BUSE3003A – Block 1

PAPER 2

Arrow (1971) – Insurance, Risk

and Resource Allocation

Agata.macgregor@wits.ac.za

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INTRODUCTION
• Insurance theory is void of economic concepts such as utility and productivity.

• Insurance is important in Economics:

• Insurance protects from financial distress
• Insurance facilitates economic growth
• Insurance can help provide a steady income stream

• The nature of insurance is the shifting of risk – do we all agree with this?

• it is the exchange of money now for money later contingent on the occurrence
of a certain event

• AIM/purpose of the paper = to investigate the possible synergies between

economic theory and insurance theory & practice i.e. is there any linkage
between insurance theory and economic theory.
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INTRODUCTION

• There are many forms of risk shifting – not only insurance

• Insurance is limited and yet risks exist everywhere = universality of risks.

• By understanding the restrictions on insurability of risks, we can understand

better the reasons why the economic system in general is so limited in its risk-
bearing ability and therefore will be in a better position to expand that ability.

• There is a responsible agent on whom the burden of any given risk falls in the
first instance. Someone always bears the risk & may not be happy to bear that
risk.

• But society has long recognized the need for permitting a business owner to
shed some of the risks and a series of institutions for shifting risks has evolved.
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RISK SHIFTING MECHANISMS
1. Insurance
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2. Stocks/shares
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3. Cost-plus contracts
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4. Bonds or notes
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5. Future contracts
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RISK SHIFTING MECHANISMS
• The ideal system = you can shift any risk – everything has a price, so both people
can be better off. There is a social usefulness to be able to shift risks.

• Society = totality of individuals – therefore society is better off when the

individuals are better off.

• i.e. if I dislike an uncertainty – I need to find someone to whom the cost of

bearing it is less than it is to me = this makes trade possible = then I pay a
premium to that person to bear the risk and both of us are better off.

• The shifting of risks allows people to engage in more risky activities which they
might otherwise not undertake = increasing production = society benefits e.g.
research and development.

• R&D as well as embarking on new projects.

• By definition research is a venture into the unknown – outcome of research
is uncertain – therefore the shifting of risk is much needed
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RISK SHIFTING MECHANISMS

• In summary: the ideal system = given certain odds (given a certain premium)
their must be price for a contract to take place (you will always find an
equilibrium point where supply = demand). The range of insurance policies
required by this ideal system is very wide.

• The devices actually available for risk-shifting are far from meeting the ideal
standards.
• In reality – cannot cover everything. Some risks you may want to keep (e.g.
don’t want to give shares and you get to keep all the profits for yourself).

• Arrow argues there is an incomplete shifting of risk – I shift risks, but I cannot
choose the exact risk that I do not want to shift or the exact risk that I do want
to shift. Some risks I want to keep, I may have to shift.
• You might not be able to find someone to bare your risk.

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SOLUTIONS

1. Doctors are licensed

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2. Bankruptcy and limited liability laws

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3. Expansion of scope of direct authority

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SOLUTIONS continued

3. Expansion of scope of direct authority

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Example on page 226 of Arrow
LIMITATIONS OF INSURANCE

1. Limited in scope
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2. Limited to the amount

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3. Insurance may impose direct costs on the insured

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4. Insurance may impose direct controls on the insured

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LIMITATIONS OF INSURANCE
Why have these limitations been placed on the insured? ___________________

• The insurance policy itself, just by buying insurance may change your behavior.
This change can occur intentionally or even subconsciously. i.e. the insurance
policy may itself change incentives and therefore the probabilities upon which
the insurance company has relied.

• This principle explains the limitations of both insurance and in particular, risk-
shifting in the market.

• Risk-bearer cannot completely define their risks. Therefore, the insurer may
refrain from insuring or may impose direct controls upon the insured.

• It is now easy to see why insurance against failure of business or research

projects has not arisen – the incentive to succeed may be too greatly reduced.

• Has solutions and will not affect market as badly as adverse selection.
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SOLUTIONS TO MH

1. Give a no-claim bonus

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2. Co-insurance
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3. No insurer will take on the risk
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• Therefore, solutions to MH need to be: Devices to reduce the obstacles to risk-

taking without diluting too greatly the necessary motivation for efficiency.

• If a complete absence of risk-shifting is bad because it inhibits the undertaking

of risky enterprises and if total risk-shifting is bad because it reduces the
incentives for their success, then it is reasonable to suggest that partial risk-
shifting might be best. This is precisely what is meant by co-insurance – the
insured pays some stated portion of the loss.
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