Question

Explain why risk aversion might result in a voluntary insurance contract when individuals are behind the veil of ignorance. Why might voluntary insurance not work in practice?

Answer 1

Meaning of Risk aversion:

Risk aversion is the behavior of humans in which they avoid risk or uncertainty.

Meaning of voluntary insurance contract:

Voluntary insurance contract is a financial protection plan that provides a cash benefit to a beneficiary upon the death of the insured.

Reason why Risk aversion might result in a voluntary insurance contract when individuals are behind the veil of ignorance because of the following:

People are mostly risk averse so, therefore they buy insurance to avoid risk.People have three alternative views of risk.

(a) Risk aversion

(b) Risk neutrality

(c) Risk loving

Most of the time people are belong to risk aversion while others belong to neutrality and loving. The risk averse prefer certain income over risky income and they are willing to buy insurance to avoid risk. So, in other words we can say that risk averse are the prime candidates for buy insurance.

For example: Risk averse people buy insurance and pay some amount of premium on time and insured our self against huge loss of income whether this gives them a lesser amount of guaranteed certain income.

Suppose all individuals are behind the veil of ignorance and hence, the risk prefers(above three mention) are willing to buy the insurance contract but the only thing is the right price of insurance.

Now the question arises how much amount of premium risk averse people will pay to the insurance company:

For Instance: Let the individual buys a car which yields him income of Rs. 40 thousands per month but if the car catches fire and due to the damage caused,his income from it falls to Rs.20 thousands per month and thus he faces a loss of income. For the cause of simplifying survey. suppose there is 50% chance that the car catching fire.Then expected value of income in this risky situation is:

E(X) = 0.5 X 40,000 + 0.5 X 20,000

=20,000+10,000

=30,000

Reason of voluntary insurance not work in place:

1. Less Portable: A common problem with voluntary insurance( especially with voluntary life insurance) is that policy does not change with the insured's job change.

2. Conversion fees are prohibited: Another problem is that when the insured job change conversion fees are restricted.So, this is the big reason that voluntary insurance not work in practice.

3. Less options of billing: The last but not the least disadvantage in voluntary insurance is that one do not have many options for billing, whereas a term insurance include options for monthly,quarterly and annually.

Conclusion: This is all about voluntary insurance in case of risk averse people and risk averse individual can take voluntary insurance to reduce burden of loss of income and pays premium.