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Imperfect information is the cause of the moral hazard problem. If an insurance company had perfect information on risk, it could simply raise its premiums every time an insured party engages in riskier behavior. However, an insurance company cannot monitor all the risks that people take all the time and so, even with various checks and cost-sharing, moral hazard will remain a problem.

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The adverse selection problem

Adverse selection refers to the problem in which the buyers of insurance have more information about whether they are high-risk or low-risk than the insurance company does. This creates an asymmetric information problem for the insurance company because buyers who are high-risk tend to want to buy more insurance, without letting the insurance company know about their higher risk. For example, someone purchasing health insurance or life insurance probably knows more about their family’s health history than an insurer can reasonably find out even with a costly investigation; someone purchasing car insurance may know that they are a high-risk driver who has not yet had a major accident—but it is hard for the insurance company to collect information about how people actually drive.

To understand how adverse selection can strangle an insurance market, recall the situation of 100 drivers who are buying automobile insurance, where 60 drivers had very low damages 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. That would equal $186,000 in total payouts by the insurance company. Imagine that, while the insurance company knows the overall size of the losses, it cannot identify the high-risk, medium-risk, and low-risk drivers. However, the drivers themselves know their risk groups. Since there is asymmetric information between the insurance company and the drivers, the insurance company would likely set the price of insurance at $1,860 per year, to cover the average loss (not including the cost of overhead and profit). The result is that those with low risks of only $100 will likely decide not to buy insurance; after all, it makes no sense for them to pay $1,860 per year when they are likely only to experience losses of $100. Those with medium risks of a $1,000 accident will not buy insurance either. So the insurance company ends up only selling insurance for $1,860 to high-risk drivers who will average $15,000 in claims apiece. So the insurance company ends up losing a lot of money. If the insurance company tries to raise its premiums to cover the losses of those with high risks, then those with low or medium risks will be even more discouraged from buying insurance.

Rather than face such a situation of adverse selection, the insurance company may decide not to sell insurance in this market    at all. If an insurance market is to exist, then one of two things must happen. First, the insurance company might find some way of separating insurance buyers into risk groups with some degree of accuracy and charging them accordingly, which in practice often means that the insurance company tries not to sell insurance to those who may pose high risks. Or second, those with low risks must be required to buy insurance, even if they have to pay more than the actuarially fair amount for their risk group. The notion that people can be required to purchase insurance raises the issue of government laws and regulations that influence the insurance industry.

Questions & Answers

The quantity of a good demanded rises from 1000 to 1500 units when the price fallsfrom$1. 50 to$1. 00 per unit. Find the price elasticity of demand?
Rishiraj Reply
what is meant by Regional policy
Itz Reply
what is demand
Tangwe Reply
nice question..
Suman
what is aggregate demand and the equation for Y(GDP)
Davido Reply
what is cost concept
Fatai Reply
is a type of mechanism which makes consumers and individuals understand the price of goods and services
Davido
who is the father of Economics
John Reply
i dont know
Suman
Adam Smith
deep
hi
Zafraan
Adam
Zafraan
smith
Zafraan
Adam Smith
Bevingtone
What is opportunity cost
Bevingtone
is the value of the next best thing you give up when making a decision.
Bongiwe
opportunity cost is a made in order to enjoy something else
Laila
what is cost concept
Fatai
Adam Smith
Md
Adam Smith
Akligo
Adam Smith
Samura
What is demand and supply
Ehwehwe
demand refers to goods and services which consumers are willing and able to buy at a particular period of time and supply refers to the goods and services which consumers are willing and able to offer for sale at a particular period of time
Davido
demand is the quantity of goods and services which a particular customer is willing and able to purchase at that point in time.while supply is a quantity of goods and services which the company is willing and able to render to the customer who purchased it at that point
Israel
Adam Smith
Israel
cost concept. it is used for analyzing the cost of a project in short and long run
Israel
opportunity cost can be seen as a forgone alternative. it can be seen as the loss of other alternatives when one alternative is chosen
Israel
cost is value of imput and output at particular period of time. but we can classify in short run and long run.
Nago
Cost is the aggregated sum accrue in procuring something worthwhile.
KATUNKUS
Adam Smith
Som
Adam Smith
Tandan
Adam smith
Hafiz
what is the formula for elasticity
Umar Reply
perc of qty chg/perc of price chg
Suman
ok
Umar
I need some help regarding economic numericals.
Hassan
Send your problems
Tandan
utility
Oppong
demand or supply equation dy hn OK iska schedule bnana above equation ko dekhty hue kasy bnaye gy
Saba
what is cobweb?
Solomon Reply
A spider's web, especially when old and dusty (The wooden carvings were almost obliterated by cobwebs)
huzaif
what is Economic
Mbarohey Reply
Economic is a social science that study human behavior in relationship with end and scarce means which have alternative uses
Agyenkwa
Economics is an inquiry into nature that causes wealth of nations.
Eric
what are the importance of economic
Mbarohey
it helps us use our limited resources to satisfy our unlimited wants
Daniel
economic is the science of wealth
Joseph
it's helps us to be current on what's going on in the world
Joseph
economics can be defined as the science of wealth
Joseph
what are the advantages of sole proprietorship
Mbarohey
is the study of mankind in the ordinary business
Awini
Economic is science which study human behavior in relation to relatively scarce resources and how they are managed
Akligo
What is the formula for calculating elasticity?
Haruna Reply
(%change in quantity) / (%change in price)
Rahul
thx
lil
.
Tandan
.
Tandan
government spending increase will cause economic grew
Jia Reply
no
Helicia
no because government expenditure is very high the growth of the economy will decrease
Davido
what is trade by batter
Iko Reply
trade involves the transfer of good or services from one person to another, often in exchange for money.
musadique
Now trade by batter :it may define as form of trading in which good are exchange directly for other goods without the use of money as medium of exchange
musadique
is it good to trade with something with a value but given something which has no value
sandra
trade in batter means the exchange of goods and services without using money
Maa
It may be defined as an exchange of goods to satisfy the needs of two parties
Haruna
is the exchange of goods and services for the consumption of human wants
Davido
mention six factors that explain efficiency and productivity of labour
fanelchainz Reply
mention six factors that explain efficiency and productivity of labour
bohvy
factors that explain efficiency of labor are 1.population, 2.technology, 3.education, 4.working environment, 5.incentives (tax holidays) and 6.religious or cultural beliefs.
Solomon
What is demand
SoFIA Reply
is the abulity and willingness of a consumer to purchase goods and services at a particular peeiod of time in a given price
Fadhil
Is goods or service that a consumer is willing and able to purchase at a particular time over a giving period of time
Konja
is the ability and the willingness to buy a goods at a particular period of time in a given price
Prince
please go ahead it's been long time you all are explaining basic topics so now there are many topics left you have to discuss them .
Zahid
what is a central bank
Fadhil Reply
transactionsss with all banks of any country
Economics

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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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