Question

Consider this :

For example, if the bicycle owners don’t bother to lock their bikes or use only a flimsy lock, the bicycle is much more likely to be stolen than if they use a secure lock. Similar examples arise in other sorts of insurance. In the case of health insurance, for example, the consumers are less likely to need the insurance if they take actions associated with a healthy lifestyle. We will refer to actions that affect the probability that some event occurs as taking care. When it sets its rates the insurance company has to take into account the incentives that the consumers have to take an appropriate amount of care. If no insurance is available consumers have an incentive to take the maximum possible amount of care. If it is impossible to buy bicycle-theft insurance, then all bicyclists would use large expensive locks. In this case the individual bears the full cost of his actions and accordingly he wants to “invest” in taking care until the marginal benefit from more care just equals the marginal cost of doing so. But if a consumer can purchase bicycle insurance, then the cost inflicted on the individual of having his bicycle stolen is much less. After all, if the bicycle is stolen then the person simply has to report it to the insurance company and he will get insurance money to replace it. In the extreme case, where the insurance company completely reimburses the individual for the theft of his bicycle, the individual has no incentive to take care at all. This lack of incentive to take care is called moral hazard. Note the tradeoff involved: too little insurance means that people bear a lot of risk, too much insurance means that people will take inadequate care. If the amount of care is observable, then there is no problem. The insurance company can base its rates on the amount of care taken. In real life it is common for insurance companies to give different rates to businesses that have a fire sprinkler system in their building, or to charge smokers different rates than nonsmokers for health insurance. In these cases the insurance firm attempts to discriminate among users depending on the choices they have made that influence the probability of damage. But insurance companies can’t observe all the relevant actions of those they insure. Therefore we will have the tradeoff described above: full insurance means too little care will be undertaken because the individuals don’t face the full costs of their actions. What does this imply about the types of insurance contracts that will be offered? In general, the insurance companies will not want to offer the consumers “complete” insurance. They will always want the consumer to face some part of the risk.This is why most insurance policies include a “deductible,” an amount that the insured party has to pay in any claim. By making the consumers pay part of a claim, the insurance companies can make sure that the consumer always has an incentive to take some amount of care. Even though the insurance company would be willing to insure a consumer completely if they could verify the amount of care taken, the fact that the consumer can choose the amount of care he takes implies that the insurance company will not allow the consumer to purchase as much insurance as he wants if the company cannot observe the level of care.

Consider the bicycle example. Suppose that the insurance company must not differentiate by the districts where theft happens. What will be the equilibrium? Why?

Answer 1

If the insurance company is unable to differentiate or is not differentiating the districts by theft , then an expected insurance based on all the districts would be found. Ie if district A has the theft probability of 0.2 and district B of 0.8 , but the insurance company is considering the same price or cost paid by both of them as same , the propkeof district A eoulf find the insurance to be of higher price and the people of district B would find it at a lower price. So district A people will refrain themselves from takinh the insurance while the district B people would buy insurance. So ultimately yhte District A people will leave the market and only district B would be left which would not be good for insurance companies since they would end up paying premium more often. .

This problem can be solved if the company does a screening or identifies the districts of crime. By doing this they can easily charge a higher rate from the more crome based areas and less from the safer areas. The more theft area individual would be ready to pay more since they would know the frequency of crimes in their areas and the safer area people wont have to pay more premium.

Also in order to avoid people from not taking care of their bicycles, insurance company can charge a fixed fee loss when paying the insurance from the individual .This paying from pocket would instill the care part in them and they would take more precaution no matter whehr they live and so the ibsursins company would be in a better position.