Imperfect Information in Insurance
Insurance is a way firms and households use to protect themselves from facing detrimental financial effect. We live in a world of uncertainty where anything can happen unexpectedly. For instance, a person can get involved in a car accident on time when they don’t have enough money to pay for the damages. Accidents don’t announce when they come to get us prepared. Insurance comes in to play for the damages when one makes a claim. Generally, individuals or firms that have taken an insurance policy make monthly and regular payments termed as premiums. And it is these premiums that cover for the damages. In other words, it is like you are saving aside some money slowly so that you can use it when the need arises. The prices of these premiums are placed by insurance companies based on the probability of certain events happening. If, for instance, you live is and area prone to fires, you will pay more premiums for insurance against fire damages that you would in an area with fewer fires.
Insurance comes to use specific information to determine the premiums to charge for a policyholder. Such information may include age, income, area of residents, and the history of their health. It is important to get the right information because it can be used to award the claims. Also, insurance companies are companies just like any other seeking to profit from what they do. There, there are very careful about how they come up with qualifications. Health insurance providers, for instance, but understand the health history of their customers. They cannot ensure aged customers because then, they will claim their benefits before maturity. Therefore, the proper information is very important.
However, the issue of asymmetric information is a major concern in the insurance company. Imperfect information is one characteristic that defines the entire financial commodity market. Asymmetric information is where one of the two parties involved in an economic transaction has more information about the product than the other party. For instance, a policyholder knows more about their health and history than they would be willing to share with a health insurance provider. When filling out the form, many of them give false information, which cannot be proved by the insurance company at the time of the application. This makes it hard for the insurer to make an informed decision on where to accept or reject the application.
Most people take several kinds of insurance, which include:
- Health insurance. It paid by employer and individuals who take the policies and is used to cover medical expenses incurred when the policyholder is hospitalized.
- Life insurance. Employers and individuals also pay this, and the benefits are paid out to the principle’ holder family when they die. It is aimed at shielding the company against funeral expenses.
- Automobile insurance. This insurance is paid for by individuals who receive compensation when the car is damaged, stolen, or caused damages to another user’s car.
- Property and Home Owner insurance. It is paid for by homeowners and renters, especially those who dwell in damaged or burglary prone areas.
- Liability insurance. Firms and individuals pay for liability insurance, and a claim is made when an injury occurs for which you are partly responsible. I
- Malpractice insurance. This is an insurance policy taken by doctors, lawyers, and other professionals. A claim is made when a poor quality of service is provided that causes harm to another person.
As stated above, all insurance involves imperfect information, both as obvious and a deeper way. At an obvious instance, future events cannot be predicted with certainty. For instance, there is no way we can tell for certain who the car will get involved in an accident, who will become ill, who will die, or have their homes robbed in the next year. Imperfect information also exists when we try to access the risk that something will happen in someone’s life over a given period of time. And insurance company finds it very hard to estimate the probability of, say, a 20 year-only driver in Washington DC, getting involved in an accident. This because it’s a large group in which some drivers will drive more carefully than others. Hence, adverse events occur out of a combination of individuals' behavior and the decision they make that increase or reduce their risk and depending on the good or bad luck of what may occur.
Policy Holders and Insurers
Insurance is based on probability. And the best way to understand it is to know how it works. Let’s use car insurance as an example. How will an insurance company determine the premiums to be paid by different groups of people? Let’s say we have a group of 100 drivers divided into three groups. In a specific year, 60 of these drivers only show a few door dings or chipped paint, which may cost around $100. The other 30 have medium-sized accidents that may cost $1000 or less to cover the damages. Then, the remaining 10 people are involved in major accidents that claim up to $15000. Assuming that we cannot identify any of these drivers at the beginning of the year, we cannot tell who belongs in any of these groups or determine their risk levels. In this, the total car accidents these whole group of 100 drivers will be involved in is 186,000, calculated as follows:
Total damage is 60x 100, plus, 30 x 1000, plus, 10 x 15000
Which comes to 6000 plus 30000 plus 150000
Equal to 186000
If each driver pays $1860 per year in premium, the insurance company gets $186000, which is needed to cover the accidents caused by these drivers. Insurance companies are often on good terms with care providers and other services; therefore, they can easily negotiate for lower rates than what an individual would have paid. This, therefore, helps them increase the benefit of consumers when they are insured while saving some money for the insurance company as well when they pay out the premiums. In other words, insurance companies earn their income from the premiums paid in by individuals. The companies invest the funds received as a premium to earn more benefits. In the past, they did not pay out much insurance claims as they have been doing recently. The investment is usually very safe and liquid, as they need to access the funds whenever a claim is made readily.
Now you understand how the insurance world works. Money comes in from the insurance company through the premiums you pay and through different investments that may be involved in and go out trough claims and operating expenses.
How does the Government get Involved?
The government, through social insurance, takes part in the insurance business. Both the federal and state governments run several insurance programs aimed at helping their citizens lead a better life. Some of the programs are not very different from those you see in the private sector because members still have to pay premiums periodically, and groups that suffer adversity benefit. Other programs shield individuals against risk, but with no explicit fund set up. There are several examples of government-run insurance programs.
The major one is unemployment insurance. Every employer is mandated to pay a small amount of money toward unemployment funds. Conclusion this is a program that the spending fund pays benefits to workers who lose their jobs and have not found a new job. They can offer support for a certain period of time, mostly for six months.
Another form of government insurance is the pension scheme. During their working year, employees receive pension funds into their pension accounts, paid by their employers. When they retire, their employer continues to pay them a small fraction of what they have been saving in Pension Benefit Guarantee Corporation. This firm will continue paying the pension benefits to the retired employee in case the company goes bankrupt, failing to pay the funds.
Deposit insurance is another example of a government program. In this case, the law demands that banks pay a small fraction of their deposits to the Federal Insurance Corporation. This amount is used in paying depositors the value of their band deposits up to $250000.
There is also the Workman’s compensation insurance run by the government. Here, the law requires employers to pay a small percentage of their employees' salaries into funds. This is done at the state level, which benefits workers when they suffer an injury at the workplace.
Last but not least is the retirement insurance, where all workers pay a percentage of what they earn into Social Security as well as in Medicare. These corporations give income and health care to the elderly. Social Security and Medicare are not insurance parse, but then, and an individual who is contributing cannot claim the benefits, although they function like insurance. Individuals continue making regular contributions in exchange for the benefits they will receive later.
Insurance companies are also faced with operations costs apart from paying the premiums. They have to hire workers, administer accounts, and process insurance claims, all of which require money. Sometimes premiums coming in and the claims being honored are more than what they earn from investing the money and administrative costs.
Accessing Risk groups and achieving actual fairness
People who purchase insurance come under different risk situations. There are those who are more vulnerable to falling sick, while others can live a long life without facing any issues due to personal lifestyles or genetics. There are those who live in areas prone to high car theft cases, or robbery instances, while others are in safe neighborhoods. Also, some drivers are more careful than others.
Insurance companies classify people risk groups to determine how much premiums they have to pay. Those who live under riskier conditions are charged more premium than others who come from less risky areas. Hence, the insurance company can charge drivers according to the expected losses. But classifying people like this has been met with serious controversies. For instance, how should the insurance company classify someone who had a major accident last year compared to another driving for a long time in the same area but has never had an accident? This is another effect of imperfect information in the insurance industry.
The issue of Moral Hazard and Adverse Selection
When people don’t have insurance, they may live a more careful life. But once they are insured, some may start engaging in riskier behavior. This is called moral hazard. For example, if you think about the cost of visiting a doctor, you will take more precautions against catching come illness, but with health insurance that covers the cost of visiting any doctor, it can be something else. Without car insurance, you will be more careful about how you drive your car than if you have one. Moral hazard is one issue that cannot be eliminated. However, insurance companies have found ways of reducing its effects. For example, they carry out investigations before making payments. Also, an injured person may be required to pay a share of the cost. Moral hazard results from imperfect information. An insurance company would avoid this problem if they had perfect information.
Another serious issue insurance companies face due to imperfect information is adverse selection. This is where a buyer of the insurance policy has more information about their risk level that what the insurance provider knows. A case of asymmetric information effect is created for the insurance company. Buyers who are at the highest risk tend to buy more of the products that those at the lowest risks, without sharing this information with insurance companies. Adverse selection can lead to the fall of an insurance company. If more people at high risk take more insurance coverage than those at low risks, the company may find themselves paying more claims than the premiums coming in. There are different ways of dealing with this issue. In the US, for instance, health insurance is often sold through groups based on the region of employment.
The insurance industry is one of the biggest contributors to economic development and the financial market. The government intervenes by offering guidance and policies that ensure proper management. And even though asymmetric information has been a major thorn in the market, many firms are finding ways to prevent adverse risks.
Author: James Hamilton