insurance - Insurance "By buying insurance,...

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Insurance “By buying insurance, individuals commit to make a payment (insurance premium) regardless of the state of the world, in return for getting a benefit (insurance payout) if the uncertain outcome is negative (car accident).” (304-305) •health insurance- $500 billion per year •auto insurance- $150 billion per year •life insurance- $140 billion per year •casualty and property insurance- $420 billion per year diminishing marginal utility from consumption - as consumption rises, utility increases, but by less and less Year 1 Year 2 Income Stream 1 $30,000 $30,000 Income Stream 2 $50,000 $10,000 Income Stream 1 yields higher utility “the gain in utility from raising consumption from $30,000 to $50,000 in year one is much smaller than the loss in utility from lowering consumption from $30,000 to $10,000 in year two” individuals desire consumption smoothing consumption smoothing - translation of consumption from periods when consumption is high to periods when consumption is low future is uncertain- various possible states of the world A) do not get hit by a car next year and do not incur large medical expenses B) do get hit by a car next year and do incur large medical expenses
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Value of health insurance to individuals Example income = $30,000 1% chance get hit by car/ medical bills = $30,000 actuarially fair insurance premium= $300 actuarially fair premium - insurance premium that is set equal to insurer’s expected payout If Sam… And Sam is… Consumption #1- Doesn’t buy insurance Not hit by car (p=0.99) Hit by car (p=0.01) $30,000 $0 #2- Buys full insurance ($300) Not hit by car (p=0.99) Hit by car (p=0.01) $29,700 $29,700 expected value of consumption (#1)→ expected value of consumption (#2)→ risk aversion - the extent to which individuals are willing to bear risk #1 and #2 have same expected value, #2 has lower probability of bad outcome→ risk averse individual prefers option #2 (why individuals buy insurance) ●with actuarially fair pricing, risk averse individuals will fully insure themselves insurers’ profits? If Sam… And Sam is… Consumption #1- Doesn’t buy insurance Not hit by car (p=0.99) Hit by car (p=0.01) $30,000 $0 #3- Buys insurance ($400) (not actuarially fair) Not hit by car (p=0.99) Hit by car (p=0.01) $29,600 $29,600 expected value of consumption (#1)→ expected value of consumption (#3)→ risk averse person might still prefer option #3 to option #1 (lower expected value for #3, but avoid large utility loss from having big drop in consumption) risk premium - the amount that risk-averse individuals will pay for insurance above and beyond the actuarially fair price How much do individuals value health insurance? It depends on how risk averse they are.
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insurance - Insurance "By buying insurance,...

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