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MTHEL 131 (32)
Chapter 1

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Mathematics Electives
David Kohler

Chapter 1: Economic Security and the Economics of Life and Health Insurance Private insurance can be defined from 2 perspectives: economic and legal - Economic:  Insurance is a financial intermediation function by which individuals exposed to a specified contingency contribute to a pool from which events suffered by participating individuals are paid. Individuals purchase the right to collect from the pool. Insurance is a contingent claim contract on the pool’s assets - Legal:  Insurance is an agreement (policy or contract) by which policyowner pays premium to the insurer. In return, insurer agrees to pay defined amount of money if a covered event occurs during policy term. - The person whose life, health or property is insured is known as the insured - Usually, the insured is also the policy owner - The person who receives the payment when the insured dies is the beneficiary. - Social insurance is different from private insurance due to its emphasis on social equity through income redistribution  government sponsored, funded by taxes - Private insurance focuses on individual equity (premiums reflected expected value of loss) The life branch of private insurance pays benefits in instances of: death – life insurance living a certain length of time – endowment, annuity, pension incapacity – disability, long-term care injury or disease – health insurance, accidental insurance, medical expense insurance Types of insurance - whole life insurance: provides coverage for the whole of the insured’s life - term insurance: pays benefits only if insured dies during the policy term - endowment insurance: pays benefits if the insured dies during policy term, and if the insured survives the policy term - annuity: contract that promises to pay the insured (annuitant) a monthly payment starting at specified age. If payments cease upon death, it’s called a life annuity - health insurance: payment is contingent on the insured incurring expenses or losing income due to health - disability income insurance: payment provoked by mental/physical incapacity preventing the insured from working - long-term care insurance: if incapacity prohibits insured’s activities of daily living - medical expense insurance: covers health care expenses Life and health insurance is divided into 4 categories: group, ordinary, industrial, credit: - Group: typically purchase by employers for benefit of their employees. - Industrial: policies issued in small amounts, less than $2000, with premiums payable on weekly or monthly basis - Ordinary: benefit amounts are larger than industrial, with premiums paid monthly or less frequently - Credit insurance: issued through lending institutions to cover debtors’ obligations if they die or become disabled Conditions for perfectly competitive insurance market: 1. large number of buyers and sellers so that no one of them can influence the market 2. sellers have freedom of entry into and exit from the market (ex. New firms can start if they see that existing firms are making excess profit) 3. sellers produce identical products (buyers have no incentive to pay more than the market price) 4. buyers and sellers are well informed about products Imperfections in Insurance Markets 1. Market power: the ability of one or a few sellers/buyers to influence price of a product of service. Relates exclusively to sellers, in 4 ways: - barriers to entry or exit - economies of scale/scope - price discrimination - product differentiation Barriers to entry/exit: - governments can require a license to sell insurance, to protect consumer - governments can flat out deny entry, creating opportunity for existing sellers to enjoy market power (high prices, excess profits) - when firms try to create legitimate barriers, products and services undergo continuous improvement Economies of scale or scope: - economies of scale—the larger the firmthe more efficiently it can operate. Becomes an entry barrier because entering firms are at a disadvantage - minimum efficient scale(MES)—when increasing firm size no longer yields efficiencies. Long-run average costs are at a minimum - constant returns to scale: growth neither adds, detracts from efficiency - decreasing returns to scale: growth detracts from efficiency - small firms find increasing returns - large firms find constant or decreasing returns - economies of scope—single firm can produce multiple products/services at a lower cost than multiple firms Price discrimination: - when firm offers identical products at different prices to different groups of customers Product differentiation: - when buyers prefer one firm’s product over that of its rivals - perceived differences in quality come from firms trying to differentiate their product from others 2. Externalities: when firm’s production or an individual’s consumption has direct and uncompensated effects on others - positive externality-- if others benefit. (ex. Factory creating jobs, reducing criminal activity). Too little of good/service is produced, price too high, too little effort devoted to enhancing externality - negative externality-- if costs are imposed on others. (ex. Factory not taking into account that pollution harms community. Prices are lower than they should be because factory is not compensating community). Too much of good/service will be produced, price too low, too little effort devoted to correcting the externality - fraud associated with health insurance is most significant negative externality in insurance. 5-15% of claims involve fraud. This causes higher premiums for everyone. - Lack of patents is most significant positive externality. Leads to lack of development 3. Free rider problems: when public goods (collectively consumed goods/services) are available to others at low or zero cost, people might take advantage - when insurance trade association lobbies for legislation, all insurers will benefit form its ac
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