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The major additional costs to insurance companies, other than the payment of claims, are the costs of running a business: the administrative costs of hiring workers, administering accounts, and processing insurance claims. For most insurance companies, the insurance premiums coming in and the claims payments going out are much larger than the amounts earned by investing money or the administrative costs.

Thus, while factors like investment income earned on reserves, administrative costs, and groups with different risks complicate the overall picture, a fundamental law of insurance must hold true: The average person’s payments into insurance over time must cover 1) the average person’s claims, 2) the costs of running the company, and 3) leave room for the firm’s profits. This law can be boiled down to the idea that average premiums and average insurance payouts must be approximately equal.

Risk groups and actuarial fairness

Not all of those who purchase insurance face the same risks. Some people may be more likely, because of genetics or personal habits, to fall sick with certain diseases. Some people may live in an area where car theft or home robbery is more likely than others. Some drivers are safer than others. A risk group    can be defined as a group that shares roughly the same risks of an adverse event occurring.

Insurance companies often classify people into risk groups, and charge lower premiums to those with lower risks. If people are not separated into risk groups, then those with low-risk must pay for those with high risks. In the simple example of how car insurance works, given earlier, 60 drivers had very low damage of $100 each, 30 drivers had medium-sized accidents that cost $1,000 each, and 10 of the drivers had large accidents that cost $15,000. If all 100 of these drivers pay the same $1,860, then those with low damages are in effect paying for those with high damages.

If it is possible to classify drivers according to risk group, then each group can be charged according to its expected losses. For example, the insurance company might charge the 60 drivers who seem safest of all $100 apiece, which is the average value of the damages they cause. Then the intermediate group could pay $1,000 apiece and the high-cost group $15,000 each. When the level of insurance premiums that someone pays is equal to the amount that an average person in that risk group would collect in insurance payments, the level of insurance is said to be “actuarially fair.”

Classifying people into risk groups can be controversial. For example, if someone had a major automobile accident last year, should that person be classified as a high-risk driver who is likely to have similar accidents in the future, or as a low-risk driver who was just extremely unlucky? The driver is likely to claim to be low-risk, and thus someone who should be in a risk group with those who pay low insurance premiums in the future. The insurance company is likely to believe that, on average, having a major accident is a signal of being a high-risk driver, and thus try to charge this driver higher insurance premiums. The next two sections discuss the two major problems of imperfect information in insurance markets—called moral hazard and adverse selection. Both problems arise from attempts to categorize those purchasing insurance into risk groups.

Questions & Answers

what is Labour of supply.
Eshmel Reply
it is called supply of labour
Emmanuel
it is the total number of those the producer is expected to employ at a given time and at an existing wage rate
Emmanuel
if the price of yam increases what will happen to demand curve?
Lawal Reply
the demand curve will decrease
Fatmah
with table and diagrametic illustration
Usama Reply
ok
Mustafe
if the price elasticity of demand for a commodity is zero the demand curve is
Aryan Reply
the demand curve is inelastic
Emmanuel
this is because price bring about a lesser change in quantity demanded
Emmanuel
how are we going to draw scale of preference
Achor Reply
how do we identify choice
Achor
how do we identify opportunity cost
Achor
opportunity cost is the forgone alternative. in oder words, it is the sacrificed goods or service for another. thus, the item you did not buy with the resources you have thereby buying another one is called opportunity cost. thanks
John
IAC curve is geueraly
Subham Reply
what are the benefits or tourism?
Maake Reply
please I don't understand the division of labor increase
Dery Reply
Labour increasing according to demand of company or as the condition of profit and standards or weight of working level ,,,,
SHOM
Please can someone help me With the demand of labour.
Eshmel
what are the basic concept of economics
Busanga Reply
end mean and scarcity
Dery
What the term economics?
Nuran Reply
economic is the study of mankind in the ordinary business life
Dery
want to find how can a geography teacher can contribute to the economic development of a country .
Bernadette Reply
how are u
Usama
i am fine
Purnima
it can help to prevent world wars 😂😂😂😂
Vedaant
it can help to prevent world wars 😂😂😂😂
Vedaant
what is labour
Ab Reply
labour is the skill of a person who knows the tinitiol thinks
Mustafe
labour can define both physical and mental effort of a man towards production
Chinedu
what is want, cost,
Muhammad Reply
during reccessionary and unemployment in a country which kind economic policy measure do we adopt
samuel
want is a mere demand of a commodity which is not backed by purchasing power.
marcus
ok
Tetteh
ok
Mustafe
what demand
Mustafe
demand is d desire backed up by d ability to pay
Emmanuel
demand is the purchases power
Dery
in what ways is monopolist competition different from perfect competition
Juliana Reply
The principal difference between these two is that in the case of perfect competition the firms are price takers, whereas in monopolistic competition the firms are price makers. Perfect competition is not realistic, it is a hypothetical situation, on the other hand, monopolistic competition is a pra
marcus
what is economics
Lizzy Reply
is the study of how you can make your own business to develop yourself and even the other countries
Abdifatah
the study of economic enable us to practice how to manage and arranged our daily basic of life.
Jonathan
Economics is a science that studies human behaviour as a relationship between ends and scarce means. .
Dan
Am I totally agree the scare means are the wants and beings the humans need
Anastassiya
simple meaning.....Demand and Supply
Pranav
economics is science and art economics means , branch of that knowledge which teach of economic nature
RAJESH
Economics is the study of human in relation to resources and scarce means to solve problems.
marcus
jkk
marcus
Economics is a Social Science that studies human behavior in relation to resources and scarce means to solve social problems.
marcus

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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