The ABC of economics (Основы экономики): Сборник текстов на английском языке. Гвоздева А.А - 21 стр.

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claims in bad ones. For further protection they also diversify across lines, selling health insurance as well as
homeowners' insurance, for example.
To an economist insurance is like most other commodities. It obeys the laws of supply and demand, for ex-
ample. However, it is unlike many other commodities in one important respect: the cost of providing insurance
depends on the identity of the purchaser. A year of health insurance for an eighty-year-old costs more to pro-
vide than one for a fifty-year-old. It costs more to provide auto insurance to teenagers than to middle-aged peo-
ple. If a company mistakenly sells health policies to old folks at a price that is appropriate for young folks, it
will assuredly lose money, just as a restaurant will lose if it sells twenty-dollar steak dinners for ten dollars. The
restaurant would lure lots of steak eaters. So, too, would the insurance company attract large numbers of older
clients. Because of this differential cost of providing coverage, and because customers search for their lowest
price, insurance companies go to great pains to set different premiums for different groups, depending on the
risks they will impose.
Recognizing that the identity of the purchaser affects the cost of insurance, insurers must be careful to
whom they offer insurance at a particular price. High-risk individuals, with superior knowledge of the risks they
impose, will step forth to purchase, knowing that they are getting a good deal. This is a process called adverse
selection, which means that the mix of purchasers will be adverse to the insurer.
In effect, the potential purchasers have "hidden" information that relates to their particular risk. Those
whose information is unfavorable are most likely to be the purchasers. For example, if an insurer determines
that
1 percent of fifty-year-olds would die in a year, it might establish a premium of $11 per $1,000 of coverage,
$10 to cover claims and $1 to cover administrative costs. The insurer might expect to break even. However, in-
sureds who ate poorly or who engaged in high-risk professions or whose parents had died young might have an
annual risk of mortality of 3 per cent. They would be most likely to insure. Health fanatics, by contrast, might
forgo insurance because for them it is a bad deal. Through adverse selection, the insurer could end up with a
group whose expected costs were, say, $20 per $1,000 rather than the $10 per $1,000 for the population as a
whole.
The traditional approach to the adverse selection problem is to inspect each potential insured. Individuals
taking out substantial life insurance must submit to a medical exam. Fire insurance might be granted only after
a check of the alarm and sprinkler system. But no matter how careful the inspection, some information will re-
main hidden, and those choosing to insure will be selected against the insurer. So insurers routinely set rates
high to cope with adverse selection. One consequence is that high rates discourage ordinary-risk buyers from
buying insurance.
Once insured, an individual has less incentive to avoid risky behavior. With automobile collision insurance,
for example, one is more likely to venture forth on an icy night. Federal deposit insurance made S&Ls more
willing to take on risky loans. Federally subsidized flood insurance encourages citizens to build homes on flood
plains. Insurers use the term "moral hazard" to describe this phenomenon. It means, simply, that insured people
undertake actions they would otherwise avoid. In less judgmental language, people respond to incentives.
Ideally, the insurer would like to be able to monitor the insured's behavior and take appropriate action.
Flood insurance might not be sold to new residents of a flood plain. Collision insurance might not pay off if it
can be proven that the policyholder had been drinking or otherwise engaged in reckless behavior. But given the
difficulty of monitoring many actions, insurers merely take into account that once policies are issued, behavior
will change and more claims will be made.
The moral hazard problem is often encountered in areas that at first glance do not seem associated with tra-
ditional insurance. Products covered under optional warranties tend to get abused, as do autos that are leased
with service contracts. And if all students are ensured a place in college, they are, in effect, insured against bad
grades. Academic performance may suffer.
The same insurance policy will have different costs for serving individuals whose behavior or underlying
characteristics may differ. This introduces an equity dimension to insurance, since these cost differences will
influence pricing. Is it fair that urban drivers should pay much more than rural drivers to protect themselves
from auto liability? In some sense, perhaps not, but what is the alternative? If prices are not allowed to vary in
relation to risk, insurers will seek to avoid various classes of customers altogether and availability will be re-
stricted. When sellers of health insurance are not allowed to find out if potential clients are HIV positive, for
example, insurance companies often respond by refusing to insure people in occupations in which an unusually
large proportion of the population is gay. One way they do so is by refusing to cover males who are florists or
hairdressers.
Equity issues in insurance are addressed in a variety of ways in the real world. Most employers cross-
subsidize health insurance, providing the same coverage at the same price to older, higher-risk workers and