Problems in insurance markets:

We  have seen  the  operation  of  insurance market  throggh  the mechanism  of defraying risk. More importantly, we also observed that through such market mechanism, except for risk spreading, Pareto improvement can be affected as some people can be made better off without making any one worse off. Thus, efficient insurance markets have  the potential of improving social welfare.

Not with standing  such theoretical insights, there are instances where you come across uninsured people. Every the basic markets such as health insurance and life insurance exhibit such features.

Insurance, which exists in many markets, is incomplete. For example, suppose an individual  is  contemplating insurance that would pay  off  in  the event  she contacted  an  incurable illness. Although  she  might choose a policy that covered all anticipated medical expenses, complete cover  of  income loss might not  be  chosen since the illness  may  foreclose some consumption possibilities. So, insurance may be  offered with deductions or caps. At  times, the coverage  may  be  denied altogether. Thus,  Lve  need to explain the persistence of incomplete insurance markets.  

Factors Behind Incomplete Insurance Market

There  are  constraints like non-availability of  credit  to  buy  insurance and people cannot afford for a policy of their own. So, even if you know that you have a disease, which demands good deal of  expenditure, it may be too late for  you  to  buy  insurance; and you bear the risk. Similarly, there are non- diversifiable risk, which cannot be insured. You may  think  of  nuclear war, where all of us will face identical risk simultaneously and there is no  is way to get back the loss through insurance. These apart, let us look for two important structural constraints, which is  why  it  makes sense  to  have less-than-full insurance, viz., Moral Hazard and Adverse Selection. We will return to these  concepts for  a greater discussion  in  the next unit and for the present acquaint ourselves with their implications in the insurance market.