Social Insurance

Public Finance Dr. Katie Sauer

Figure 12-1: Government Spending, 1953 & 2007

Expected Value Expected value incorporates the probability of an occurrence of an event with its outcome. E[X] = p1X1 + p2X2 + + pnXn pi is the probability of an event Xi is the outcome associated with an event The probabilities must always sum to 1.

Suppose that in a year, there is a 0.1% chance that you will be involved in a car accident resulting in $300,000 worth of damages and injuries 10% chance that you will be involved in a car accident resulting in $9000 worth of damages What is the expected value of the damages?

E [Damages] = (0.001)(300,000) + (0.10)(9,000) + (0.899)(0) E [Damages] = 300 + 900 + 0 = 1200 You should be willing to pay $1,200 per year for an insurance policy that covers all of your expenses. If your insurance company charges you $1,200, they are charging an actuarially fair price.

Actuarially fair pricing means your insurance firm will earn zero expected profit. E [profit] = premium expected payout = 0 = premium (probability of payout)(payout amount) Ex: E[profit] = 1200 (0.001)(300,000) (0.10)(9000) = 1200 300 900 =0

Ex: You are playing roulette. - 38 pockets - choose red 16 pocket to bet $1 on - if the ball lands in red 16, win $35 - if the ball lands in any other pocket, lose $1 Calculate your expected value of a $1 bet. E [$1 bet on red 16] = = (1/38)(35) + (37/38)(-1) = 0.92 0.97 = - 0.05

Ex: Insurance Sams income is $50,000 per year. There is a 1% chance that Sam will get hit by a car next year, resulting in $20,000 in medical expenses. Sams utility function is U = C0.5 . Sam can buy insurance for m cents per dollar of insurance coverage $b. Assume an actuarially fair policy.

Sams expected utility function can be expressed as: E[U]= (0.99)(50,000 mb)0.5 + (0.01)(50,000 mb 20,000+b)0.5 An actuarially fair policy means that the firm earns zero expected profit: E[ ] = mb (0.01)b = 0 m = 0.01

Substituting in for m yields: E[U] =(0.99)(50,000 0.01b)0.5 + (0.01)(30,000 0.01b +b)0.5 Maximizing with respect to the level of insurance coverage yields:

xEU (0.00495) (0.00495) !  0.5 xb (50,000  0.01b) (30,000  0.99b) 0.5

Set it equal to zero and solve for b.

(0.00495) (0.00495)  !0 0.5 0.5 (50,000  0.01b) (30,000  0.99b) 30,000  0.99b ! 50,000  0.01b b ! 20,000
It is optimal for Sam to buy $20,000 of coverage. He will fully insure against the risk.

If Sam wants $20,000 of coverage, he pays a premium of: mb m20,000 from earlier we found m = 0.01 (0.01)(20,000) $200

Calculate Sams Expected Utility: - found m and b E[U]= (0.99)(50,000 mb)0.5 + (0.01)(50,000 mb 20,000+b)0.5

E[U]= (0.99)(50,000 200)0.5 + (0.01)(50,000 200 20,000+ 20,000)0.5 E[U]= 220.93 + 2.23 = 223.16

What if Sam had only partially insured? - paid $100 for $10,000 of coverage E[U]= (0.99)(50,000 100)0.5 + (0.01)(50,000 100 20,000+ 10,000)0.5 E[U]= 221.15 + 1.99 = 223.14

The Expected Utility Model Your utility takes the following form: U = C0.5 You are hit by a car with probability p. If you get hit, your medical costs are . Your income is W, regardless of whether you get hit. You can buy insurance for a premium of m per dollar of insurance coverage. Insurance will pay you $b if you are hit. Insurance is actuarially fair.

Your expected utility can be written as: E[U] = (probability of not getting hit)(utility) + (probability of getting hit)(utility) E[U] = (1 p) (W mb)0.5 + (p)(W mb + b)0.5

Actuarially fair policy: E[ ] = mb pb = 0 mb is the amount they receive in premiums pb is the expected payout

mb pb = 0 Simplifying yields: mb = pb m=p For example, if the risk of payout is 10%, then the insurance firm will charge 10 cents per dollar of coverage.

Substitute m = p into the expected utility. E[U] = (1 p) (W mb)0.5 + (p) (W mb + b)0.5

E[U] = (1 p) (W pb)0.5 + (p) (W pb + b)0.5

Now, maximize the expected utility by choice of coverage (b).

xEU  p(1  p)(0.5) p(1  p)(0.5) !  0.5 xb (W  pb) (W  pb  H  b) 0.5

Set equal to zero and solve for b.

 p(1  p )(0.5) p(1  p)(0.5)  !0 0.5 0.5 (W  pb) (W  pb  H  b) p(1  p)(0.5) p (1  p )(0.5) ! 0.5 (W  pb) (W  pb  H  b) 0.5 (W  pb  H  b) 0.5 ! (W  pb) 0.5

?(W  pb  H  b) A ! ?(W  pb) A

0.5 2 0.5 2

W  pb  H  b ! W  pb

b !H
The optimal amount of coverage to buy is the amount that exactly offsets the medical costs. - full insurance

Expected Utility Theory tells us that with actuarially fair pricing, individuals will want to fully insure themselves to equalize consumption in all states of the world. People differ in their taste for risk.

Given that it is theoretically optimal to have full insurance, why have Social Insurance? Asymmetric Information & Adverse Selection

Suppose there are 100 careless insurance consumers who dont pay attention when crossing the street. 5% chance of getting hit by a car $30,000 medical bills Suppose there are 100 careful insurance customers who always look both ways. 0.5% chance of getting hit by a car $30,000 medical bills The insurance firm doesnt know who is careless and who is careful.

Strategy 1: Ask each person if they are careful or not. Everyone will say they are careful. actuarially fair premium = (0.005)(30,000) = $150 Total premiums = 200 x 150 = 30,000 E [profit] = 30,000 (0.005)(30,000)(100) (0.05)(30,000)(100) = 30,000 15,000 150,000 = 30,000 165,000 The firm will lose money, so will not offer any insurance. - market failure

Strategy 2: Offer a pooled rate. Divide the expected payout by the number of people and charge that amount to everyone 165,000 / 200 = $825 Now, the careful consumers may choose not to purchase the insurance. Collect premiums from the careless: 100 x $825 = $82,500

Pay out: (0.05)(100)($30,000) = $150,000 The insurance firm will still lose money. The careful consumers will not be able to purchase their optimal amount of insurance. - market failure

Overcoming Asymmetric Information 1. Risk Premiums Many people are risk averse and are willing to pay more than the actuarially fair price for insurance. If our careful consumers are risk averse, they may be willing to pay $825 - $150 = $675 in a risk premium. Wed then have a pooling equilibrium. - all fully insure, which is optimal - not priced fairly for all

2. Separate Products at Separate Prices - try to get customers to reveal information Option 1: $30,000 of coverage for $1,500 (0.05)(30,000) = 1,500 $10,000 of coverage for $50 (0.005)(10,000) = 50

Option 2:

Likely that the careless would choose option 1 and the careful would choose option 2. This is called a separating equilibrium. - not optimal for the careful (market failure)

Government Involvement Rationale: - asymmetric information / adverse selection - externalities - uninsured motorists - administrative costs - economies of scale - redistribution - tax low-risk to subsidize high-risk - paternalism

Social Insurance vs Self-Insurance Suppose you are unemployed. Forms of self-insurance to get you through: - personal savings - borrow - money from other members of household - money from extended family, friends, church Suppose you can receive Unemployment Insurance. The UI Replacement Rate is the ratio of UI benefits to pre-unemployment earnings.

UI replacement rate and the drop in consumption

(a) No savings, credit cards, money from friends - at 0% UI replacement rate, consumption falls 100% - at 100% UI replacement rate, consumption falls 0%

(b) Some savings, credit cards, money from friends - at 0% UI replacement rate, consumption falls 50% - at 100% UI replacement rate, consumption falls 0% - use UI instead of private funds

(c) full private source of funds - at 0% UI replacement rate, consumption falls 0% - at 100% UI replacement rate, consumption falls 0% - use UI instead of private funds

The Consumption-Smoothing Role of Social Insurance When events are predictable, social insurance plays a smaller consumption-smoothing role. When events are less costly, social insurance plays a smaller consumption-smoothing role.

Optimal Social Insurance Systems: should partially, not completely insure people against adverse events. Benefits: consumption smoothing Costs: moral hazard