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12.5 The Problem with Insurance: Moral Hazard
Social Insurance: The New Function of Government
12.3 Other Reasons for Government Intervention in Insurance Markets
12.2 Why Have Social Insurance? Asymmetric Information and Adverse Selection
12.1 What Is Insurance and Why Do Individuals Value It?
Chapter 12
12.4 Social Insurance Versus Self-Insurance: How Much
Consumption Smoothing?
12.6 Putting It All Together:
Optimal Social Insurance
12.7 Conclusion
In the preamble to the United States Constitution, the framers wrote that they were uniting the states in order to “provide for the common defense, promote the general welfare, and secure the blessings of liberty to ourselves and our posterity.”
For most of the country’s history “common defense,” was the federal government’s clear spending priority.
Since then, the government’s spending priorities shifted dramatically, away from “common defense” and toward promoting “the general welfare.”
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Important Social Insurance Programs Social Security Unemployment insurance Disability Insurance Workers Compensation Medicare
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Public Finance and Public Policy Jonathan Gruber Third Edition Copyright © 2010 Worth Publishers 4 of 29
C H A P T E R 1 2 ■ S O C I A L I N S U R A N C E : T H E N E W F U N C T I O N O F G O V E R N M E N T
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Common features of Social Insurance programs Contributions are mandatory A measurable, enabling event Benefits are not related to one’s
income or assets (not means tested)
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Understanding the economics of insurance markets
Why individuals value insurance Why insurance markets may fail
Adverse selection Moral hazard
What tradeoffs in designing social insurance
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Key terms Adverse selection—the insured
individual knows more about their own risk level than does the insurer
Moral hazard---when you insure against adverse events, you can encourage adverse behavior.
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Why insurance Insurance premium---paid to insurer In return, insurer promises payment
to individual if adverse event happens Examples: Health, car, property, farm
crops,
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Why do individuals value insurance?
Individuals value because of Diminishing marginal utility
Ie. They choose 2 years of smooth income over 1 year of high consumption and 1 year of starving --because excessive consumption does not
raise utility as much as starvation lowers it. They prefer to smooth out consumption
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Why individuals value insurance?
When outcomes are uncertain, individuals wish to smooth their consumption over possible states of the world
Examples: State1: get hit by a car State2: not getting hit
Goal is to make choice today that determines consumption in future for each of these states
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Insurance, contd.
Consumers smooth by using some of today’s income to insure against adverse outcome tomorrow.
Basic insurance theory suggests that individuals will demand full insurance to smooth their consumption across states of the world.
Same consumption possible whether accident occurs or not
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Expected Utility Model
EU = (1-p) U(C0) + pU(C1)Where
•p stands for the probability of an adverse event
•C0 and C1 stand for consumption in the good and bad states of the world
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Analyzing an individual’s demand for insurance
Assume, a 1% chance for and accident with $30,000 of damages
Sam can insure some, none, or all of these medical expenses
Policy cost: m cents per $1 of coverage A policy pays $b for an accident His premium is $mb
Full insurance: m x $30,000 State 0: $mb poorer State 1: $b-$mb richer than if he doesn’t buy
insurance
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Expected utility model Sam’s desire to buy depends on price of
insurance An actuarially fair premium sets the price
charged equal to the expected payout $30,000 x .01 = $300 (act. fair prem.)
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Expected (Utility) Decision to buy insurance also affected by
risk preference Assume a utility function U= √C.
C0= 30,000 Without insurance: .99√30,000+.01 √0 =171.5 With actuarially fair insurance: .99√29,700 + .01√29,700 = 172.3 Utility is higher with insurance Partial insurance is lower utility
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Table 1
The expected utility model
If Sam … And Sam is …
Consumption
Utility √C
Expected utility
Doesn’t buy insurance
Not hit by a car (D=99%)
$30,000
173.20.99x173.2 + 0.01x0 = 171.5
Hit by a car (D=1%) 0 0
Buys full insurance(for $300)
Not hit by a car (D=99%)
$29,700
172.30.99x172.3 + 0.01x172.3 = 172.3
Hit by a car (D=1%)$29,700
172.3
Buys partial insurance(for $150)
Not hit by a car (D=99%)
$29,850
172.8
0.99x172.8 + 0.01x121.8 = 172.2
Hit by a car (D=1%)$14,850
121.8
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Result implications Even if insurance is expensive, if
premium is actuarially fair, individuals will want to insure against adverse events.
Implication: The efficient market outcome is full
insurance and thus full consumption smoothing
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Role of risk aversion Risk aversion: extent to which an
individual is willing to bear risk Risk averse individuals have a rapidly
diminishing marginal utility of consumption
Individuals with any degree of risk aversion will buy insurance priced fairly.
If not priced fairly, they will not buy
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Why have social insurance? Asymmetric information
Insurance markets have information asymmetry between individuals and insurers
Individual knows more about their likelihood of an accident than insurer
Example: Health: the individual knows more about
their health history Insurer is reluctant to sell an actuarially fair
policy to a person with “high risk”
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Asymmetric Information Ex. 2 groups of 100 people
1st has 5% chance of injury 2nd has .5% chance
Table 2---results People have the option of buying
insurance and will do so for fair deal Only high risks take policy loses
money
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Why Have Social Insurance? Asymmetric Information and Adverse Selection
12 . 2
Example with Full InformationExample with Asymmetric Information
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Adverse Selection Problem Insurance market fails because of adverse
selection: Individuals know more about their risks than
insurance company Only those with high chance of adverse
outcome, or if premium is a fair deal, buy insurance
Adverse selection causes insurance companies to lose money
?should we mandate buying insurance? Example (HIV, pre-existing condition,
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Will asymmetric information lead to Market Failure?
Not if: Most individuals are fairly risk averse (ie they
will buy an actuarially unfair policy) Policy has a risk premium above the actuarially
fair price This leads to a pooling equilibrium where people
buy insurance even though it is not fairly priced to all individuals
Insurance companies can offer separate products at different prices Consumers reveal info on their riskiness Separating equilibrium- for different individuals
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Asymmetric information Separating equilibrium leads to a
market failure Insurers force low risks to choose
between expensive (unfair) full insurance or partial low cost insurance
Low risk group do not get full insurance—suboptimal
University health policy options
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How does government address adverse selection problem?
It could: Impose a mandate that everyone buy
private insurance ($825 per policy) Offer insurance directly
Both options have low risks subsidizing high risks
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Other reasons for government intervention Externalities
Negative health externalities Administrative costs
Economies of scale in administration Redistribution
With full information (genetic testing), insurers can identify high risks
Fairness of this discrimination? Paternalism
Individuals won’t insure unless govt. forces Government failure is refraining from helping
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Other ways to smooth consumption Self-insurance (Unemployment ex.)
Own savings Labor supply of family Borrowing from friends charity
Government Unemployment Insurance crowds out private provision No gain from government action Efficiency costs from raising government rev.
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Example: Unemployment Insurance
The UI replacement rate is the ratio of unemployment insurance benefits to pre-unemployment earnings.
Figure 2aFigure 2a shows some examples of the possible relationship between the UI replacement rate and the drop in consumption when a person becomes unemployed.
A larger fall in consumption means less consumption smoothing.
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Example: Unemployment Insurance
Panel A shows the scenario in which a person has no self-insurance (e.g., no savings, credit cards, or friends who can loan money to her). With no UI, consumption falls by 100%. Each percent of wages replaced by UI benefits
reduces the fall in consumption by 1%, shown by the slope equal to 1 in panel A.
In this case, UI plays a full consumption smoothing role: there is no crowd-out of self-insurance (because there is no self-insurance).
Each $1 of UI goes directly to reducing the decline in consumption from unemployment.
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Example: Unemployment Insurance
Consider the other extreme, in panel C. A person has full insurance (perhaps private UI or rich parents). With no UI, consumption falls by 0%. Each percent of wages replaced by UI benefits does
not reduce the fall in consumption at all, as shown by the slope equal to 0 in panel C.
In this case, UI plays no full consumption smoothing role, and plays only a crowd-out role.
Each $1 of UI simply means that there is one less dollar of self-insurance.
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Example: Unemployment Insurance
In a middle-ground case (Panel B), UI plays a partial consumption-smoothing role.
It is both smoothing consumption and crowding out the use of self-insurance.
Figure 2bFigure 2b summarizes these lessons. The UI consumption smoothing and crowding-out effects depend on the availability of self-insurance.
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Lessons for Consumption-Smoothing Role of Social
Insurance
In summary, the importance of social insurance programs for consumption smoothing depends on: The predictability of the event. The cost of the event. The availability of other forms of
consumption smoothing.
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THE PROBLEM WITH INSURANCE: MORAL HAZARD
When governments intervene in insurance markets, the analysis is complicated by moral hazard, the adverse behavior that is encouraged by insuring against an adverse event.
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THE PROBLEM WITH INSURANCE: MORAL HAZARD
Consider the Worker’s Compensation program, for example. Clearly, getting injured on the job is the kind
of event we want to insure against. It is difficult, however, to determine whether
the injury was really on-the-job or not. The insurance payouts include both medical
costs of treating the injury, and cash compensation for lost wages.
Under these circumstances, being “injured” on the “job” starts to look attractive.
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THE PROBLEM WITH INSURANCE: MORAL HAZARD
By trying to insure against a legitimate event, the program may actually encourage individuals to fake injury.
Nonetheless, moral hazard is an inevitable cost of insurance, either private or social. Because of optimizing behavior, we increase the incidence of bad events simply by insuring against them.
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What Determines Moral Hazard?
The factors that determine moral hazard include how easy it is to detect whether the adverse event happened and how easy is it to change one’s behavior to establish the adverse event.
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Flood Insurance and the Samaritan’s Dilemma
A P P L I C A T I O N
When a disaster hits, the government will transfer resources to help those affected. Since individuals know that the government will bail them out if things go badly, they will not take precautions against things going badly.To reduce taxpayer-funded federal expenditures on flood control, the federal government established the National Flood Insurance Program (NFIP) in 1968.
• Areas with a 1% chance of flooding in any given year are given the option of buying flood insurance through the program.
• Following Hurricane Katrina, it was revealed that nearly half of the victims did not have flood insurance. The claims from those who did have flood insurance bankrupted the program.
• Failures of the NFIP have many sources. Among these is that many individuals opt out of paying for insurance.
This is a classic example of the Samaritan’s Dilemma: If the government is going to continue to help individuals in disasters, and people are not required by law to buy flood insurance, then why buy it?A solution to this problem would be to mandate the purchase of flood insurance at actuarially fair prices in areas at risk of flooding.
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Moral Hazard Is Multidimensional
Moral hazard can arise along many dimensions. In examining the effects of social insurance, four types of moral hazard play a particularly important role: Reduced precaution against entering the adverse
state. Increased odds of entering the adverse state. Increased expenditure when in the adverse state. Supplier responses to insurance against the
adverse state.
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PUTTING IT ALL TOGETHER:OPTIMAL SOCIAL
INSURANCE There are four basic lessons:
First, individuals value insurance and would ideally like to smooth consumption.
Second, insurance markets may fail to emerge, primarily because of adverse selection.
Third, private consumption smoothing mechanisms may be available; to the extent they are, one must examine new consumption smoothing versus crowding out of existing self-insurance.
Fourth, expanding insurance encourages moral hazard.
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PUTTING IT ALL TOGETHER:OPTIMAL SOCIAL
INSURANCE These lessons have policy implications. First, social insurance should be partial.
Full insurance will almost always encourage adverse behavior.
Second, social insurance should be more generous for unpredictable, long-term events where there is less room for private consumption smoothing.
Third, more moral hazard should lead to less insurance.
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Recap of Social Insurance:The New Function of
Government
What is Insurance and Why Do Individuals Value it?
Why Have Social Insurance? Social Insurance versus Self Insurance:
How Much Consumption Smoothing The Problem with Insurance: Moral
Hazard Putting it All Together: Optimal Social
Insurance