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LECTURE+4+-+Insurance+concepts

LECTURE+4+-+Insurance+concepts - Lecture 4 Insurance...

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Lecture 4: Insurance Concepts Health Economics 01:220:316 Prof. Derek DeLia, Ph.D.
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Insurance and the allocation of risk Unpredictable events Risk transfer Protection of endowments Material wealth Health status Health insurance for health care
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Decision to purchase insurance Individual consumer w/wealth = 10,000. Loss = 1,000 with probability 0.1 0 with probability 0.9 What is the expected loss ? What is expected wealth ? How much would the consumer be willing to pay to avoid this risk?
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Risk attitudes If WTP > E(L), the consumer is risk averse . If WTP < E(L), the consumer is risk seeking . If WTP = E(L), the consumer is risk neutral .
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Consumers & sellers of insurance Consumers Risk premium : RP = WTP – E(L) How do risk attitudes relate to RP? Consumer 1 is more risk averse than consumer 2, if RP1 > RP2 for all possible risks. Insurers Insurance premium P If P=E(L) ==> actuarially fair If P>E(L) ==> actuarially unfair If P<E(L) ==> actuarially more than fair
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Mutually beneficial exchange Setting the insurance premium Pure premium = E(L) Actual premium : P = pure premium + loading charge Loading charge = costs + profits Exchange : WTP > P Who buys insurance if P is actuarially unfair? Necessary & sufficient condition for exchange RP > loading charge
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Example: Loading & risk aversion All consumers have $10,000 of wealth and face the risk of losing $1,000 with probability 0.1. Insurance is available to fully protect consumers against this loss. It costs $10 to sell
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