This paper examines the economic foundations of insurance as a mechanism for managing risk. Beginning with the concept of risk and how insurance pools losses across large populations, the paper discusses the law of large numbers and the importance of independent risks. It then analyzes market failures including adverse selection—where high-risk individuals disproportionately purchase insurance—and moral hazard, whereby insured parties reduce their loss-prevention efforts. The paper concludes with an overview of government's four major roles in insurance markets: direct provision, subsidization, mandating residual markets for high-risk groups, and regulatory oversight. Throughout, the paper demonstrates that effective insurance depends on accurate risk assessment, appropriate pricing, and clear understanding of the true costs involved.
An understanding of insurance must begin with the concept of risk. Risk is defined as the variation in possible outcomes of a situation. A shipment of goods to Asia might arrive safely or be lost in transit. Another potential scenario is that a person may incur zero medical expenses in a good year, but if struck by a car, expenses could exceed $100,000. We cannot eliminate risk from life, even at extraordinary expense. Paying extra for double-hulled tankers still leaves oil spills possible. The only way to eliminate auto-related injuries is to eliminate automobiles. Thus, the effective response to risk combines two elements: efforts or expenditures to lessen the risk, and the purchase of insurance against whatever risk remains.
Consider a shipment of $1 million in goods. If the chance of loss on each trip is 3 percent, the expected loss will be $30,000. Let us assume that the shipper can use a more costly method and cut the risk by one percentage point, saving $10,000 in expected losses. If the additional cost of this shipping method is less than $10,000, it is a worthwhile expenditure. However, if cutting risk by a further percentage point will cost $15,000, that expenditure sacrifices resources. To deal with the remaining 2 percent risk of losing $1 million, the shipper should consider insurance. To cover administrative costs, the insurer might charge $25,000 for a risk that will incur average losses of no more than $20,000. From the shipper's standpoint, however, the insurance may be worthwhile because it provides a comparatively inexpensive way to deal with the potential loss of $1 million. Note the important economic role of such insurance: without it, the shipper might not be willing to risk transporting goods in the first place.
In exchange for a premium, the insurer will pay a claim should a specified contingency arise—such as death, medical bills, or shipment loss. The insurer, whether a corporation with diversified ownership or a mutual company made up of the insured themselves, is able to offer such protection against financial loss by pooling the risks from a large group of similarly situated individuals or firms. The laws of probability ensure that only a tiny fraction of these insured shipments will be lost, or only a small fraction of the insured population will face expensive hospitalization in a year.
If, for example, each of 100,000 individuals independently faces a 1 percent risk in a year, on average, 1,000 will have losses. If each of the 100,000 people paid a premium of $1,000, the insurance company would collect a total of $100 million. Leaving aside administrative costs, this would be enough to pay $100,000 to anyone who had a loss. But what would happen if 1,100 people had losses? The answer, fortunately, is that such an outcome is exceptionally unlikely. Insurance works through the magic of the law of large numbers. This law assures that when a large number of people face a low-probability event, the proportion experiencing the event will be close to the expected proportion. For instance, with a pool of 100,000 people who each face a 1 percent risk, the law of large numbers says that 1,100 people or more will have losses only once in one thousand.
In many cases, however, the risks to different individuals are not independent. In a hurricane, airplane crash, or epidemic, many may suffer at the same time. Insurance companies spread such risks not only across individuals, but also across good years and bad, building up reserves in the good years to deal with heavier claims in bad ones. For further protection, they also diversify across lines, selling both health and homeowners' insurance, for example.
The risks normally insured are unintentional, either due to the actions of nature or the inadvertent consequences of human activity. Terrorism creates a new model for insurance for three reasons: (1) the losses are man-made and intentional; (2) massive numbers of people and structures could be harmed (theft losses fall in the first category, but not in the second); and (3) historical experience does not provide a yardstick for assessing likely risk levels. Nuclear war presented equivalent challenges in the twentieth century. Had there been a significant nuclear war, insurance companies simply would not have paid. The losses would have been too massive to pay out of assets, and many of the assets underlying the insurance would have been destroyed. In time, appropriate insurance arrangements for this new category of massive risk will be developed.
An economist views insurance as being like most other commodities. It obeys the laws of supply and demand, for example. However, it is unlike many other commodities in one important respect: the cost of providing insurance depends on the identity of the purchaser. A year of health insurance for an eighty-year-old costs more to provide than one for a fifty-year-old. It costs more to provide auto insurance to teenagers than to middle-aged people. If a company mistakenly sells health policies to older clients at a price appropriate for younger clients, it will assuredly lose money, just as a restaurant will lose if it sells twenty-dollar steak dinners for ten dollars. The restaurant would lure lots of steak eaters. So, too, would the insurance company attract large numbers of older clients. Because of the differential cost of providing coverage, and because customers search for their lowest price, insurance companies go to great pains to set different premiums for different groups, depending on the risks each will impose.
Recognizing that the identity of the purchaser affects the cost of insurance, insurers must be careful to whom they offer insurance at a particular price. Those high-risk individuals whose knowledge of their risk is better than that of the insurers will step forth to purchase, knowing that they are getting a good deal. This is a process called adverse selection, which means that the mix of purchasers will be adverse to the insurer.
What leads to this adverse selection is asymmetric information: potential purchasers have more information than the sellers. The potential purchasers have "hidden" information that relates to their particular risk, and those whose information is unfavorable are thus most likely to purchase. For example, if an insurer determined that 1 percent of fifty-year-olds would die in a year, it might establish a premium of $12 per $1,000 of coverage—$10 to cover claims and $2 to cover administrative costs. The insurer might naively expect to break even. However, insured individuals who ate poorly or who engaged in high-risk professions or whose parents had died young might have an annual risk of mortality of 3 percent. They would be most likely to purchase insurance. Health fanatics, by contrast, might forgo life insurance because for them it is a bad deal. Through adverse selection, the insurer could end up with a group whose expected costs were, say, $20 per $1,000 rather than the $10 per $1,000 for the population as a whole; at a $12 price, the insurer would lose money.
The traditional approach to the adverse selection problem is to inspect each potential insured. Individuals taking out substantial life insurance must submit to a medical exam. Fire insurance might be granted only after a check of the alarm and sprinkler systems. But no matter how careful the inspection, some information will remain hidden, and a disproportionately high number of those choosing to insure will be high risk. Therefore, insurers routinely set high rates to cope with adverse selection. Alas, such high rates discourage ordinary-risk buyers from buying insurance. Though this problem of adverse selection is best known in insurance contexts, it applies broadly across economics. Thus, a company that "insures" its salesmen by offering a relatively high salary compared with commission will end up with many salesmen who are not confident of their abilities. Colleges that insure their students by offering many pass-fail courses can expect weaker students to enroll.
Once insured, an individual has less incentive to avoid the risk of a bad outcome. A person with automobile collision insurance, for example, is more likely to venture forth on an icy night. Federal pension insurance induces companies to underfund and weakens the incentives for their employees to complain. Federally subsidized flood insurance encourages citizens to build homes on floodplains. Insurers use the term moral hazard to describe this phenomenon. It means, simply, that insured people undertake actions they would otherwise avoid. Stated in less judgmental language, people respond to incentives. In the above salesman example, not only are low-quality salesmen enticed to join, but all salesmen, even those of high quality, are given an incentive to be less productive.
Ideally, the insurer would like to be able to monitor the insured's behavior and take appropriate action. Flood insurance might not be sold to new residents of a floodplain. Collision insurance might not pay off if it can be proven that the policyholder had been drinking or had otherwise engaged in reckless behavior. But given the difficulty of monitoring many actions, insurers accept that once policies are issued, behavior will change adversely, and more claims will be made.
The moral hazard problem is often encountered in areas that, at first glance, do not seem associated with traditional insurance. Products covered under optional warranties tend to get abused, as do autos that are leased with service contracts.
Government plays four major roles with insurance: (1) Government writes it directly, as with Social Security, terrorism reinsurance, and pension guarantees via the Pension Benefit Guaranty Corporation (PBGC) should a corporation fail. (2) Government subsidizes insurance, quite explicitly in some programs such as federal flood insurance, but only de facto in other cases (for example, the PBGC has a large projected deficit). (3) Government mandates a residual market for high risks (for example, Florida's program for hurricanes or many states' programs for high-risk drivers). Governments hold down prices in such markets either by creating a state fund to cover losses or by requiring insurers who participate in the voluntary market to pick up a certain portion of this high-risk market. (4) Government regulates matters such as premiums, insurance company solvency, and permissible criteria for pricing insurance (for example, for auto insurance, race and ethnicity are banned everywhere; Michigan bans geographic designations smaller than a city).
Property liability insurance is regulated at the state level, providing many opportunities to compare the efficacy of alternative approaches. The three main regulatory approaches to pricing have been: (1) prior approval, in which regulators must approve rates before they go into effect; (2) use and file, in which companies set rates, but regulators can disallow them subsequently if they are found excessive; and (3) open competition, a market-based system in which rates are deemed not excessive as long as there is competition. Empirical studies conflict as to whether regulation leads to lower prices.
Government participates far more in insurance markets than in typical markets. The two great dangers with government participation in insurance arise when, as is common, the goals for participation remain vague (for example, promoting the insured activity, redistributing income, or spreading risk effectively), or when its expected cost is not recognized in budgets. With insurance, as with all government endeavors, the citizenry deserves to know both the rationale and the cost.
"Core principles and persistent challenges"
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