640 Class 8 - Class 8 Insurance and Risk Management George...

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Class 8 Insurance and Risk Management George D. Krempley Bus. Fin. 640 Winter Quarter 2008
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Definition: Adverse Selection The tendency of persons with a higher- than-average chance of loss to seek insurance at standard (average) rates, which if not controlled by underwriting, results in higher-than-expected loss levels.
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Adverse Selection and Classification Adverse selection occurs when the insurer cannot classify, but the policyholders know their risk At a given price, high risk people will buy more coverage low risk will buy less coverage
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Heterogeneous Buyers: Two groups of buyers One Group (MAPs: middle aged professionals) Possible Loss Probability $0 0.95 $10,000 0.05 Another Group (YUMs: young unemployed males) Possible Loss Probability
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Implications of Heterogeneous Buyers Our initial assumptions are that: Equal number of each type Losses are Independent Full Insurance is mandatory Costless to distinguish MAPs from YUMs
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Implications of Heterogeneous Buyers Initial Scenario: Equal Treatment Insurance Company is only insurer Premium for everyone = $750 Does Equal Treatment cover its costs? __Yes__, the YUMs pay less than
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Implications of Heterogeneous Buyers New Scenario: allow competition Competition from Selective Insurance Company If Selective assumes Equal Treatment will continue to charge $750, how does Selective set price to maximize profits, Premium to MAPs =$600 Premium to YUMs = $1100 Profit per policyholder = $100
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Implications of Heterogeneous Buyers What happens to Equal Treatment? It would experience adverse selection I.e., it would obtain an adverse selection of policyholders -- only the YUMs will purchase from Equal Treatment Thus, Equal Treatment will have to classify or lose money
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Implications of Heterogeneous Buyers Key Points: Profit Maximization + ==> Risk Classification Competition Lack of Classification + ==> Adverse Selection Competition
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Deductibles and Adverse Selection Insurer offers multiple policies with different deductibles and different prices per dollar of coverage Lower deductible (higher coverage) policies have a higher price per dollar of coverage Higher risk people might choose the lower deductible (higher priced) policies Lower risk people might choose the higher deductible (lower priced) policies
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Deductibles and Adverse Selection Result: applicants separate themselves into different policy groups Thereby, permitting the insurance company to classify and underwrite risks in a low-cost way
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Similar Purpose of Policy Limits People have limited amount of wealth they want to protect Reduce classification costs when consumers have information that is costly for insurers to obtain Example: Homeowners’ policy might limit coverage for jewelry losses to $1,500 Those with more expensive jewelry buy special coverage Insurer does not have to investigate the value of each policyholder’s jewelry
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640 Class 8 - Class 8 Insurance and Risk Management George...

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