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insurance

In economic terms, anything used to reduce the downside of risk. In its most familiar form, insurance is provided through a policy purchased from an insurance company. But a fuller definition would also include, say, a financial security (or anything else) used to hedge, as well as assistance available in the event of disaster. It could even be provided by the government, in various ways, including welfare payments to sick or poor people and legal protection from creditors in the event of bankruptcy. Conventional insurance works by pooling the risks of many people (or firms, and so on), all of whom might claim but in practice only a few actually do. The cost of providing assistance to those that claim is spread over all the potential claimants, thus making the insurance affordable to all. Despite the enormous attraction of insurance, private markets in insurance often work badly, or not at all. Economists have identified three main reasons for this. * Private firms are unwilling to provide insurance if they are uncertain about the likely cost of providing sufficient cover, especially if it is potentially unlimited. * moral hazard means that people with insurance may take greater risks because they know they are protected, so the insurer may get a bigger bill than it bargained for. * Insurers are at risk of adverse selection. The people who are most likely to claim buy insurance, and those who are least likely to claim do not buy it. In this situation, setting a price for insurance that will generate enough premiums to cover all claims is tricky, if not impossible. Insurers have found ways of reducing the impact of these problems. For example, to counter adverse selection, they set higher health-insurance rates for people who smoke. To limit moral hazard, they offer reduced premiums to people who agree to pay the first so-many dollars or pounds of any claim. An efficient system of insurance, in its broadest sense, can contribute to economic growth by encouraging entrepreneurial risk taking and by enabling people to choose which risks they take and which they protect themselves against.

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