Chapter 13, Problem 1LO

To determine

The different types of insurance products and the ways in which insurance companies can reduce asymmetric information problems

Context Introduction:

Asymmetric information means that one of the parties in a financial transaction has more information about the product/transaction than the other party. Asymmetric information in insurance markets is also termed as adverse selection. In terms of insurance, adverse selection describes the fact that customers who know that they are particularly prone to bad risks are more inclined to take out insurance than those who know that they are at good risks. It typically occurs because customers know more about their bad risks/weaknesses than the insurance company.

Suppose you are a forgetful person who usually forgets the key in the lock when leaving the house in the morning, might find theft insurance as a good value. However, the insurance company has sold claims to many such forgetful (bad risk) customers like you, thereby increasing the average claims on basic premiums and making losses.

Explanation of Solution

Asymmetric information is a problem because some people know that they are relatively prone to bad risks but would not reveal this to the insurance company and the insurance company is not able to differentiate between a bad risk and a good risk.

To try and reduce the problems of asymmetric information, insurance companies try to accumulate lots of information about potential policyholders. They try to collect information through medical examinations, surveyors, third-party dealers, etc. before fixing the premium or giving the cover.

After collecting all the information, policyholders can be put in different small, reasonably homogeneous pools and be charged appropriate premiums. They try to diversify the portfolio and use the law of large number to predict the average outcome.

Insurance products are of many types, namely:

1. Life Insurance that covers the financial loss of an individual in case of their premature death to their family. The insurer can carry out a proper medical examination and try to collect information about the occupation, habits, residence area, age, family history, etc.
2. Health Insurance covers the health of an individual in case they need treatment, medication of any kind. The insurer can carry out a proper medical examination and try to collect information about the occupation, habits, residence area, age, family history, etc.
3. Theft & fire Insurance covers the loss in an event of theft or fire, respectively. The insurance company can insure only a part of the home or charge a high premium if the property is in a theft prone or fire-prone region.
4. Mortgage Insurance pays for the mortgage in the event of default by the debtor. The insurance companies keep a regular check of the credit history of the debtors and if the credit is disbursed to good credit rated customers.