indeed the insurance company is counting on the fact that most people will not make claims on their policies otherwise, it couldn’t payout the large claims to those few who are unlucky and still stay in business From the standpoint of the economy as a whole, the role of insurance is not to eliminate the risks inherent in life but to spread them around more efficiently. Consider fire insurance, for instance. Owning fire insurance does not reduce the risk of losing your home in a fire. But if that unlucky event occurs, the insurance company compensates you. The risk, rather than being borne by you alone, is shared among the thousands of insurance-company shareholders. Because people are risk averse, it is easier for 10,000 people to bear 1110,000 of the risk than for one person to bear the entire risk himself. The markets for insurance suffer from two types of problems that impede their ability to spread risk. One problem is adverse selection: A high-risk person is more likely to apply for insurance than a low risk person because a high-risk person would benefit more from insurance protection. A second problem is moral hazard: After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses. Insurance companies are aware of these problems, but they cannot fully guard against them. An insurance company cannot perfectly distinguish between high-risk and low-risk customers, and it all of its customers’ risky behavior. The price of insurance reflects the actual risks that the insurance company will face after the insurance is bought. The high price of insurance is why some people, especially those who know themselves to be low risk, decide against buying it and, instead, endure some of life’s uncertainty on their own.

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