2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. Chapter 5: Economic theory 2: Insurance Barr: Economics of the Welfare State: 4e

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. Organization of the chapter 1. Introduction 2. The demand for insurance 3. The supply side 4. The insurance market as a whole: Private and social insurance

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. 1. Introduction Definitions of insurance A device to protect individuals against risk An actuarial mechanism Two questions: Why do people insure voluntarily (the demand- side question)? Under what conditions will the private market provide insurance efficiently (the supply-side question)?

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. 2. The demand for insurance

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved Individual demand Why might a rational individual choose to insure when the expected pay-out is less than his premium payments? If a person is risk averse, uncertainty causes disutility; hence certainty is a commodity yielding positive marginal utility, for which he will pay a positive price

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved Insurance as a mechanism for pooling risk The twin intellectual bases of insurance The law of large numbers: individuals may face uncertainty, but groups can face approximate certainty Gains from trade arise from individuals agreeing to pool risks

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved An example: Annuities With an annuity a person exchanges a lump sum for an annual payment of income for life This is a form of insurance, since individuals pool the risk of dying younger or older With annuities, those who fail to achieve their life expectancy subsidise those who live longer than expected But since people do not know how long they are going to live, such risk-pooling can improve the individual’s welfare

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. 3. The supply side How actuarial insurance works Premium = (1+α) pL where p = the probability that the event will occur L = the size of the loss α = transactions costs, etc.

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. Conditions under which competive insurance will be efficient 1 Probabilities must be independent 2 Probability must be less than one 3 Probability must be known or estimable 4 No adverse selection 5 No moral hazard Endogenous probability Third-party payment problem

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. 4. The insurance market as a whole

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved The existence and efficiency of private insurance markets The existence and efficiency of private insurance rests on three sets of conditions The demand for insurance must be positive None of the technical problems just discussed cause problems on the supply side It must be possible to supply insurance at a price the individual is prepared to pay

2 H i g h e r E d u c a t i o n © Oxford University Press, All rights reserved. 4.2 Social insurance Differs from actuarial insurance in 2 ways: Compulsory, hence Up to a point, gets round adverse selection Allows redistribution The contract is not fully specified, hence Benefits can respond to unforeseen events Enables protection against uncertainty as well as risk