Insurance choice and risk:

We have seen that people, in general, are risk averse and would be willing to buy insurance. Viewed from such a perspective, insurance is an exchange in which you make a payment  in order to get rid of a gamble - that is, to avoid or reduce a risk. However, if everyone is risk averse, a seller of insurance seems a part of the group. You cannot then explain the existence of an insurance market without saying that insurance company  is risk lover. To come to a definite conclusion, if will be necessary for us  to examine the operation of insurance market.  

The  risk reduction mechanism adopted by  the insurance markets depend on the  law  of  large numbers,  which  helps evaluate uncertain outcomes with almost certainty. Consequently, risk  pooling risk, spreading and risk transfer tools are adopted. The risk pooling and risk transfer mechanisms result  in Pareto improvement in the society. The fact that insurance market exhibits the persistence of either no  insurance or  less  than  full insurance  is  tried  to be  explained. While credit constraints could be a major factor for people to not buying insurance, there are structural problems like adverse selection of moral hazard, which result in less than full insurance  as  a  viable option.

Insurers  may  have less information about potential risks than the insurance purchasers resulting in adverse selection. Insurers unable to monitor for the behaviour of insured leads to moral hazard problems.  Such  problems give rise  to  self-selection in  insurance markets. When the resulting equilibria exist, which are seen by considering pooling and separating equilibrium, often found to be Pareto inefficient.