ECONOMICS OF SOCIAL
POLICY: INSURANCE
INSURANCE
Mechanism to protect people against risk.
It’s the market solution to imperfect information
concerning the future.
For the demand side, see micro slides on risk and
uncertainty:
Imagine a Risk-Averse individual
An individual will insure up until the point where the premium is
equal to the probability of the event x the Loss;
Gross Premium ≤ p . L
By pooling risks, due to the law of large numbers, the
variance of the average income will tend to zero.
Therefore, by participating in the pool, the individual
can acquire certainty.
INSURANCE
It is, however, the supply side where most of the
problems of actuarial insurance arise.
ACTUARIAL INSURANCE can be represented by the
equation:
Π = (1+a)pL
Gross Premium = (1+ admin costs).Probability of Loss. Value of
loss.
However, based on the following requirements:
I: INDEPENDENT PROBABILITIES
II: KNOWN OR ESTIMABLE PROBABILITIES
III: PROBABILITIES LESS THAN ONE
INSURANCE
Asymmetric Information is key to many arguments for the efficiency of the welfare state
and comes in two flavours:
ADVERSE SELECTION
MORAL HAZARD
Adverse Selection:
Otherwise known as Hidden Knowledge. Occurs when the agent has more knowledge than
the principal, and is able to conceal that knowledge to get a better bargaining position.
The Insurer cannot ascertain whether the potential customer is a good risk or a bad
risk. Thus the second criteria (probabilities must be known or estimable) is violated.
Two equilibriums the insurer may choose to follow:
Pooling equilibrium: Av. Π = (1+a)[JpH + (1 – J)pL ].L where ‘J’ is the probability of being a high
risk or low risk individual. However, this is not a stable equilibrium as other packages will be able
to steal away low risk customers (due to premiums being higher for them).
Separating equilibrium: Where the company attempts to offer a different premium to each of the
groups; attempts to appeal to self selection by offering policies with incentives for customers to
reveal their true probabilities. However, this could lead to incomplete cover.
Therefore, an outcome of adverse selection is CREAM SKIMMING, where the company
attempts to recruit good risks and avoid bad risks – this leads to gaps in coverage for good
risks and the market thus either fails completely or is incomplete.
INSURANCE
Moral Hazard:
Otherwise known as Hidden Action it implies that the probability of an event
occurring and/or the Loss associated with that event are endogenous.
There are four cases:
I: Endogenous P at a substantial Psychic Cost:
For example, it is possible to influence the probability of death, but it would be pointless to do
so. Moral Hazard poses no real threat to efficiency.
II: Endogenous P at no real Psychic Cost:
No incentive to invest in preventative measures as burden of loss is passed onto the insurance
company (and thus everyone else). This is the PAULY result – people under-invest in
preventative measures. However, insurance is still possible, if inefficient.
III: Endogenous P with substantial Psychic Gains:
Uninsurable risks, generally as the company can’t estimate a reasonable premium.
IV: Endogenous L at no real cost (Third-Party Payment Problem):
Can lead to over consumption on the demand side (all you can eat restaurant) and supply side
(medical care paid for by the insurer).
Moral Hazard can be attacked via regulation or incentives:
Regulation – Inspection to ascertain the true insured loss in a damage claim.
Incentives – Deductibles, Coinsurance, No claim bonus bear some of the cost of the
loss onto the purchaser. However, none faces the individual with the full marginal
cost of his actions.
INSURANCE
Should Insurance be competitive?
Yes; competition will reduce premiums to their minimums and
erode surplus profits like in any other industry.
BUT there are three conditions in which the attractiveness of
insurance competition is diminished:
I – Imperfect Consumer Information:
Due to technically complex insurance plans, or inability to correctly choose the
appropriate plan, the gains from competitions may diminish.
II – Imperfect Producer Information:
Leads to adverse selection + moral hazard.
III – Excessive administration costs:
If excessive, will lead to an incomplete market – those who would insure are put
off because the admin costs raise the costs of premiums above their demand.
Solution is either regulation/subsidisation of private markets or
public funding via social insurance.
INSURANCE
A common feature of most social insurance schemes is that
there is compulsory membership (i.e., through tax
contribution).
This makes possible the three different forms of social
insurance, which increasingly diverge from actuarial
insurance:
SOCIAL INSURANCE: Benefits based on a contributions record
and the occurrence of a specified contingency. This is a pure pooling
equilibrium.
UNIVERSAL BENEFITS: Tax-financed benefits rewarded on the
basis of a specified contingency (i.e., unemployment) without a
contributions record or incomes test.
SOCIAL ASSISTANCE: Awarded on the basis of specified
contingencies and incomes test.
Social insurance can break the link between premiums and
individual risk – thus it can also cover UNCERTAINTY.
INSURANCE CASE STUDY:
INFORMATION PROBLEMS IN
HEALTH CARE
HEALTH CARE INSURANCE
Insurance Problems with HC:
Adverse Selection
Moral Hazard
Probabilities Less Than One (Terminal Patients/Pre-existing conditions)
Higher admin costs in private firms than in large national institutions (Economies of
Scale).
Adverse Selection:
This is particularly true for the elderly in America, who find it difficult to get insurance –
what insurance they do get is based on a pooling equilibrium, which, as we know, drives
out the ‘good’ risks and is uncompetitive in a private market.
An example occurred in the US in Harvard; the longshot is that there was a university
insurance plan and a new university – supported private insurance plan; about 20% of
students took the latter, as both had similar premiums.
However, because of changes in financing, premiums for the latter rose substantially, and
the share of students fell to 15%.
Those that switched were YOUNG and HEALTHY – the new insurer made a loss that
year.
The insurer then raised premiums due to a higher average risk, and the percentage fell again; an
adverse selection spiral had started.
This is Adverse Selection; the good risks sought out a more favourable option, but the bad
risks knew they were still getting a good deal.
HEALTH CARE INSURANCE
Moral Hazard is a more
complex problem; it operates Cost/Benefit
through two main channels:
Endogenous probabilities:
Especially with elective
surgeries or pregnancy. It may
also encourage under
consumption of preventative
measures. MSC
Third-Party Payment
problem:
As doctors and patients don’t MPB=Demand
face any direct costs, they act
as if the marginal cost is zero,
and this leads to over-
consumption as the diagram Q* Q’ Q of HC
shows.
Overconsumption
HEALTH CARE INSURANCE
Thus:
ADMIN + GAPS IN COVERAGE Under-consumption of HC.
INEFFICIENCY Indeterminate
THIRD-PARTY PAYER Over-consumption of HC.
Solutions
Market Based Solutions:
Limit Cover, Co-insurance, Deductibles, No claims bonuses.
However, you don’t make the consumer face the true MC of their actions, Health Status
is hard to contractually define so there can never be specificity.
Intervention to reduce inefficiency:
Mandating coverage to prevent good risks opting out + prevent externalities associated
with non-insurance.
This may be inequitable for the low-risks who essentially subsidize the high risks.
Cover must not be excluded for those with pre-existing conditions.
Incomplete coverage can be prevented by basing insurance on ABILITY TO PAY rather
than INDIVIDUAL RISK Social Insurance/tax based system.
