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.