Economics
Scope
Economics tests microeconomic foundations relevant to insurance-expected utility, risk aversion, information asymmetry-and the macro/policy environment in which insurers operate. Korean questions often require you to distinguish a certainty equivalent from an expected value or to identify the market failure created by hidden information.
Core rules
- Expected utility: EU = Σ p_i u(w_i). A concave u implies risk aversion.
- Certainty equivalent CE satisfies u(CE)=EU. Risk premium = E[W] - CE.
- Adverse selection arises when the insurer cannot observe risk type; high-risk buyers disproportionately select generous coverage.
- Moral hazard arises after contracting when coverage changes behavior.
- Demand for insurance generally rises with risk aversion and falls with loading; full coverage at fair odds is optimal for a risk-averse expected-utility maximizer.
- Elasticity, externalities, and public goods explain why some insurance markets are regulated or subsidized.
Worked example
Wealth is 100. A loss of 40 occurs with probability 0.1. Utility is u(w)=√w. Find EU, CE, and the risk premium.
EU = 0.9√100 + 0.1√60 = 0.9×10 + 0.1×7.746 = 9 + 0.7746 = 9.7746. CE = 9.7746² = 95.54. Expected wealth = 0.9×100 + 0.1×60 = 96. Risk premium = 96 - 95.54 = 0.46. The person would pay up to about 0.46 above the actuarial loss to avoid the gamble. Reasoning: concavity makes the utility of the expected wealth exceed expected utility, creating a positive risk premium.
Traps
Do not call the expected loss the risk premium. Adverse selection is pre-contract hidden type; moral hazard is post-contract hidden action. A risk-neutral person has a linear utility and zero risk premium. Check whether the question uses wealth or profit as the argument of the utility function.