CHAPTER 7

DEMAND FOR INSURANCE

Why buy insurance?
 Demand for insurance driven by the fear of the
unknown
 Hedge against risk -- the possibility of bad outcomes

 Purchasing insurance means forfeiting income in

good times to get money in bad times
 If bad times avoided, then money lost
 Ex: The individual who buys health insurance but
never visits the hospital might have been better off
spending that income elsewhere.

Bhattacharya, Hyde and Tu – Health Economics

Risk aversion
 Hence, risk aversion drives demand for
insurance

 We can model risk aversion through utility from

income U(I)
 Utility increases with income: U(I) > 0
 Marginal utility for income is declining: U(I) < 0

Bhattacharya, Hyde and Tu – Health Economics

Income and utility
 Graphically,
 Utility increasing with income U’(I) > 0
 Marginal utility of income decreasing U’’(I) < 0

Bhattacharya, Hyde and Tu – Health Economics

Adding uncertainty to the model
 An individual does not know whether she will
become sick, but she knows the probability of
sickness is p between 0 and 1
 Probability of sickness is p
 Probability of staying healthy is 1 - p

 If she gets sick, medical bills and missed work will

reduce her income
 IS = income if she does get sick
 IH > IS = income if she remains healthy

Bhattacharya, Hyde and Tu – Health Economics

Expected value
 The expected value (mean) of a random variable X,
E[X], is the sum of all the possible outcomes of X
weighted by each outcome’s probability
 If the outcomes are X=x1, x2, . . . , xn, and the probabilities
for each outcome are p1, p2, . . . , pn respectively, then:
E[X] = p1 x1 + p2 x2 + · · · + pn xn

 In our individual’s case, the formula for expected

value of income E[I]:
E[I]p = p IS + (1- p) IH

Bhattacharya, Hyde and Tu – Health Economics

Example: expected value
 Suppose we offer a starving graduate student a
choice between two possible options, a lottery and a
certain payout:
A: a lottery that awards $500 with probability 0.5 and $0
with probability 0.5.
B: a check for $250 with probability 1.

 The expected value of both the lottery and the

certain payout is $250:
E[I]p = p IS + (1- p) IH
E[I A] = .5(500) + .5(0) = $250
E[I B] = 1(250) = $250

Bhattacharya, Hyde and Tu – Health Economics

People prefer certain outcomes
 Studies find that most people prefer certain
payouts (like B) over uncertain scenarios (like A)

 If a student says he prefers uncertain option,

what does that imply about his utility function?

 To answer this question, we need to define

expected utility for a lottery or uncertain
outcome.

Bhattacharya, Hyde and Tu – Health Economics

Expected Utility
 The expected utility from a random payout X
E[U(X)] is the sum of the utility from each of the
possible outcomes, weighted by each outcome’s
probability.

 If the outcomes are X=x1, x2, . . . , xn, and the

probabilities for each outcome are p1, p2, . . . , pn
respectively, then:
 E[U(X)] = p1 U(x1) + p2 U(x2) + · · · + pn U(xn)

Bhattacharya, Hyde and Tu – Health Economics

Example
 The student’s preference for option B over option A
implies that his expected utility from B, is greater
than his expected utility from A:
E[U(B)] ≥ E[U(A)]
U($250) ≥ 0.5 U($500) + 0.5 U($0)

 In this case, even though the expected values of

both options are equal, the student prefers the
certain payout over the less certain one.
 This student is acting in a risk-averse manner over the
choices available.

Bhattacharya, Hyde and Tu – Health Economics

Expected utility without insurance
 Lottery scenario similar to case of insurance
customer
 She gains a high income IH if healthy, and low
income IS if sick where her income I is a random
variable
 Uncertainty about which outcome will happen,
though she knows the probability of becoming
sick is p
 Expected utility E[U(I)]p is:
E[U(I)]p = p U(IS) + (1- p) U(IH)

Bhattacharya, Hyde and Tu – Health Economics

E[U(I)] and probability of sickness
 Figure shows how expected utility changes as the probability of sickness changes.
 Consider a case where the person is sick with certainty (p = 1):
 E[U(I)] = U(IS) equals the utility from certain income I S (Point S)
 Consider case where person has no chance of becoming sick (p = 0):
 E[U(I)] = U(IH) equals utility from certain income I H (Point H)

Bhattacharya, Hyde and Tu – Health Economics

What if p lies between 0 and 1?
 For p between 0 and 1, expected utility falls on a
line segment between S and H

Bhattacharya, Hyde and Tu – Health Economics

Ex: p = 0.25

 For p = 0.25, person’s expected income is:

E[I] = 0.25·IS + (1 - .25)·IH
 Utility at that expected income is E[U(I)]0.25 (Point A)

Bhattacharya, Hyde and Tu – Health Economics

Expected utility and expected income

 Crucial distinction between

 Expected utility E[U(I)]

 Utility from expected income U(E[I])

 This distinction in the case when p=0.5:

The individual's expected income from the sickness

lottery:
E[I]0.5 = 0.5·IS + (1 - 0.5)·IH
And expected utility from the sickness lottery:
E[U(I)]0.5= 0.5·U(IS) + (1 - 0.5)·U(IH)

Bhattacharya, Hyde and Tu – Health Economics

 For risk-averse people, U(E[I]) > E[U(I)]

Bhattacharya, Hyde and Tu – Health Economics

Risk-averse individuals in the utility-
income model
Synonymous definitions of risk-aversion:
 Prefer certain outcomes to uncertain ones with the
same expected income.
 Prefers the utility from expected income to the
expected utility from uncertain income
 U(E[I]) > E[U(I)]

 Concave utility function

 U’(I) > 0
 U’’(I) < 0

Bhattacharya, Hyde and Tu – Health Economics

A basic health insurance contract
 The individual approaches a health insurance company
that offers a policy with the following features:
 The individual pays an upfront fee r regardless of
whether she stays healthy or becomes ill.
 Payment r is known as the insurance premium
 If ill, customer receives q -- the insurance payout
 If healthy, customer receives nothing from the insurance
company
 Either way, customer loses the upfront fee r
 Customer’s final income is:
 Sick: IS + q – r
 Healthy: IH + 0 – r

Bhattacharya, Hyde and Tu – Health Economics

Income with insurance
 Let IH’ and IS’ be income in the healthy and sick
states with the insurance contract.
 Sick: I S’ = I S + q – r
 Healthy: IH’ = IH + 0 – r

 Remember that risk-averse consumers want to

avoid uncertainty in buying insurance
 For them, optimally
E[I]p = IH’ = IS’
An insurance contract that fulfills this equation is said to
be actuarially fair, full insurance. Bhattacharya, Hyde and Tu – Health Economics
Full insurance
 Full insurance means no income uncertainty
IS’ = IH’

 Final income is state-independent

 Regardless of healthy or sick, final income is
the same

 Risk-averse individuals prefer full insurance

to partial insurance (given the same price)
Bhattacharya, Hyde and Tu – Health Economics
Full insurance payout
 State independence implies
IH’ = IS’
 So
IH + 0 – r = IS + q – r
IH = IS + q
q = IH – IS

 The payout from a full insurance contract is

difference between incomes without insurance

Bhattacharya, Hyde and Tu – Health Economics

Actuarially fair insurance
 Actuarially fair means that insurance is a fair bet
 i.e. the premium equals the expected payout
r=pq

 Insurer makes zero profit/loss from actuarially

fair insurance in expectation

Bhattacharya, Hyde and Tu – Health Economics

Actuarially fair, full insurance

The above algebra shows that with contract, the individual’s

income is E[I]p regardless of whether she turns out to be sick or
healthy. Notice that consumers with actuarially fair, full insurance
achieve their expected income with certainty!

Bhattacharya, Hyde and Tu – Health Economics

Bhattacharya, Hyde and Tu – Health Economics
Insurance and risk aversion
 As we have seen, simply by reducing uncertainty,
insurance can make this risk-averse individual
better off.
 The nature of the insurance contract is that the
individual loses income in the healthy state (IH >
IH) and gains income in the sick state (IS < IS)
relative to the state of no insurance
 In other words, the risk-averse individual willingly
sacrifices some good times in the healthy state to
ease the bad times in the sick state.

Bhattacharya, Hyde and Tu – Health Economics

Insurer profits
 Now consider the same insurance contract from
the point of view of the insurer
 Premium r

 Payout q

 Probability of sickness p

 E[] = Expected profits that the insurer makes

Bhattacharya, Hyde and Tu – Health Economics

Fair and unfair insurance
 In a perfectly competitive insurance market, profits
will equal zero

 Same definition as actuarially fair!

 An insurance contract which yields positive profits is
called actuarially unfair insurance:

 An insurer would never offer a contract with

negative profits
Bhattacharya, Hyde and Tu – Health Economics
 When insurance is fair, in a sense, it is also free.
 The customer’s expected income does not
change from buying the contract, so she
effectively pays nothing for it.
 Despite the fact that the Premium r is positive in
an actuarially fair contract, the price is actually
zero.
 Thus, the Premium associated with an insurance
contract is not its price.

Bhattacharya, Hyde and Tu – Health Economics

Full vs. partial insurance
 Partial insurance does not achieve state-
independence

 Size of the payout q determines the fullness of the

contract
 Closer q is to IH – IS , the fuller the contract

Bhattacharya, Hyde and Tu – Health Economics

 Comparing insurance contracts
 AF -- Actuarially fair & full
 AP -- Actuarially fair & partial
 A – Uninsurance

 U(AF) > U(AP) > U(A)

Bhattacharya, Hyde and Tu – Health Economics

 The income uncertainty the individual faces is
largest in the case of no insurance: She receives
either IH or IS, which may be significantly
different.
 Partial insurance lowers her uncertainty but does
not eliminate it altogether since ISP is still less
that IHP.
 Only with the highest quantity of insurance – full
insurance – does the individual reach state
independence and fully eliminate income
uncertainty. Bhattacharya, Hyde and Tu – Health Economics
The ideal insurance contract
 For anyone risk-averse, actuarially fair & full
insurance contract offers the most utility
 Hence, it is called the ideal insurance contract

 Ideal and non-ideal insurance contracts:

Bhattacharya, Hyde and Tu – Health Economics

Comparing non-ideal contracts
 AF – Full but actuarially unfair contract
 AP – Partial but actuarially fair contract

Bhattacharya, Hyde and Tu – Health Economics

Comparing non-ideal contracts
 In this case, U(AF) > U(AP)
 Even though AF is actuarially unfair, its relative
fullness (i.e. higher payout) makes it more desirable
 But notice if contract AF became more unfair, then
expected income E[I] falls
 If too unfair, AF may generate less utility than A P

 Similarly, AP may become more full by increasing its

payout
 Uncertainty falls, so point AP moves
 At some point, this consumer will be indifferent between
the two contracts
Bhattacharya, Hyde and Tu – Health Economics
Conclusion
 Demand for insurance driven by risk aversion
 Desire to reduce uncertainty
 Diminishing marginal utility from income
 U(I) is concave, so U’’(I) < 0
 U(E[I]) > E[U(I)]

 Risk aversion can explain not only demand for

insurance but can also help explain
 Large family sizes
 Portfolio diversification
 Farmers scattering their crops and land holdings

Bhattacharya, Hyde and Tu – Health Economics