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IAI Actuarial Core Principles · Business Management · Decision-making process, attitude to risk and competition

An Indian life insurer is deciding whether to enter a regional market currently held by one incumbent. If the insurer enters, the incumbent can either fight with a price war (entrant loses Rs 10 crore, incumbent earns Rs 20 crore) or accommodate (entrant earns Rs 15 crore, incumbent earns Rs 30 crore). If the insurer stays out, it earns 0 and the incumbent earns Rs 60 crore. The incumbent threatens a price war. Using backward induction, what should be concluded?

The threat is not credible. After entry the incumbent earns Rs 30 crore by accommodating against only Rs 20 crore by fighting, so it will accommodate. Knowing this, the entrant should enter and earn Rs 15 crore rather than nothing.

  1. AThe threat is not credible, so the insurer should enter and the incumbent will accommodateCorrect
  2. BThe threat is credible, so the insurer should stay out
  3. CThe insurer should stay out because the incumbent earns most when it does
  4. DThe insurer should randomise between entering and staying out
  5. The incumbent should fight because 20 exceeds 15

Explanation

Once entry has occurred, the incumbent compares fighting (20) with accommodating (30) and prefers to accommodate. The threat is therefore not credible. Anticipating this, the entrant compares 15 from entering with 0 from staying out and enters.

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