Insurance and Imperfect Information
Insurance and Imperfect Information
Insurance is a method that households and firms use to prevent any single event from having a significant detrimental financial effect. Generally, households or firms with insurance make regular payments, called premiums. The insurance company prices these premiums based on the probability of certain events occurring among a pool of people. Members of the group who then suffer a specified bad experience receive payments from this pool of money.
Many people have several kinds of insurance: health insurance that pays when they receive medical care; car insurance that pays if they are the driver in an automobile accident; house or renter’s insurance that pays if possessions are stolen or damaged by fire; and life insurance, which pays for the family if the principal dies. This table lists a set of insurance markets.
Some Insurance Markets
| Type of Insurance | Who Pays for It? | It Pays Out When . . . |
|---|---|---|
| Health insurance | Employers and individuals | Medical expenses are incurred |
| Life insurance | Employers and individuals | Policyholder dies |
| Automobile insurance | Individuals | Car is damaged, stolen, or causes damage to others |
| Property and homeowner’s insurance | Homeowners and renters | Dwelling is damaged or burglarized |
| Liability insurance | Firms and individuals | An injury occurs for which you are partly responsible |
| Malpractice insurance | Doctors, lawyers, and other professionals | A poor quality of service is provided that causes harm to others |
All insurance involves imperfect information in both an obvious way and in a deeper way. At an obvious level, future events cannot be predicted with certainty. For example, it cannot be known with certainty who will have a car accident, become ill, die, or have his home robbed in the next year. Imperfect information also applies to estimating the risk that something will happen to any individual. It is difficult for an insurance company to estimate the risk that, say, a particular 20-year-old male driver from New York City will have an accident, because even within that group, some drivers will drive more safely than others. Thus, adverse events occur out of a combination of people’s characteristics and choices that make the risks higher or lower and then the good or bad luck of what actually happens.
This lesson is part of:
Information, Risk, and Insurance