Question

Discuss the following and provide some examples/applications for each :

1. The term insurance can be defined in both financial and legal terms. How do these definitions differ?

2. Describe the difference between direct and indirect losses.

3. What is adverse selection? How do insurers try to prevent adverse selection?

4. Explain the statement that adverse selection causes subsidization.

Answer 1

The term insurance can be defined in both financial and legal terms. How do these definitions differ?

The financial definition focuses on an arrangement that redistributes the cost of unexpected losses. That is, the collection of a small premium payment from all exposed and distributed to the smaller number of insureds suffering loss. The legal definition focuses on a contractual arrangement whereby one party agrees to compensate another party for specific losses. The financial definition provides for the funding of the losses whereas the legal definition provides for the parameters to the agreement – the legally enforceable contract that spells out the legal rights, duties and obligations of all the parties to the contract.

Describe the difference between direct and indirect losses

Direct losses are the immediate first result of an insured peril. Specifically, this is the actual physical loss or destruction of property. Indirect losses are a result of a direct loss. If there are losses arising out of the loss of use of an object, it is an indirect loss. An example would be the destruction of an assembly robot in a car factory. The immediate loss or destruction of the robot would be the direct loss. The resulting production line shutdown, idled workers, loss of sales, or increased cost of continuing operations at the same level of production is the indirect loss .

What is adverse selection? How do insurers try to prevent adverse selection?

Adverse selection refers generally to a situation in which sellers have information that buyers do not have, or vice versa, about some aspect of product quality—in other words, it is a case where asymmetric information is exploited. Asymmetric information, also called information failure, happens when one party to a transaction has greater material knowledge than the other party.

In the case of insurance, adverse selection is the tendency of those in dangerous jobs or high-risk lifestyles to purchase products like life insurance. In these cases, it is the buyer who actually has more knowledge (e.g., about their health). To fight adverse selection, insurance companies reduce exposure to large claims by limiting coverage or raising premiums.

insurers try to prevent adverse selection because If the company charges an average price but only high-risk consumers buy, the company takes a financial loss by paying out more benefits or claims. Adverse selection can lead to financial risks for insurance companies and higher health insurance premiums for consumers.

Explain the statement that adverse selection causes subsidization.

When insurance consumers commit adverse selection, losses will be higher than expected for the group. In essence, they will be sharing losses with others whose exposure to loss is less than theirs. Those “others” will then be subsidizing the losses of the adverse selectors