The Game Theory can be defined as being a branch of mathematics and economics that concerns itself with the making of strategic analysis of gaining a competitive advantage in the market. Under the games theory, the actions of the participants determine the outcomes of other individuals (Aumann &Robert, 13). In the past, the game theory has effectively been used in biology, war and business ventures. The following paper seeks to examine the application of the Games Theory by insurance firms.
Both the Economic Behavior and the Game Theory are ideal models for determining the factors that influence consumer trends. In insurance, it can be employed to examine the factors that lead to the making of logical decisions by both the management and the consumers.
Understanding the applicability of the Games Theory requires an evaluation of the Winner’s Curse model in the insurance industry. The model is based on the assumption that all the insurers are independent, identical and in competition for profitability at the same risk level(Aumann &Robert, 26). It means that the consumers have a high prevalence from the firms with the best prices and offers. While the model does not allow for the differentiation of products and services, it serves as the basis of gaining a competitive edge in the market. In the Book, Wealth of Nations, Adam Smith notes that there is the need to create a distinction between market and natural processes.
While the market price is the amount at which a commodity is sold, the natural price is the value of a commodity that is influenced by factors of production. According to the Economy theory, the market price is a reflection of the interaction between the supply and the demand curves. Insurance firms undertake to ensure that while there is an increase in the marginal revenues, the marginal cost is kept at the minimum. It implies that finding the interaction between the marginal revenue and the marginal costs would signal high profits from an insurance firm.
In the case of the Games Theory, it takes the assumption that all players are rational beings and will seek to pay for services or products that offer full value of their money. It further implies that the player, in theory, is wholly aware of other alternatives and has cellar preferences. It is imperative to note that a rational model is made of a set of strategies and also an equal realization of the impacts of the strategies (Combs. 97). In insurance covers, if the payoff function is seen as being stochastic, the player will behave in a manner that maximizes the value.
The behaviors of insurance customers can better be explained using the von Neumann-Morgenstern utility. The model notes that in diffract axioms of rational behavior, there are chances that the decision maker/ consumer will act as if trying to maximize the gains. It is the basis of the expected utility theory which notes that an evaluation of the statistical outcomes of a gamble leads to the attainment of the subjective value. The expected utility hypothesis has proven to be of great use in both gambling and insurance.
Game Theory in Insurance
Given these factors, it is critical to monitor factors that infancy the decisions of the customers. In 2011, there was the banning of the use of gender factors by insurers to determine the benefits and profits that come with their operations. Unless the rules of the game in the insurance industry are set by an external regulator. There are always chances of manipulating eth rules with the objective of gaining a competitive advantage. Nay attempt to change the game is regarded as being strategic moves which are influenced by their credibility.
An insurance firm must thus undertake to ensure that its strategic moves are credible through taking axillary actions like making commitments or promises to customers (Combs, 106). While threats are also regarded as being axillary moves, there are less effective in an effort to win more customers. However, it can be used to intimate other market players thus seeing a significant change in the price of the insurance covers. Likewise, using promises to control the actions of the players may prove to be useful (Marden et al., 880) Insurance takes the form of a commitment where the management and the customers commit to upholding the content of the insurance policy.
The expected lifetime value of money is used in the calculation of most of the insurance covers. An example can be taken among two insurances firms that offer farmers covers against natural disaster such as flooding and drought. Assume that these insurances firms A and B receives an application from a client whom they are certain will make a claim during the year. Taking the cost of settling and administering the claim as being $ 10, it implies that both firms would make simultaneous quotes without realization in a setting where the insurer failed to make a claim.
The logic in the outlined case implies that insures A will strive to ensure that the quote is B and also less than the $ 10. It implies that if A assumes that B will charge the customer $13, A may decide to charge $ 11. Such a trend points out that there is a tendency to have a Nash Equilibrium in insurance operations. However, the equilibrium would only occur in settings where the insurers only charged $10 implying that the winning firm would make zero profits. However, the case would have been different in a situation where the firms had knowledge of the number of years that the customer would need insurance.
It means that the firm would have the information that the claim would be renewed on an annual basis thus costing $ 10. If firm A wins the cover for $10, it implies that it would charge the same cost or lower it. The mopve would be with an objective of reducing the chances of losing the client to firm B. While some ventures may not yield revenues, a firm may opt to operate at the equilibrium as an incentive of reducing the competitive advantage of rival firms(Delong & Łukasz, 240).
However, the case is different in cases where the insurance covers are sold through a brokerage firm. In such an environment, the level of demand would be affected by the promises and commitments offered by the brokerage firm. Based on the outlined information, it is cellar that game theory can be used in an insurance firm setting to come up with strategies that led to a competitive advantage. In most cases, insurance firms tend to offer homogenous products hence the need to come up with other approaches such as reducing the cost of the insurance covers.
Aumann, Robert J. “Game theory.” The New Palgrave Dictionary of Economics (2017): 1-40.
Combs, Barbara, et al. “Preference for Insuring Against Probable Small Losses: Insurance Implications.” The Perception of Risk. Routledge, 2016. 89-110.
Delong, Łukasz. “Time-inconsistent stochastic optimal control problems in insurance and finance.” Collegium of Economic Analysis Annals 51 (2018): 229-254.
Marden, Jason R., and Jeff S. Shamma. “Game theory and distributed control.” Handbook of game theory with economic applications. Vol. 4. Elsevier, 2015. 861-899.
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