The business sector is increasingly competitive: competition between the consumer and the service provider. In order to make profits, companies engage in numerous strategic planning and information sourcing. On the other hand, consumers compete with service providers in information sourcing in order to make favorable decisions. The insurance sector portrays its competitive nature through their methods of information asymmetry.
My essay is to point out the key economical issues related to asymmetry of information in the insurance sector. All of the key issues related to the insurance trade, including the assessments of compensations for damages.
Like in any most business markets, the insurance market involves asymmetry of information. Asymmetry of information entails the inequality of knowledge regarding certain business risks. Consequently, asymmetry of information can also refer to a situation where the traders in a particular side of the market are aware of information, which unknown to traders in another side of the marketplace. Thus, some traders who have complete knowledge to some market information would accrue some benefits through misrepresentation of information to work on their favor. In the insurance sector, there is a high level of information asymmetry where the insured party is more aware of their risks than the insurance company does. This leads to a situation where individuals facing the highest risk act aggressively and more actively in applying for insurance. Such a situation refers to the concept of adverse selection.
Adverse selection also referred to as adverse self-selection is a common habit for most insured parties. It refers to a situation whereby traders in the market prefer to engage in business with randomly selected individuals from the population rather than persons who volunteer trading. In the insurance business, insurers would be better off doing business with randomly selected individuals rather than the willing volunteers. This is because they feel that people who have volunteered might have the highest risks thus requiring the insurers to incur higher expenditures. As a result, adverse self-selection creates an imbalance in risk information. Problem arises where the insured party enters an insurance policy with the insurer, while there is adverse self-selection.
This creates an advantage for the insured party because of information asymmetry (Cowley & Phillipson, 120). Adverse selection leads to the situation referred to as the Lemon’s problem, which occurs in the business that involves sale of used vehicles. In this case, it is evident that there is asymmetry of information since the seller of the used car knows some information, which is unknown to the buyer. Hence, there is adverse selection in the lemon’s problem, which would arise due to some misrepresentation of information by the seller of the used car, thereby resulting to higher cost of the vehicle, which would be hurting the buyer. The lemons problem portrays how the insurer would have to take up higher risks from an insured person who does not provide complete information of his or her risks.
Apparently, adverse selection is not the only problem related to information asymmetry. There is also the problem of moral hazard. With respect to adverse selection, there is a moral hazard situation because the interests of the agent do not focus towards the principal interest. Moral hazard occurs where the agent engages in information asymmetry, which gives them an obvious advantage over the insurance provider. For instance, agents may apply for life insurance and then they start engaging in risky behaviors (Cowley & Phillipson, 78).
In economics, all the problems at hand need analysis and assessment in a bid to maximize profits. This has made various business measures formulated in place by insurers. This includes the key decisions made with respect to the firm’s activities conducted both within the internal production and within the external market outsourcing.
In a competitive market economy such as the insurance market, the nature of the firm is different. Insurance firms are meticulous in order to minimize the costs of production. The efficiency of market approach by insurance firms develops a profit potential. The nature of organization for many insurance firms includes proper and efficient structural designs (Morgan, Katz & Rozen, 269).
Internal production of service processing has a different approach in insurance firms. For instance, since insurance covers deal with legal requirements, the role of legal agents is very essential. Therefore, insurance companies can choose whether to outsource all of its legal work to a law firm or hire permanent lawyers for the firm. Further, the insurance business involves a wide range of risks. It is hard dealing with the huge numbers of risks, thus, some insurance companies engage in risks specialization. For instance, some insurance companies only deal with health insurance. These companies have deep market knowledge of their specific insurance specialization. Therefore, this reduces the chances of information asymmetry because they have the proper measures to employ in seeking information (Cohen & Siegelman, 89).
The profit margin rate of most insurance companies is a core aspect that helps in making key investment decisions. Analyzing profitability helps insurance companies analyze how much money they keep from their agents because of pooling of risks (Morgan, Katz & Rozen, 270). However, there are instances where the availability of insurance market increases due to an impending risk. For instance, for areas where floods are frequent, residents tend to seek insurance covers against floods for their property. This scenario creates an increased profit making ground. However, the risk involved is huge and it can lead to massive losses on the insurance companies. Therefore, insurance economists engage in cost reduction strategies, which help reduce costs. For instance, insurance companies would consider reducing the premium pay for clients who take preventive measures against floods (Cohen & Siegelman, 167). This reduces the occurrence potential of the risk.
Insurance economics and theories appear complex while applied in certain situations. There are few chances of risk occurrence or uncertainty while offering insurance covers, from the insurer’s perspective. Unless in risks like death, which are certain. Insurance economics and principles apply certain strategies with an aim of maximizing profits. For instance, in life insurance, the chances of death occurrence need reduction in order to increase the term for premium payment for the client. Similarly, in adverse selection situations where most people seek insurance covers for risks that are almost certain, insurance companies will most likely evade these types of markets. For instance, in areas prone to frequent floods, insurance companies will avoid giving insurance covers (Cohen, 67).
In addition, when the risk is high and the demand for insurance covers is low, the government can come in. For instance, public vehicle insurance is mandatory in many countries as a legal requirement. This favors insurance companies in receiving covers. Most insurance companies have too many policies, which determine risk compensation. These policies make it hard or even impossible for the insurer to compensate the client more than the premiums received. This reduces the chances for making loses. For instance, in fire and accident insurances these policies come into play. However, in order to succeed in pooling of risks, certain measures are required. For example, insurance companies will offer risks compensations for accidents under tough restrictions where issues like driving under the influence will face penalty. This enables insurance companies minimize the costs and maximize the revenues (Cohen, 90).
There are high levels of perfect competition in the insurance business. There is frequent entry and exit of companies. This creates tough competition among insurance companies where no company makes excessive profits. Consequently, since there is a low government participation in the insurance business since all parties knowledgeable of the terms of contract. In the current insurance market, there are high levels of information for both the clients and the insurance cover providers. Therefore, there is a less chance for adverse selection since high risks distinguish themselves from low risks. On the other hand, the levels of moral hazard among clients reduce as the insured engages in moral hazard penalties. For instance, where the client engages in moral hazard, the insurer will most definitely increase the amount of premiums (Cohen & Siegelman, 156).
One of the challenges that limit the chances of adverse selection is the chances of misinterpretation of risks. The misinterpretation of risks can lead to a client choosing to get an insurance cover or not get an insurance cover. However, in scenarios where the client overestimates the cost of risk of the level of prevalence of the risk, the insurer makes profit. In addition, a client may misinterpret the risk at hand. The insurer may take a different approach towards the risk that the client did not suppose. The uncertainty of the insurer’s decision over the risk may cost the client due to misinterpretation of risks (Chiappori &Salanie, 102).
Furthermore, the cost of obtaining information limits the levels of adverse selection. Adverse selection involves wide search of information. Subsequently, there are costs associated with the search of information. This reduces the chances for adverse selection where some clients shy away from applying for insurance covers because they assume the costs are high. However, individual can easily ask other insured parties about the cost of insurance of certain risks, which may pave way for adverse selection. Nevertheless, if the individual decides to engage him or herself in an insurance cover, the cost of premium that they will incur while engaging in adverse selection may be costly. In addition, if the risk fails to receive compensation for policy breech, they may end up incurring losses. Therefore, there is fear of uncertainty among many clients (Chiappori & Salanie, 114).
There is a consumer behavior where most people consider maintaining their status quo. This consumer behavior portrays most people are prone to risks when their status quo changes. For instance, most people would not get insurance covers prior to a first risk occurrence. The loss related to the prevalence of the risk will motivate them to get insures. Therefore, this consumer behavior reduces the chances of adverse selection among clients. Further, the low cases of compensations by insurance companies’ makes individuals shy away from getting insurance covers.
General compensation rules conclude that if the onset of the risk occurrence is direct but the output measure is uncertain, the parties involved will negotiate for legal measures. If the court deems the case as uncertain, the insured and the insurer can agree based on compensation reward.
Further, compensation rules indicate that if the risk outcome is observable and measurable, then through the proper legal procedures for compensation. However, the general compensation rules state that if the risk output is not perfectly observable, then the two parties involves cannot structure the best legal employment measures due to chances of asymmetric information and moral hazard (Cohen, 54).
Experts agree there are no adverse selection and moral hazard in the life, automobile, and health markets. Furthermore, clients who engage in these insurance covers are more likely to exploit the insured risk. This research has challenged the problem of asymmetry of information in the insurance market. In addition, there is a low level of factual evidence on the prevalence of asymmetric information in the market. Consequently, economists argue that the equilibrium relationship observed between risk occurrence and insurance coverage can affect the insurance market in various ways. For instance, it can affect the potential for public policy, market efficiency and the structure of information.
In some insurance cases where there is no relationship between the risk occurrence and the insurance cover, the issues of moral hazard and adverse selection are arguably ineffective. Furthermore, insurance companies may lack substantial informational evidence towards the relationship between risk occurrence and the insurance cover.
The insurance cover is widely competitive and the level of insurance information is becoming important. There is an increasing improvement in the public awareness on insurance cover. This has led to insurance companies offering even complicated insurance covers. However, there has been strong criticism over the poor compensation rates by insurance companies. In addition, some policies are contradicting and they only favor the insurer, which leaves out the client. This has reduced the public’s belief the insurance companies.
Work Cited
Morgan, W, Katz, M and Rosen, H. Microeconomics (2nd European edn), (McGraw Hill, 2009); pp 266-282.
Cawley, J and Philipson, T. “An empirical examination of information barriers to trade in insurance”, American Economic Review, 89(3), 1999: 827.
Cohen, A and Siegelman, P. ‘Testing for Adverse Selection in Insurance Markets’, Journal of Risk and Insurance, 77(1), 2010: 39-84 [NBER] Working Paper No. 15586.
Cohen, A. ‘Asymmetric Information and Learning: Evidence from the Automobile Insurance Market’ Review of Economics and Statistics, 87(4), 2005: 197-207.
Chiappori, P and Salanie, B. “Testing for asymmetric information in insurance markets”, Journal of Political Economy, 108(1), 2000: 56-78.
