EXTERNALITY

In insurance, externalities refer to benefits or costs incurred by a third party as a result of the insurance policy purchased by the insured or by the practices of an insurer.
Externalities may be positive or negative. If the insurance policy or the insurer (through its practices) in any way brings a cost burden on a third party, it is termed negative externality. Positive externality on the other hand involves a third party benefiting from an insurance policy purchased by someone else or the operations of an insurer. Positive externality is sometimes associated with the free rider problem

Examples – Positive;

·         In an area that does not have a public fire department, homeowners who purchase fire insurance provide a positive externality to neighboring properties which are now less at risk of the protected neighbors’ fire spreading to their unprotected houses.

·         A road user with a comprehensive motor policy provides positive externality to other users who do not have the policy.

Examples – Negative;

·         When an insurer has insured so many people that it could charge relatively lower premiums than other insurers in the market, these other insurers will have to incur additional cost, either to reduce their premiums or attract policy buyers.

·         Morale hazards of a smoker who has a health insurance leads to costs to a third party who takes in the smoker’s second hand smoke