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.

(1)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?

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

Answer 1

1) The fact that Jody lives in a forest, makes his house prone to forest fires. Also, one should know that wood construction can easily be harmed with fire. In such case it is most likely that Jody will buy the insurance.

2) The above condition imply that the existence of more and more risk-averse people would mean a good business for the insurance company. However, the insurance company is unable to tap on the business opportunity and this has caused the insurance market to suffer. The same amount of premium would mean that someone with a mangaeable outcome would recieve an exact same amount than those who suffer from instances where they will need help.