Law and Economics of Insurance

Dr. G Bharathi Kamath, Associate Professor, College of Insurance, Insurance Institute of India

Economics

Introduction
What is economics?

The Economic Way of Thinking

The Economic Problem

Economics is the study of how best to allocate

scarce resources among competing uses. Scarcity is the lack of enough resources to satisfy all desired uses of those resources.

At all levels
Micro- Households/Firm

Meso- Industry
Macro- Economy

Three core issues must be resolved:

WHAT to produce with our limited resources.

HOW to produce the goods and services we

select. FOR WHOM goods and services are produced; that is, who should get them.

Role of economics in economic activity

Insurance as an important part of economic activity

Mobilization of savings
Investment Economic growth and development Increase in productivity

Risks and uncertainty

Future is uncertain and involves several risks

Risk is actuarial probability that can be calculated

in advance whereas uncertainty is accidental and therefore cannot be calculated on the grounds of historical facts or empirical conclusions

Types of risks
Dynamic Demand and supply Changes in consumer preferences Technological changes Innovation Regulations Market speculation Competitors suppliers Pure/static Loss arising of static risk- quantifiable and measurable

 Balancing the needs of the insured and the insurer

 Law of diminishing marginal utility

Law of equi-marginal utility

Marginal utility of money and insurance Present sacrifice of money income (present loss of utility/certain loss) future loss of income due to occurrence of an event (expected loss of utility/expected loss)

Benefits of Insurance activity

Ensures efficiency and productivity in economic

structure(insured has to concentrate on speculative risks only) The need for liquid assets and contingency reserve decreases Capital resources can be mobilized to more productive use Reduction in the cost of handling risk benefits the society as a whole Channelizing the investment in the economy by the insurers Social security and welfare

Definitions
Wealth- Adam smith

Welfare- Marshall
Scarcity- Robbins Growth - Samuelson

Significance
Consumption

Production
Exchange Distribution

Assumptions for economic laws

Rationality

Ceteris paribus
Optimization Consumer Producer

Branches of Economics
Micro economics

Macro Economics

Concept of Equilibrium
Static and dynamic

Stable and unstable

Short and long run Partial and general

The Mechanism of Choice

An economy is largely defined by how it answers

the WHAT, HOW and FOR WHOM questions

The Invisible Hand of a Market Economy

The market mechanism is the use of market

prices and sales to signal desired outputs (or resource allocations). The market decides the mix of output in an economy.

The Invisible Hand of a Market Economy

Laissez faire is the doctrine of leave it alone of

nonintervention by government in the market mechanism.

Government Intervention and Command Economies

Karl Marx argued that the government not only had

to intervene but had to own all the means of production. Markets permit capitalists to enrich themselves while the proletariat toil long hours for subsistence wages

Government Intervention and Command Economies

John Maynard Keynes offered a less drastic

solution In Keynes view, government should play an active but not an all-inclusive role in managing the economy

Mixed economy
A mixed economy is one that uses both market

signals and government directives to allocate goods and resources. Most economies use a combination of market signals and government directives to select economic outcomes

Economic Systems
Planned

Market
Mixed

Concepts of Demand and Supply

Need , willingness, ability to buy and Demand

Stock and Supply

Supply and Demand

Supply is the ability and willingness to sell

(produce) specific quantities of a good at alternative prices in a given time period, ceteris paribus.

Supply and Demand

Demand is the ability and willingness to buy

specific quantities of a good at alternative prices in a given time period, ceteris paribus.

Determinants of Supply
Price

Cost of Production
Techniques of production Taxation Natural factors Price of related products Price of Factors of Production Expectations about future price

Generalized Supply Function

Variable Relation to Qs
Direct
Inverse

Sign of Slope Parameter

P PI Pr T Pe F

k = Qs/P is positive l = Qs/PI is negative

Inverse for substitutes

Direct for complements

m = Qs/Pr is negative m = Qs/Pr is positive

n = Qs/T is positive r = Qs/Pe is negative s = Qs/F is positive

Direct Inverse Direct

Law of Supply
Law of Supply

Supply Schedule and Curve

Determinants of Demand
Price

Price of related products

Taste and preference of Consumers Income levels of the consumer Expectations about the future price Demographic conditions Fashion Demonstration effect

Generalized Demand Function

Variable Relation to Qd
Inverse
Direct for normal goods Inverse for inferior goods

Sign of Slope Parameter

P M PR

b = Qd/P is negative c = Qd/M is positive c = Qd/M is negative

Inverse for complements

Direct Direct Direct

Direct for substitutes

d = Qd/PR is positive d = Qd/PR is negative

e = Qd/ is positive f = Qd/Pe is positive g = Qd/N is positive

Pe N

Types of demand
Price

Income
Cross

 Law of demand

Demand schedule and curve

 Equilibrium of demand and supply

Shifts in demand and supply curves

Elasticity of Demand
Meaning

Types of elasticity Price Income Cross

Types of Price Elasticity Perfectly elastic Perfectly inelastic Relatively elastic Relatively inelastic Unitary elastic

Price Elasticity
The response of consumers to a change in price is

measured by the price elasticity of demand.

Price Elasticity
The price elasticity of demand (E) is always

negative because quantity demanded decreases when prices increase.

The absolute value of the price elasticity of demand will always be greater than zero.

Elastic vs. Inelastic Demand

If E is larger than 1, demand is elastic. Consumer response is large relative to the change in price. If E is less than 1, demand is called inelastic. Consumers arent very responsive to price changes.

If E equals 1, demand is unitary elastic.

Extremes of Elasticity
A horizontal demand curve means that demand is

perfectly elastic.
Any price increase would cause demand to fall to zero.

A vertical demand curve means that demand is

completely inelastic.
Quantity demanded will not change regardless of the

price change.

Determinants of elasticity
Nature of the product

Variety of uses
Number of close substitutes Durability of the commodity

Proportion of income spent

Habits Level and range of price change

Period of time
Possibility of postponement Relation with other products

Elasticity of Supply
Meaning

Types Relatively elastic Relatively inelastic Perfectly elastic Perfectly inelastic

Factors affecting elasticity

Cost of factors of production

Availability of factors of production

Time period Technological advances Government regulations

Theory of Production and Analysis of Costs

Concept of firm and industry

Factors of Production Land Labour Capital Organization

Types of costs
Money and real costs

Fixed and variable costs

Opportunity costs Private and social costs Short and long run costs

Laws of Production
Law of diminishing Marginal returns

Law of returns to scale

Economies of scale

Concept of Revenue
Meaning

Total revenue
Average revenue Marginal revenue

Break even Point

TR=TC

Market Structure
Equilibrium of firm Equating MC and MR

Types of Market Structures

Perfect market-characteristics Large number of buyers and sellers Homogenous products Free entry and exit Perfect knowledge Mobility of factors of production No transportation costs No government interference

AR and MR curve in a perfectly competitive market

Demand for a Competitive Price-Taker

Demand curve is horizontal at price determined by

intersection of market demand & supply

Perfectly elastic

Marginal revenue equals price

Demand curve is also marginal revenue curve

(D =

MR)
Can sell all they want at the market price Each additional unit of sales adds to total revenue an amount equal to price, i.e. MR=AR=P

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Market Power
Ability of a firm to raise price without losing all its

sales
Any firm that faces downward sloping demand has

market power
Gives firm ability to raise price above average cost

& earn economic profit (if demand & cost conditions permit)

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Monopoly
Single firm

Produces & sells a particular good or service for

which there are no good substitutes New firms are prevented from entering market

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Measurement of Market Power

Degree of market power inversely related to

price elasticity of demand

The less elastic the firms demand, the greater its

degree of market power The fewer close substitutes for a firms product, the smaller the elasticity of demand (in absolute value) & the greater the firms market power When demand is perfectly elastic (demand is horizontal), the firm has no market power

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Determinants of Market Power

Entry of new firms into a market erodes

market power of existing firms by increasing the number of substitutes A firm can possess a high degree of market power only when strong barriers to entry exist
Conditions that make it difficult for new firms to enter a

market in which economic profits are being earned

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Common Entry Barriers

Economies of scale
When long-run average cost declines over a

wide range of output relative to demand for the product, there may not be room for another large producer to enter market
Barriers created by government
Licenses, exclusive franchises

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Common Entry Barriers

Input barriers
One firm controls a crucial input in the production

process
Brand loyalties
Strong customer allegiance to existing firms may

keep new firms from finding enough buyers to make entry worthwhile

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Common Entry Barriers

Consumer lock-in Potential entrants can be deterred if they believe high switching costs will keep them from inducing many consumers to change brands

Network externalities Occur when value of a product increases as more consumers buy & use it Make it difficult for new firms to enter markets where firms have established a large network of buyers
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Monopolistic Competition
Large number of firms sell a differentiated

product
Products are close (not perfect) substitutes

Market is monopolistic Product differentiation creates a degree of market power

Market is competitive Large number of firms, easy entry

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Oligopoly Markets
Interdependence of firms profits Distinguishing feature of oligopoly Arises when number of firms in market is small enough that every firms price & output decisions affect demand & marginal revenue conditions of every other firm in market

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Strategic Decisions
Strategic behavior Actions taken by firms to plan for & react to competition from rival firms Game theory Useful guidelines on behavior for strategic situations involving interdependence

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Market demand for insurance

Price

Government regulations
Market structure Nature of product (type of insurance)

Elasticity of demand for insurance

Market demand is relatively inelastic than

individual demand Availability of substitutes Price of the product(premium) Mandatory (inelastic demand) Income levels Product differentiation and brand loyalty Individuals demand inelastic when compared to business and industrial establishments

Income elasticity of insurance

Level of economic activity and income levels Life insurance Personal lines of insurance Property insurance

Cross elasticity of insurance

Level and intensity of competition

Brand loyalty

Supply of Insurance
Labour intensive industry

Low level of fixed costs; high level of variable costs

Break even point (TR=TC) Supply depends on the number of players Government regulations regarding pricing

Market structure of insurance

Number of competitors

Pricing
Product differentiation Barriers to entry Economies of scale/market size Capital requirements Compulsory investments FDI cap Regulatory environment

 Insurance has to be SOLD rather than being

BOUGHT

Thank You

Queries if any? Now or later kamath@iii.org.in