Question

Tamara and Jay both bought life insurance. Tamara has always been a rock climber, but she did not disclose this to the insurance company before she bought insurance. Jay will only attempt rock climbing now that he has insurance. Jay did not disclose this to the insurance company before he bought insurance. Describe the result of the asymmetric information held by Tamara and Jay.

Answer 1

Asymmetric information : one party of a transaction has incomplete information of the other i.e, buyers can have more information than sellers or vice versa. It is commonly observed in the insurance market.

Tamara: purchase of insurance without disclosing that she is a rock climber is a case of adverse selection. We can think of the fact that Tamara is a rock climber as an unobserved characteristic by the insurance company. She (or her relatives) is more likely to collect on the insurance sooner than expected, but the insurance company is unaware of this. The insurance premium does not correctly account for the possibility that Tamara will die rock climbing.In this type of asymmetric information, the chances of the individual claiming the insurance increases and this would be biased in favor of buyer, which is Tamara than seller ie the insurance company since they have incomplete information.

Jay: This is also a type of asymmetric information which occurs after the transaction has taken place. Moral hazard is the result of Jay taking up rock climbing only after he has purchased life insurance. Beginning to rock climb is an unobserved behavior by the insurance company. This would also increase the chances of claiming by Jay from the insurance company. In such type of asymmetric information, the buyer becomes careless after the transaction because now there is a security net which exists, due to which the person starts taking more and more risk. Eg: after the car insurance, the owner may leave the car unlocked, which would increase the risk of theft.