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...they providing coverage. Furthermore insurance firms are assumed to have access to the capital markets for any needed funds should they suffer a large loss that exceeds their net worth. For these reasons firms are assumed to be risk neutral and choose actions that maximize their expected profits. Under this model firms should also be willing to supply unlimited amounts of insurance to those at risk, charging premiums that are just high enough to cover their expected claims plus their administrative costs. Actual behavior of firms may differ from this ideal world for several reasons:
* Firms may not have perfect information on the pool of individuals seeking insurance. To the extent that those demanding coverage have better information on their risks than those providing insurance, there will be asymmetric information between buyers and sellers. This can create problems of adverse selection, as will be discussed below, in which insurers are unwilling to supply unlimited amounts of coverage and are unable to tailor premiums that reflect each individual's risk level.
* Once coverage is sold to individuals, the insurers may not be in a position to monitor and control behavior. To the extent that insured individuals behave in a way that increases the chances of a loss occurring and the insurer is not aware of these actions, then the insurer faces a problem of moral hazard.
* Insurers may not have easy access to additional capital should they suffer catastrophic losses and therefore may not try to maximize expected profits. If there is asymmetry of information between outside investors who provide capital and inside managers who control its use, then Greenwald and Stiglitz (1990) show that managers who are rewarded with a share of the profits but suffer a large penalty in case the firm suffers insolvency will behave as if they are risk averse. For example, suppose an insurance underwriter is concerned with his future employment opportunities should his firm be declared insolvent. He may then limit the amount of coverage for a particular risk or charge higher premiums than otherwise if he perceives...
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