ECON211 Public Sector Economics

Part II: Social Insurance

Lecture 6: Social Insurance

Applications

Christine Ho
Singapore Management University

Unauthorized distribution of course materials is strictly forbidden.

 Outline

• Social Security • Longevity risk

• Health Insurance
• Pay-as you go system
• Funded system
• Health risk
• Information asymmetry
• Health care systems

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 Social Security

• Longevity risk
• Reasons for intervention
• Issues with intervention

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 Longevity Risk
• Uncertainty about lifespan
• Suppose that we anticipate that we will die on our 80th
birthday and thus spend all our money by the 80th birthday
• Then, if we were to actually live up to our 90th birthday,
we will have to live in poverty for the last 10 years of life

• Individuals usually want

insurance against the risk of
living longer than expected

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 Insurance for Longevity Risk
• An annuity is an insurance plan that charges a
premium and then pays a fixed sum of money at some
regular interval until death of the policy holder
• You pay the insurance company a fixed lump sum
accumulated through savings during your working life
• You can then reap a fixed annual income from the
insurance company for as long as you live

• Single priced annuities redistribute from short-lived

to long-lived
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 Asymmetric Information Issues
• Adverse selection
• Individuals possess more information on
their own longevity risk than insurance co.
• Annuities attract the long-lived
• Empirically small market for annuities

• Moral hazard
• Knowing that society will never let
anyone starve in old age, individuals
may choose to save inadequately
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 Pay-As-You-Go Social Security
• A Pay-As-You-Go (PAYG)
Social Security system is one
where the current working
generation is taxed to finance the
consumption of the current
retired generation

Taxes Benefits
Working Social Retired
Generation Security Generation

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 Social Security in the USA
• Contributions
• Payroll tax on workers
• Employer (6.2%) + Employee (6.2%) = 12.4% of earnings
• Earnings cap at around $137,500+

• Benefits
• Eligibility for benefits
• Worked and paid SS contributions for 40 quarters over the lifetime
• Aged 62 or older

• Amount
• Lifetime annuity based on highest 35 years of earnings
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 Social Security and Savings Behavior
• Savings provide a way of smoothing consumption
across time periods
• Simple model
• Two periods: current and future
• Individual earns income M0 in the current period as
earnings and M1 in the next period from employer provided
private pensions
• In the current period, the individual can save S in a bank
account which yields (1+r)S in the future period
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Future Consumption
Private Savings

c
c1
1  r S
e IC0
M1
S

c0 M0 Present Consumption
Future Consumption
Crowding-Out

c
c1

ess
B e IC0
M1
S ss T

c0 M0 Present Consumption
 Class Exercise 1
• Suppose that Adam lives only two periods where he earns W in period
0 and is retired in period 1. He has preferences of the following form
u  ln c0    ln c1 
where c0 is period 0 consumption and c1 is period 1 consumption and
δ is his rate of time preference. Let r be the interest rate.
1. What is Adam's ratio of period 0 to period 1 consumption?
2. Now suppose that the government taxes Adam amount T in
period 0 and gives Adam Social Security Benefits B=(1+r)T in
period 1. What is Adam's ratio of period 0 to period 1
consumption with Social Security?
3. Is there any difference between the consumption bundles chosen
before and after the introduction of Social Security? Explain why
or why not.
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Suggested Solution to Class Exercise 1
• Utility maximization
Max u  ln c0    ln c1 
s.t. Budget Constraint
• Budget constraint without Social Security
c1
c0  W
1 r
• Budget constraint with Social Security is the same since B = (1+r)T
• Thus, relative consumption is the same
c0 1

c1  1  r 

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Social Security and Early Retirement

Lecture 6 Evidence-Based Economics 14

 Reforming Social Security

• Social Security Crisis

• PAYG
• Funded

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 Pay As You Go Social Security
Young Worker Old Retiree

Generation 1 SS Benefits
PAYG

Generation 2 Payroll taxes SS Benefits

PAYG

Generation 3 Payroll taxes SS Benefits

PAYG

Generation 4 Payroll taxes SS Benefits

  PAYG

Generation N Payroll taxes
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 Scope for Program Reform
• Benefit replacement ratio under the PAYG system
Benefits*Retirees = Tax Rate*Wage*Workers

Benefits Wor ker s


Tax *Wage Re tirees

• With an aging population, there are fears that the

current system may not be sustainable

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 Aging Population

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 Social Security Crisis

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 Potential Reforms within PAYG
• Raise the payroll tax
• Pros: raise revenue
• Cons: distortionary effects of taxation

• Raise the retirement age

• Increasing life expectancy
• Pros: lower benefits payments
• Cons: healthy life expectancy?

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 Funded Social Security System
• Debates pointing towards a funded Social Security system
where one contributes towards the cost of one's own
consumption in retirement
• Fully funded pension system
• SS contributions go into a personal account from which funds can
be invested
• SS benefits can be withdrawn upon reaching the retirement age

• USA: Individual Retirement Accounts (IRA), 401k's

• Singapore: Central Provident Fund (CPF)

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 Funded Pension System
Young Worker Old Retiree

Funded
Generation 1 Payroll taxes SS Benefits

Funded
Generation 2 Payroll taxes SS Benefits

Generation 3 Payroll taxes Funded SS Benefits

Funded
Generation 4 Payroll taxes SS Benefits

  
Funded
Generation N Payroll taxes SS Benefits
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 Singapore Central Provident Fund
• Contributions
• Ordinary account: home, investment, education
• Special account: old age, retirement related financial products
• Medisave account: hospitalization expenses, medical insurance
• Employer (17%) + Employee (20%) = 37% of earnings

• Benefits
• Can withdraw savings from aged 55 or older subject to CPF
retirement sum of S$192,000+
• From age 62 will receive monthly payments from the CPF
minimum sum until exhaustion or can purchase a life annuity
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 Advantages of Funded Systems
• Reduction in labor supply distortions
• SS potentially encourages early retirement

• Reduction in savings distortions

• A funded system may encourage private savings which in
turn leads to an increase in investment

• Higher returns on investment

• Long term private returns on investment tends to be
higher than the SS return

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 Disadvantages of Funded Systems
• Risk
• Investing the funds may be risky

• Administration
• The more the available portfolios and investment
opportunities, the higher the administrative costs

• Distribution
• Personal accounts typically do not lead to redistribution
from young to old or from rich to poor

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 Transition Challenges
• When switching from PAYG to a Fully Funded
system, the last generation loses
• The first generation of beneficiaries from a PAYG system
gains since they did not contribute but enjoy SS benefits
• The last generation of young workers will lose out

• Typically, policy makers try to spread the costs

across several generations, the transition generations
• Would you vote for a government
that wants to tax you twice?

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 PAYG versus Funded system
• Which system is more effective against
longevity risk?
• If you save in a personal account such as the CPF,
your savings gets invested in financial instruments
such as bonds
• When you retire, you need to sell the financial
instruments to get retirement benefits
• Who will purchase the financial instruments?
• The dwindling younger generation!

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 Ageing Population Crisis!
• If the younger generation disappears,
• Will you have anything to eat?
• Who will take care of you?
• Will there be any production in the economy?

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Raise Fertility and Productivity

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 Health Insurance Markets

• Information Asymmetry
• Adverse Selection
• Moral Hazard

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 Health Insurance
• Health insurance is about providing insurance
against negative health shocks
• Uncertainty on when we are going to fall sick or get into
an accident
• Uncertainty on what type of disease or injury we will get

• Negative health shocks may

entail high medical costs

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 Health Insurance Plans
• Insurance plans require people to pay a premium in order to
receive compensation in case an adverse event occur
• Most insurance policies also require individuals to pay for
some of their health expenses out of their own pockets
• Copayment: a fixed amount paid by the insured for a medical
service e.g. you pay $20 each time you see the doctor
• Coinsurance rate: a percentage of the medical bill paid by the
insured person E.g. 20% of the medical bill

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 Asymmetric Information Issues
• Health insurance suffers from adverse selection
where those who are higher risks are the most
likely to take health insurance while the lower risks
are less likely to take health insurance
• Health insurance suffers from the problem of
moral hazard when individuals are tempted to
• Engage in more risky behavior once insured
• Incur higher medical expenses once insured

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 Harvard Death Spiral
• Before 1995, 2 health insurance plans:
• (i) more generous and (ii) less generous.
• Harvard University gave a large subsidy for the more generous
insurance plan such that employees were encouraged to enroll
• After 1995, the subsidy was cut
• Younger employees opted for the less generous plan and older
employees opted for the more generous plan
• The premium for the more generous plan increased substantially in
order to cover the costs of insuring older employees which lead to
more younger employees to drop out and further increases in the
premium until the more generous plan was eliminated

Evidence-Based Economics 35
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 Insurance Gaps in the USA

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 The Uninsured in the USA
• 46 million or 15% of the population are without any
insurance coverage prior to Obamacare
• The demographics of the uninsured
• 10% of children less than 18 years old
• 32% of people in households that earn below the poverty line
• Moreover,
• 39% [9%] of the uninsured population live in households that earn
more than $50,000 [$75,000]
• 20% of the uninsured population are noncitizens

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 Bankrupt from Medical Bills

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 Free-Riding on Tax Payers
• Cost shifting
• Those without insurance often delay getting treatment thereby
leading to an increase in total costs of treatment
• Hospitals and tax payers cover the medical costs of the uninsured
• Negative financial externality on taxpayers

• In the USA,
• The uninsured pay for only 30% of the medical services they use
• They receive free care from hospitals
• Prior to Obamacare, uninsured individuals received approximately
$84.9 billion in uncompensated care
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 Obamacare

Lecture 6 Evidence-Based Economics 41

Price
Patient Side Moral Hazard

P S  SMC
DWL
Insurance 
Compensation

CO PMCI
Out of Pocket Medical Expenses
D  SMB
QNI QI Medical Services
 Class Exercise 2
• Suppose that an individual's demand curve for doctor's visits per year
is given by P=100-25Q where Q is the number of doctor visits per
year and P is the price per visit. Suppose also that the marginal cost of
each doctor visit is $50.
1. How many visits per year would be efficient? What is the total cost of
the efficient number of visits?
2. Suppose that the individual obtains insurance. There is no deductible,
and the coinsurance rate is 50%. How many visits to the doctor will
occur now? What are the individual's out-of-pocket costs? How much
does the insurance company pay for this individual's doctors' visits?
3. What is the deadweight loss caused by this insurance policy?
4. What happens to the size of the deadweight loss if it turns out that the
marginal external benefit of visiting the doctor is $50?
Lecture 6 [RG] Chapter 9 Ex. 6 43
Price
Efficient Visits
100

50 S  SMC

D  PMB
2 4 Medical Services
 Efficient Visits cont’d
• Demand
P = 100 – 25Q
• Efficient visits
DD = SS
50 = 100 – 25Q
Q=2
• Total cost
TC = $100

Lecture 6 [RG] Chapter 9 Ex. 6 45

Price
With Insurance
100

50 S  SMC
Insurance  DWL
Compensation
25 PMCI
Out of Pocket Medical Expenses
D  PMB
2 3 4 Medical Services
 With Insurance cont’d
• Visits with insurance
25 = 100 – 25Q
Q=3
• Out-of-pocket cost
Individual cost = 75
• Insurance cost
Insurance cost = 75
• Deadweight loss
DWL = 12.5

Lecture 6 [RG] Chapter 9 Ex. 6 47

Price
Positive Externalities
100

75
DWL
50 S  SMC

PMCI SMB
25

D  PMB
2 3 4 Medical Services
 Positive Externalities cont’d
• With positive externalities, optimal amount
SMB = SMC
150 – 25Q = 50
Q=4
• Deadweight loss with positive externalities under insurance
DWL = 12.5
• Note that
• Positive externalities implies under consumption of 2 units
• Moral hazard from insurance increases consumption from 2 to 3
• The deadweight loss from under consumption is thus lower with
insurance than without
Lecture 6 [RG] Chapter 9 Ex. 6 49
 Health Insurance in Singapore
• Hybrid system that aims at promoting a combination
of individual responsibility and community support
• Finance
• Privately financed (66%) and publicly financed (33%)

• Management
• Primary care: Private practitioners (80%) and public
polyclinics (20%)
• Hospital care: Private hospitals (20%) and public
hospitals (80%)
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Health Insurance Schemes in Singapore

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 Health Expenditures and Life Expectancy

Source: Figure 1 Towers Watson derived from World Health Organization

Take Home

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 Main Lessons
• Social security insures against the risk of living longer than expected
• Justifications for government provision
• Disincentive effects on labor supply
• Main features in USA and Singapore
• When switching from PAYG to a Fully Funded system, the
transition generations lose
• Reasons for government intervention in health insurance markets
• Adverse selection in health insurance markets
• Moral hazard in health insurance markets
• Obamacare compulsory insurance and Singapore’s funded system
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 Next
• Required Readings: [RG] Ch: 9,11
• Review, read, and write down your own notes
• Reinforce and check your understanding are important early on
• A good exercise is to draw graphs and do the mathematical derivations on your
own, and write down explanations in your own words complemented with the
required readings.

• Mid-Term Exams:
• In the next class
• Closed book 1.5 hours
• Bring stationary, non-programmable calculator…

• Next Lecture: Taxation

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