Question

Information for question 13 - 16. your laptop costed you $500 five years ago (i.e. it is a 5-y old laptop) when you purchased it. it was lost and the loss is covered by your homeowners insurance. assume there is no deductible in your home insurance policy (which means you most likely pay a higher premium than a policy with a deductible, all else being equal). the laptop now costs $720 to replace and it has an estimate life of 8 years.

Answer 1

Understanding insurance market dynamics and the impact of adverse selection is essential. If everyone pays the same premium, high-risk individuals are more likely to buy insurance, leading to potential losses for the insurer. This illustrates the necessity for risk assessment in premium setting.

Step-by-step explanation:

When assessing the insurance market, we consider various risk levels among policyholders. In a simplified scenario involving 100 drivers, some have minor incidents costing $100, others have medium accidents costing $1,000, and a few experience severe accidents with $15,000 in damage. If premiums are set at $1,860 uniformly, this would aggregate to $186,000, covering all accidents. However, this model introduces the concept of adverse selection, where higher-risk individuals are more likely to purchase insurance, knowing their likelihood of filing a significant claim. If an insurer cannot distinguish between low, medium, and high-risk drivers but sets a premium based on average claims, low and medium-risk drivers may opt-out. This leaves the insurer with predominantly high-risk clients and potential financial losses.

Furthermore, as premiums rise to cover high-risk losses, even more, low and medium-risk individuals are discouraged from participating, thus escalating the insurer's predicament. This example illustrates the complications in setting premiums in the insurance sector without the ability to precisely assess individual risk.