The second situation that leads to ambiguity aversion asymmetric knowledge. By asymmetric knowledge I mean that one of the parties and some transaction know something of the other parties do not.

Asymmetric Knowledge

You’ve experienced this if you’ve ever haggled about the price of some handcrafted artwork, sought a second opinion about a medical procedure or try to buy used car. When you step onto the used car lot you and the salesperson are playing a level field, the salesperson knows the history of the vehicle including relative facts like its repair history you don’t.

The salesperson knows about any tricks the dealership uses to make his car seem more attractive they really are you don’t and the salesperson knows the local market. Conditions including typical selling prices for similar vehicles you don’t, unless you’ve really done your homework. Similar asymmetries arise in any situation were knowledge relevant to some decision is possessed by one person but not others.

Purchasing insurance

We don’t like asymmetric knowledge we don’t like the ambiguity creates and we want to withdraw from the decision, walking off of the used car lot in a way for a potentially untrustworthy partner. One common example of an asymmetric knowledge situation is purchasing insurance. Think for a moment about why insurance exists at least as a consumer product.

Insurance exist for two key reasons: the first reason is that the odds are in the insurer’s favor the insurer can estimate the risk associated with a particular sort of insurance policy. This allows them to set the premium sufficiently high so the people who purchase a specific sort of insurance pay and more through their premiums on average the entrance have to pay out in claims. So why would any rational person by insurance?

The answer comes from a second reason: policyholders are more risk-averse than insurers. Each of us who owns insurance of some form is at least somewhat risk-averse
we don’t want to face the catastrophic consequences of a severe illness or complete loss of her home or car and so we are willing to pay more for insurance policy in its expected cost of the insurer.

Spreading risks

The insurer spreads out its risk over many many policyholders so it can be close to risk neutral and still make money. As a quick digression psychological factors pushing many people to purchase insurance for the wrong reasons. Ensuring a relatively inexpensive consumer-electronics product like a smartphone is rarely a good idea.

Yes, it’s easy to imagine circumstances in which we might need that insurance, but no the loss of the smart phone would rarely be financially catastrophic. Given the substantial markups in many limits on electronics insurance policies, most people would be better served passing on the policy just self-insuring and saving the money.

Buying protection against ambiguity

Conversely, flood insurance has historically been heavily subsidized by the US federal government even though flood insurance is often expensive it’s expense typically underestimates the true cost of insuring very expensive real estate against the rare natural disaster and the loss of the home would be a truly catastrophic event for which few people could self-insure.

But only a small minority of people for whom flood insurance is optional actually purchase that insurance. People often see insurance as important protection against relatively common and moderately costly losses, like when buying insurance against loss when smartphone or when setting a low deductible on one’s auto insurance.

Mitigating risk

But that attitude gets the goal of having insurance exactly wrong. We don’t buy insurance to mitigate probability, but to mitigate risk. Common events like drop smartphones and some minor fender bender’s aren’t worth ensuring dense because the odds aren’t in our favor but rare and catastrophic events like threats to our health or loss of her homes are surely worth insurance.

Even though the odds still aren’t in our favor we are better served by a known small loss than a rare and catastrophic loss. So far I still talk about insurance as a sort of risk, but there’s a really remarkable way in which insurance who’s into the domain of ambiguity
Historically, insurance markets of the United States determine how much a given person should pay based on a sense of shared risk, if you and I both apply for an insurance policy and neither of us has a particular salient pre-existing condition then each of us might be treated similarly by the insurer.

Risk-adjusted pricing

By ensuring a large enough group of people, some of whom were very healthy and others of whom required much more medical care, an insurer could spread out its risk across enough people that its costs could be statistically estimated. Now let’s suppose of someone who has a pre-existing condition, something like a recent stroke, applies for medical insurance.

If there is a true market for insurance it stands to reason that this person should pay more for their insurance then someone with no such condition. So they should be held by insurance, but pay a higher price. Here’s the key problem: insurers often wouldn’t even offer them a policy. Why not? Insurers are acutely sensitive both the risk-adjusted pricing and making as much money as possible.

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