Question

Jody and Douglas are risk-averse and both own residential homes worth $1,000,000. Douglas’s home is brick construction and is located in the Mohave Desert. Jody’s home is wood construction and is located in the San Bernardino national forest. If all owners of $1,000,000 residential properties must pay the same premium for fire insurance, explain which consumer, Jody or Douglas, is more likely to buy home insurance?

i.) Does your answer above imply a market failure problem for the insurance company and/or consumers of insurance?

Answer 1

Since Jody's home is made up of wood and it has more propensity to catch fire, then it is Jody who is more likely to buy the home insurance. Since the home made up of wood, can catch fire with more ease than the others, then its insurance premium would have been higher as well. It creates an opportunity for Jody to buy the home insurance and protect home made of wood.

i.

Here, information asymmetry takes place between the insurance company and Jody as customer, where the insurance company lacks information about the type of materials used in the home. It creates an adverse selection problem for the insurance company that can lead to the market failure.  Further, there will be more propensity to take risk by Jody and payment of insurance will be done by the company, making the investors or other consumers of the company to suffer. It is a moral hazard problem, also leading to the market failure. Here, investors as well as other consumers of the insurance company will also suffer.