Information Problems

Imagine that you’re a bookie who takes football bets. A player on the Buffalo Bills wants to (illegally) bet that the Bills will lose their next game. Should you take this bet? This player has inside information about the game. He also has some ability to influence the chance of their losing. You might refuse this bet because you suspect the player would make it only when he is certain of defeat. It’s dangerous to bet with someone who knows more about the underlying event than you do.

Whenever insurance companies sell policies, they are issuing them to people who have superior information. When you buy life insurance, you are betting with your insurance company that you will die. You obviously have information about your health that the insurance company lacks. The insurance company should suspect that the reason you want to buy life insurance is because you know you are sick. Indeed, if you find out you are going to soon die, it would be a good strategy to buy lots of life insurance. The people who would most want insurance are inevitably those people whom the insurance company would least like to have as customers.