Insurance companies and risk neutrality

The requirements for the insurance market to be efficient are that the least risk adverse agent bears all the risk. This means that the agents will be bearing all the risk giving the insurance company a more certain outcome.

The market will also have to be in equilibrium, which means that two conditions will be have to be met. The first is the break even condition; this means that no contract makes negative profits. If the insurance company is not making profit off of a contract then this is inefficient and may mean the company would have to shut down depending on the profit made from other contracts. The market will also have an absence of unexploited opportunities for profit. If this is not that case then rival companies can exploit this opportunity and offer a better contract.

To be efficient the insurance market a firm will also have to be in perfect competition so they can offer a fair insurance (Risk premium = PR of loss x loss). If they do not offer fair insurance, another company can under-cut them and steal all their customers.

Finally, the market will need to have perfect information so they can offer the correct premium to everyone. Otherwise they will have to pool equilibrium as they will not know individual risk types. This would mean low risk people will be essentially paying for part of the high risk candidates insurance as well as their own which is not Pareto efficient. Pareto efficiency is when principal cannot be made better off without making the agent worse off. This condition must be met for the market to be efficient. If it is not met then they will be at a point where both parties can be made better off.

The insurance markets pretty much meet all the requirements above and so to an extent are efficient. Although of course perfect information is not quite possible.  Insurance companies reduce the amount moral hazard and adverse selection in the market by for example, making candidates fill out forms which void contracts if  information proves to be false and offer no claims bonuses.

To discuss whether risk neutrality is a necessary and sufficient condition for insurance to take place, we need to look at what would happen in the three possible scenarios: risk neutral, risk adverse and risk loving.

We can start by looking at a risk-neutral insurance company. In reality, large organisations such as insurance companies tend to be risk neutral for mainly two reasons: the risks are small relative to the organisations size and as they offer so many risk contracts, on average they all tend to cancel each other out. A risk neutral insurance company earn their profit from the fact that the value of premiums they receive is either greater than or equal to the expected value of the loss.

Even insurance companies that take on purely risky customers will still be risk neutral as they will raise the premiums to offset the extra risk. For example, some specialist  holiday insurance companies may only take on candidates who already have pre-existing medical conditions and find it difficult to get insured elsewhere. The companies will offset the extra risk however by charging much higher premiums. Again the value of premiums they receive will be either greater than or equal to the expected value of the loss.

An insurance company cannot be risk averse because of the nature of the insurance market. If the company is risk averse, then it will charge premiums much higher than the expected value of the loss. In the presence of perfect information and perfect competition, customers will not choose to insure with this company as there will be better alternatives elsewhere. Therefore the if the insurance company was risk averse it would get no customers and soon fail.

Finally, an insurance company will not work in the long run if it is risk loving. A risk loving firm would accept lower premiums from customers than a risk neutral firm would and hope that the gamble pays off. This would mean that they would be expected to make a loss overall as their premiums would be less than their expected loss. Therefore eventually they would be making a negative profit and would have to shut down. (Unless they are very, very lucky!)

So for all of these reasons, it’s necessary for an insurance company to be risk neutral for insurance to take place. It is also a sufficient condition for insurance to take place as they will be at a minimum, breaking even and so can continue to exist in a perfectly competitive market, and they can offer a competitive premium to survive in a market with perfect information. Being risk neutral will also allow the insurance company to be efficient, as they will be making the break even condition.