Published online by Cambridge University Press: 05 February 2013
Now that we have described the types of demand and supply anomalies relative to the benchmark models, we analyze several real-world insurance markets to illustrate when behavior would be classified as anomalous. At the heart of that determination are two questions:
Do consumers make decisions regarding insurance purchases consistent with the expected utility model?
Do insurers set premiums in competitive markets (without price regulation) so as to maximize expected profits?
RELEVANT ASSUMPTIONS FOR EXAMINING BEHAVIOR
Answers to these two questions are simplest in situations with well-specified and well-known loss probabilities and an insurance market that has the following characteristics:
A substantial number of at-risk individuals whose losses are independent of one another;
Loss amount per event that is large relative to buyers’ wealth but small relative to insurers’ capital;
Low costs to consumers for becoming well informed about potential losses;
Freedom of consumers to decide whether to buy insurance and, if so, how much coverage to purchase;
Free entry by insurers, with freedom to set premiums.