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Buying and Selling Lemons

The market of lemons explains why company insurances are so cheap, and the professionals call the key effect adverse selection.

I mean, this has bugged me for some time - why is it so expensive to buy personal insurance for myself, but it only costs a few dollars a month to get excellent life coverage as part of a work package, possibly from the same insurance company that was going to charge you a hundred dollars a month?

It is a simple explanation, and it begins with information, or, to be precise, the asymmetric nature of it. Insurance companies can gather and calculate statistics for life expectancy for the general population, and they can use these numbers to formulate life policies to sell to people at fair value. However, when these insurance companies try to sell such policies, less healthy individuals are more inclined than the more healthy individuals to buy these policies. If you know you are sick, your expected returns from buying a life insurance is higher than if you know (or think) you are as fit as a horse.

Insurance companies have no way of differentiating between the more healthy and less healthy individuals, but soon realize that the people who buy the insurance are more likely to be sick. (And they pay out more than the statistics suggests) To counteract this, companies will undoubtedly increase the prices of the life insurances, which further discourages healthy individuals. No matter what price the insurance is set at, this trend continues. Even if life insurance costs $10,000, individuals who are sick and find the returns profitable will be more likely to buy the insurance than healthy individuals. The asymmetry of information, in this example the health of oneself, causes adverse selection.

In the workplace, however, everyone is given the same life insurance as part of work. Because everyone buys the same life insurance, adverse selection no longer plays a part, and the "fair price" (plus obligatory obscene profit-margins) for life insurance can be given to employees.

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