Published online by Cambridge University Press: 05 February 2013
So far, we have offered a view of what the supply and demand for insurance look like in three markets in which consumers and insurers behave much as classical economics predicts. The conditions we set for the benchmark models of demand and supply assumed that consumers have good information on the likelihood of a loss and its consequences, so they can determine how much insurance to purchase so as to maximize their expected utility. From an insurer perspective, all risks were assumed to be independent so that, according to the law of large numbers, providers of coverage could price on the basis of expected losses without fear of being driven into bankruptcy by massive total claims.
Although these assumptions present a picture of how an insurance market should work and sometimes is approximated in reality, as exemplified by the three markets highlighted in Chapter 4, the untidy truth is that they are often violated in other markets. In this chapter, we delve into some of the complications that arise when information is imperfect, consumers do not maximize expected utility (EU), and losses are not independent. These modifications to the benchmark models of demand and supply lead us to address the question as to whether the formal approaches that incorporate these features can explain the actual functioning of insurance markets, or whether anomalies still exist that require other models of choice.