Barr, N. (1998). 5. Economic theory 2: Insurance. In The Economics of the Welfare State (Third Edit., pp.

108
128). Oxford, UK: Oxford University Press.

.:.dNillbeeii,
::ntormatio

5
CHAPTER
EconomictheorY2:
Insurance

:. :risht d r,
' :::.n l l L l l n

i n shi ch rhepl ateri \ permi rrd

l n ru ra n .e ,trA n i n s e n i u s n ro derngdmeofchan' c

hei' bea'iniSilL"J::::i;j!:[l'i
ic'ion'h.t
"'nl'i"..'i.i"nr".on!
'"

1. Introduction
meandiflerentthlngs'
The term'insurance"is u sedby differenrPeopleto
. asa devicewhich offersindividualsProl'riondgdi'rsl/rslr'or
privrt'
. as an actuarial me.furtristn(equation 512)' normally organizcd in the
'lhefirstdelinesinsuranceinterlnsofitsobjective'thesecondintermsofaDlethodb\
cernIn'
be pursued Erer wherein stittltionsaren oi ln sura
,"hi.lt tlt"t of1".tit'"
-ight stili be regardedas insurancein that they offer lrrotectior
,L.t .tgit
."...J.."*,
agaiNt risk.
'It
suchasburglnry'death'or 'n'
ispossibletoinsureagainstnrarrycommon mishaps

il1
holidavdeposirstostthrougi
Jil;;";;;i,'sti;',"".a"u".,1bvbad 'ucothe''nndfor
*t nl tTI:i:^:j.1:.lI:''
foro"
i ,.'.'"* p""iur",obuvlifeinsurance

"" 9"C- a representatlvc

lndNlou.
"".*
companiesusuailymaker profit thus
culiorrs,sinceirrsurarrce

..ccit.st.rrinUen.nti"thclongrunthanhePaysincontributions,
"i"i j'..,;*
\ hJr'''
*" ou('rio'r':\ lr\ du Pcuplcin'rrre'olunrarilt:an'lundcr
r'\Pe
'"
.l , r.'... r1'c1r:,,'e|tr,rk' 1r"'idern'r'rrr'e? Ihe'eq'r(niun'(orcefnr'lg
in sections:
tupply iides ofthe insurancemarketarediscussed
,n:.1'.irl" J..rl"r
will ciilt:
equilibrium
".a
.ircumstonc"" in *hich a market
-i.ction + **iae.i ih"
"nJ:.
\ r : r . ; i1. . : .

f . r ' unnnddr c s n t o t t h 'a r s u m 'n i h r h e A p l c 'J r a r t h 't n d o i r h e r l i a t t e r

:: iinB ur

5.lnsurance
class
of amoreSeneral
areexamples
discussed
rient. Marryof theproblems
rn problcm (seethe Furfier Reading).The p'rallels rvill be noted aswe

for insurance
2. Thedemand
2.1. Individualdemand

.a
L
{

pay outislessthan
r:: a rationalindividualchooseto insurewhentheexPected
_:.rmpavments?
The answer,ifhe is risk averse,is that uncertairtylc].secauses
ir:., re;ce certaintyis a commoclityyieldingpositivemarginalutility, lor which
5*t1--.:. r positiveprice.The formalargumentstartswith thedefinitionofa dsk-averse
ai someonewith diminishingmarginalutilityof income,asshownin Figure
Hr..:.:i

y , yieldingutility U(/r), anda'god'

!.J. i-rose thereis a'bad'outcome,
":t":i:'
Theindip' 3rd p., resPectivelv
probabilities
with
n- 'I.irs utility U(r.), occurrirg
utilityarel
'o.1 :3\Pectedincomeandexpected
(5 . 1 )
income:n(/) = , = P,Y,+P./'
tsxpected
= U = p,U(y) + P.U(.y.).
tsxpectedutility:E(U)
= 1100,and
1 : = p. = 0.5, enpectedincome,1, is midrvaybetweenI and ./, (if /!
=.1,669,11'."7 = 1553);ardexpectedutility, t, is midwavbetweenU(t/,) anj (/J'
'
:: is importantto realizethatarisk-averseindividualcan obt6in the utility U intwo
.::irel,v dilTerentw6ys.
. It couldbe obtainedasthe erPd.r.dutility from an uncertainincomeof/, orlr' Note
dirfter)',orJ',with corrcthar the individual Deverreceivestjeachyearshereceives
(or
outcone jst.
averagc)
expected
spondingutiiities tI(1,,) and U(/.);the
. ,{lternatively,shecould obtain t from a .s/t in income 1*, as shown directlyby
the uiility functjon in Figure 5.1.[fhcn a personinsures,what she is buying is

Sh
'li
rhii ir
rdual

tPe.
onsl
Eist.

\ rationalindividual$'itl be indifferentbctween(a) al] erpcctedincomel arisingfron

:ncertainoutcomes/jandnand (i;) a Iowerincomei,*,$'ith certainty.Thevalueofcer
:Jrnti,, thu,

v = , _ t,
rnd a rationalindividualwill paya netprice,@,solongas:
Q<V.
:Ior anint . du. r ion, s c c ! $r handlaid l e r ( l e 9 i : . h . s ) , ! i r i a n l l 9 e 6 : .lhl ) , r l d t h cr u i t h e r R e a r l n B

109

Concepts

,|

,|'

rn.orle

1"

individual
Flq.5.1Thed e m a n dfo r i n surancebYa fati onalrisk-averse

premiums'
aid net incomeih
Tables L Gro$ andnet insurance
goodaid badYeaB(l
li.o m e ,iBu m n ceP remum and oenelI

4 . N e rn
r c o ml (erl (r)rl 3l )
5 N dP rd i u m((2) (4Jl

Coodvear

*o r *

LO00
s50

r00
550
900

450
100

r00

the grossprc'
Thc net price of insurance'd),shouldb c'trefullvdistinguishedfrom
chargsan
mrun. the rlifferenceis sho n in Tablc5' 1,$'hrethe inslrrdncecompany
pr.mi,,nt uffSSO,andcornpelsatcsforupto t900 oflosl inco-nc in.a'good'Year
r'U lcJ\inPr rr('
",*u,rl
Pd)'i !'o" Prc'niLn.ul l
rrr-,-rr r'l,. 1-.'.'nir,'n1.ol t' rr00..rnd
i0r'urr(cr!c'
rr."rnri'I r00 'h( pJ!''rfrerrriLrrrrulI
' d '<.rl-a
o it. IFL\ l5e r'l'r!l
irr'ur.'.l.ci' l" gudrdnl('J n<l InruTe or
., it
|
^l
^l
:1i
pa'v
average
Irc i.r f.r..1iLrn. o. is thediffercncebelweerthegrosspremiumandthe
r,ui T:r irrl:: l. thr indn idualt erpcctedloss

ttL) = lL

110

(5 . 5)

j:ff :1ij.tfiil:,x'." ross,

Z,times
theprobabiiity,p,
thar
it wilroccur.
;H"

:.,

p.n.D l

;'i:i1i.:!l1n.nri.r
lr
li;:
^i*ifilli#",",ffi
:i,l:":1il.:""":;i',i*:il!;,,1|;1,::,;;::;,.,,,rq.,.,,,o,,
i {,we,.r,,n
.rh"
-.hi. L,;rl. s,.* p,.rium. rnrheerd,

'r.br

2.2. The natureofthe

product:

Insurance
asam".t uni.- fo.pJJting.irt
l::I;i,:ll;.::ii,'i):;::iffiT::;i:lii::l,hrgenLr'rb.<n..Jgain,,romrrudc
i"' ;9o'rr'4"t'.".,ppro{imdrc
"ll'o* tr" *, 1"""" r,",i")l'llli;

-jl^i'l;l'
.H,ff
ii:J;flii:;";:*jii::lr * ;';;::J;t;ii,T:T
l;:,#;;;:
;"a'
.ri,",i",;
-:#;;;*ln{:rjt}il:,li\:L:;:;11il;1;1;".'c..
he,e
dr(N.".h
.ii;

:::;llr,,

;";;;;;;;:,
;lf ?il.];,J:
il:J.:,1"::::;li;i

.' ,;#;,il1,y,
l1]ro',lo""t:".:*esameprobabilitydNrributionofoutcomes.
for eachindividuat
arejndependent
of rhosefor everyother
Intheahseneeofrn.urance,rhe!Jri:n._,,

.".",*ppo."
o,,,il^;;:,:;:iiiJ::l::;:i],i:.Ii:T
:i,lil,l;jl,*i,,;;;;
.

_l
.Y= i (.y i +

f1 + .. . + yI).

ls.7)

Thispoolingisaformofinsurance.Thevarianceforsocietyis
var(/,+/: +... +/") = Nv a r(J , )
nn.edl in(omes
arerndeFendent
andhaverl
ud,vi
dL,al

i*m,!e,He.:.il.il:: ;;:,;"."#:
)li,ll;1,,u.,;,F",n_*,"'.,n"

111

Concepts

\.ant) = va(( !!

+ L. +
I NN

.+]

'-'(#)

var(r,)
=___r__,0,asN+_.
N
Wlrat equation
shows is that, if N idcntic.r y disr.ibured
and ,.**"5":]
,(5-ti)
tncomesarepooled,
rhevariarrceof averageincome (and hencethe risk
to tlr.i;vid_

zeroasN rendsto infiniry:Bybadins,(i.e.poolins),

i;;t;;;;;-"
:.lll.,lends
:9
acqurecertainry

2.3. An example:
Annuities

iff il::..,';:*iliY ;:::[:'Ji:fl il;y:r

sion

rorm
orpooring
A'individuai
cou]d

t*
stream
fortheresr
ofh",lif",,)..",,,
".',1t;T,h,'J:1,'::1:,1;';:"J:fi::*t'"
A =y+-\a
1+ r

/
n
(1+ r)'

(s.e)

More generally,the capitalcostofagiven inconrcsrream

rs

A=Jlyn,a.

( s.10)

Considersomeonewith t50,000accumulated
in pensioncontibutionsoverhis
workinglife.Hecouldfinancehis
retiremenr

i,.:

Lri ! ii-l-

.:_i lubic.r

*J.*i,|r,,'J,T.::1il:',*:*:i;:T;rTiili':ii::3."

1il1'Jii""l:l'Jii:
il'-'"Hf
ililTTl?*i'.T,i'J":ijiilJl':"lHi#,liiJ'ffi
a-p,
a",a
r,"ro,.,,
u'ilr;;;;.i;;;;;i:::il""'.i::I::i
",T"1::,ilJ:*T:11

lii!fri:,1r:.'#;:"::,*:H1*jtl:Ti,'J.HT:T*ili1a

canpay for th long lived becaiseit is based

on averagetifOerpectancy.
Hor.large is the annuity?Equation (5.i0) can
be rewrirtenas
y=g\4,4,r)

( s.11)

;tl:iilffi
:"i;l-*,:
ru:"im:il:i;.:n:**;
iT:...Ti',:i',i""'T
sc.cullnand lonesdges:c|.61oi sliglir (19s8:ch.
r0).

'|12

:re probab

5.lnsurance

(5.8)

The insurancecompanywill pay a lower annual income the longer it

rF ExPEcrANcY.
spects to paybenefit.In princiPle,this dependson fourbroad factors
he hasto live and the smallerthe
.{ge.Theyounger a person,the longe! on average,
innuity in respectofa SivenlumP sum.
men.Otherthingsbeingequal,awomanwill
sr,t.Onaveragewomenlivelongerthan
jrerefore receivea smallerannuity than a man ln practice,many pension schemes
:\rol acrossmen and women, not leastfor the equity reasonsdiscussedin ChaPter9'

ndent
tividb can

-.tion4.2.
Hedhfi.With annuities,itis thelongiivedwho are'bad'risks.But it is easiertodetect
ieakh problemsthan to prove theii absence,hencecompaniesusually pool across
ivhereit is theshort-lived'
isihh for annuities.Thereis no suchpoolingfor life insurance,
rnen with detectablehealthproblems,whoarebad risk.
-\Iaritalrfatrs.\Vherean annuity is payableaisoto a survivingsPouse,the agediffer:n.e betlveenhusbandand wife becomesrelevant.Ifl retire at 65' and my wife is con:rderablyyounger,sheistikely to oudive me by many years,in which casethe Payoutpedod,
r. is longer,and the annuitycoirespondinglysmallerHowever,whelea schemeis com-

could
'pen-

?ulsory(e.g.apensionschemeforschoolteachers),insurancecompaniesusuallypool
.!-ross men aSed65 irespective of the ageof their wives This is feasiblebecausefor the
the averageagedifference is Predictable-'
-ErorP

(5.9)

5. 10)
r hls
herelplus
nak
atery
gous

tund

If changesin the pice level are not to affect the real value of an annuntEFAT!oF
'NrEREST.
ofthe nomrateofinteiest(i.e theexcess
iri_,it is necessarytobasecalculationsonthercal
has
accumulated
alump
iral interest rate overthe rate ofinflation). Supposean individual
=
('t
l2) and
live for l2 years
.umoft50,000, andtheinsumncecompanyexPectshimto
anticipatesa realrateofinterestof 3 Percent (r= 0.03).The actua.ialvalueofan annui$ is obtainedby substitutingthesevaluesinto equation( 5.11) to obtain a valuefor /.
The subjectofannuitiesin the contextofpension frnanceis a major topic in ChaPter9

side
3. ThesuPPlY
3.1. Thesupplyof insurance
the price at which the Privale markei will supply
This part of the chapterdiscusses
insurance,and then turns to a number of tcchnicalProblems.'

i.l 1)
I the
f,ted

PREMTuM.
Supposethat I insurethe contentsofmy housefor t1,000,when
TfiEacruARrAL
probability
of
being
burgledis l per cent.From equation(5.5) mI expectedlossis
the
'Ihetactthd:rchs.tr.ncsare@npulsorlisimportanr,anaPetrdncu$cdjnnroredduninscctions3.2and42
nndRces
l),Si8lit?(1943:.h.12)'GrlErll99:r)
' See,inas.edingorderoadim.LJly,strrchddlandHilL{1997:.h

113

Concepts
The
the insuredloss,I, multiplied by the probabiiity,l,' that I lvilt experiencethe loss
(r'e
l
per,vear
payout
t10
to
Per
insurancecompanyknowsthat or averageit $'ill have
centoftl,000). The actuarialprenium for the ith individuaL,z" is then dehnedas:

n , = (t + . 1 )p , L

(5.r2

wherep, L is the individual'sexpectedloss,and (1+a) is the loadingwhich ihe insur

assess
the
ancecornpanyaddsto coverad;inistrative costs(e g sendingan expertto
a
in
damage)and'norrnal pto6t. rr is the price at lvhich insuranccwill be supPlied
competitivemcrkctThe actuarialprernium in equation (5 12) restson a rumber of conditionson theissueo1
probability,p,.Someare strictly technical,othersbring us directlyback to tb-eperf..t inioi-ation. Problernsofeither sort can makeprivateinsuranceineflicientor
impossible.
Private insurancerequires,lirst, that the Probability of the
PRoBAslLlTlEs.
TNoEPENDENT
insuredevntfor any individual is indepeldent ofthat for anyoneelse'This condition
becauseinsurancedependson the existencein a given Period of a pre
is necessary
probabilitiesare
dictablenumber ofrvinners and losers lf, in the extreme'individual
Thus actr'rarial
else'
completelylinked,then ifone personsuffersa losssodoeseveryone
shocks
insuiance'cancope with irililidrcl shocksbut not with 'ommo' or J-J'stemic
in Chapter9' Section3) isinflation'
An important problem under this head(discussed
schemc'Ivillaffectall
pension
which, ifit affectsanyone memberofan actualial
oNt.The relevantprobabilitymustbe lessthan one lfnot'equatron
PRoBABTLITYLEssTHAN
(5.12)simpljiiesto:

r= 1 1 + (x )l > L

( s.13)

th e insurcdloss l mighl, for exdmPle'havetopaya

anclthe actuarial premium exceeds
lo*e'ol t l 00U Pri\ile in\ur
premiumolil.5ri0loin\uf<.gJin'l Po'entid'hurgran
il ln economr(term'lh{:re
an-euillnorbeo|fercJbc'autrherewillb<nodemandlor
ri'k. Jnd hen.eno g rin' ir"m Lrade'
i\ no oo'!ibrlitvol 'pre.rdinli
ufillh<Jth i'<qL'al
hronnall'ill s her(rhcprubdhihrv
foirhe.
problem
ari'<
crn
Thi'
insurto one ;nlcss insuranceis takenout beforethe condition is diagnosedMedical
theprobabilpreciselybecause
coverfor pre-existingconditions
arcc usuallyexcludes
is too high to insure.Advanesin Seneticscreeningwillcreate
treatment
needing
ity of
niajLxproblems:the moreandbeitertheinfbrmation aboutaperson'sfuturehealth'the
g.eatci th. ett.,tt ofp.. e){isting'and henceuninsurable,conditjors (seeChapter12'
BarI I995)
Section3.I, and,for fullerdiscussion,
\\'e ha|e seen(Chapter4, Section3.2) that marketeffrciencyrequiresperfectinfor m.rtion on the P;rt oiconsumersand firms Firms may faceproblemsin a number of
not be wcll informed aLroutthe quatity of labour' nor lending,ru'., emplo'eis
-ov
borowers A particularclassof
th. ,tegreeof riskiressof prosPective
insiiturion,
"bo,,t
infornralion probli'm concernsinsurancemarkcts'

114

5.Insurance
estimable lnsurance
The relevtnt probdbili!y must be koown or
srchr. ,qoBABlLlTlEs.
(the prviouscondition) no'*'lf
.,::':.:i. risf, bu! cal1nolcopew]!h "frdrT rl
X1:":

it i'
,.. :.'.'"r..'. lr 'hcrr''ur.rJ.c'ror knosrh<p'ol'Jl'rlir! l.l' P."':'ll1i
1'2

o' ''"
!n,'n,h.'m(ql,n'I
:li:l,l:liilll;;lll,i"ll;li'"^.",;

-'.

;j,;il'lll;:::;l:n::*:lll:
l:'ili::l:;T;;ilL}::iil;;

::.ofltlacrs hich indcnpcnsionsagail

..,,.,r..iL","".ii.".,r,eprobauiritvdistriburionorl]fi:::i:*:::?ll:iH:::li":
ar
-::::r9,Sectionl1) Si ;Larproblms
cr 9, Sectiorl3 l )
.' -;ri

,l'::iil::':''l'J""il1;;
:=:.i::*ff ii:ll;iil':il:fi:l:f,'.:i::'i
-,.;hitsh','t-ro"erilr'rre
rnli:,elo;'lii:':'iJl'I[J:;:i:]l
h(i..1
:. .,
l,A'

,',

".-,'

Jn on'eJr fom
n." ir' l h<rorn'crdri'<'\l'cr(rhef rf'h r'J"

-,,h?,
iisurersA
I ..-::.rlillhealthfrommedical
reishitlttenaction thdtis'situations
*'r"'"
,,, ,;i;,,;'"','"il;;."t}lo'"'a
'rr"
-i""'

:',.;r.:,tir
illii:i::ili".'#:i:T:
:i*rujt*.lx::^:"i:::j:t::il:
*'
1ot*J:-;'.*i,H:,Til:t
-..,.f 12,5..1i.n: rlirhustrr$obabiriq'ra
generall,verch
:',: .:.lualmcdicalcoverwill

information
3.2. AsYmmetric
about thc Nel. ::i. relcctionanil moral h'lTarclare centralto efficienc'vargnments
r -,lrte,andsomeritfurtherdiscussron'
moregcneralconceptof

is a manifestatronrn lnsurarcelnarkctsofthe
rt,lisESELEcrloN
*.-lii;;;i;;it;i;i
tly
i9ea
be:'er
anruch
m:'vhare
ii'" pu..r'"'"'uri"'u'"nce

it-

;:'.,i:lli'iii"liii'.'il:.*.Tl:
,,-:xr**m:*:J:;;,r'xxlll
.o-p"tit;". *'Tl;o.l-l

:-::-.tiv informed.

s".i"rt

-"i*"'t

:'ilii::
:'X):i:lf,il:i::*:
una*
iun""'

*1.r".".'."'r
' .::.i1iiffii"i1i:'J,i:.11il;.'.ifi;lm;;,"
individual$'ill insure
-,;;i;;;;;pt;"'

(e g

costs)'a rational

'o-:dministrati'e

:;iTllillJiiililxl"'lli'lli.:l;::l:i:ii::lliiTi":iil',',;lil"'"'fiiilll:ii'j;:iil[1fJii"i'"'i;iil:;

\
wh\'$(Lee
7"'rrinBfrand
,'e,e,.,r
' It:ll,1i,lli;1Lj,i"liL"".i:ill:.1,;j''i'l'lY:'""',li1l"r,.*,,^'"*-,

' :

l u l lr r ( l9 9 ll tr n llRr ' sr l9 3 9 l

115

Concepts

Indiff*en.e cuats for

Fiq.5.2.Effectsofadversesetectionon a competrtiv
equilibrium

*j',til"-li:1ii:?llill:i:1.,':;..:::iJ.:"-'urn)wi,,bethesamervheni,,aswhe.
groups
orpeopre,
io,r',isk
witha
.'ff#,ii:1ii",i:'ifi,::'r'r',h'*i*if""'" vo

i''*.",.*
a;.,,,
g,iif
il;;ilil*Ji;:;ill!:iil:il3;i:..ff
ji:
:;x111'll;il:l:

individualrisk.Thus:

E L= l t+

d)?tL.

E = \l +

cx)pH l .

tlii
n:liii:d:ii{fi::T#l+F_:T.":}:_""':'i:Tf:,t

,ndl idua
.rn inilue
doing.\\l
kno\{led

rfuir;:m;ji#rriinft
i{[Tr*riTl[:,:i:.*:HH;H
116

canno'f
dis'[insuishhish
+il#i#'fr#ifi*#s
""'"'"-'l^--",'
base<J
_ = ,,-,.
",,il,T,,r];ium

o'averagerisk:
_.

rfjt;1li[[{r*rr-:}:;iU,*U:*il*di
rfjy3l":il*lklifi,;i;ll
r1[f,ki::l;r
:j^,;j;.:i!l:,.
i;
lrr
j
*lt;,i.::l:ti;i
,:.
:,ll:l:r;l;:;;":tni'lFjl_
.l;Jill;t;:
:;:J;;,.;:Till,
;"+tit,"..i',.i,jil
l;i:"1i1",.,,#li
ln

lii::i:rli';l:'lil
t::,':t::;';:'1,'::f
411;t:
.,:il$,t:,
r::l';;l:x;"
:
.,:i'fi

:;"';iil:*1,:
,ut:iii"il}fi;if
:[i:;
:,,.::?fl
j:[
::i.:

:li,:
l;l$:*,,*i:l,:lltlIilT[iir;:t]*jfu;

j:;iiirr':-':
nr'T*T
ftHi[i
":rt*'ruTlJr:l
i$
,;.,lxl
.i:liil::',l
i1i1:;;:i;l;

:: l'::l,;;;if ii,:,:_,,.,1'*:::::l
l:l
;u:,,

;:n:;ll:r,:iiH:rt
l jfri:iiilil
ir: r;*,:*
;imli:

i.li

rt..
tt ri:.
mf-

tc..

t-*ir,+*imi#,3,igd
jr#
l
*1hi
{il",r}
*:ii:l
:lr#li;t
;
i[*H,
::ll;;";:;:::;Tt"1:::;:n
lil:*ml;;:;fJ,
:ffi ;:l^::
ffiil
117

Concepts
activil)',:'
on l Prelentivc
( 1974)considers
lhe caseofindividu:lexpcnditure
PalLly
Fronasocia]PoinIofview'Ih'
of the in s[redeverI
$'hichcar redu.etheprobabilit,v
cfficientlevclof:is rvhcreits m.lrginalcostis cqurlto thc marlildl rcductionin insurcd
losses.Br.rLif lossesare fiLllyinsurcd and the insuraDcecomPary crnnot nronltor nr
actif it\', the prival inccntiveis to spcndlittlc or nothing on it
dividual prc1.nii\,
pcople,in shorr, will bchavedilTcrcntlvil thcy are inslLred.At ils simPlesl,mv e\trJ
spcnding on z reducesrn,vprenium b,v onl,van inlilitcly smirll amounl: the main
peoplcwho now pa,vslightlvlo*'er premiums'Asa resull
arcotherinsLLrcd
berreficiaries
ol lh is t)-peL)1e\ tcrnalit)',t'aulyargues'individualsfacePrilalc i n.entilcsto under Invest
in prevcntivecclivities.
xlllosses,i"l'd
to oneslrongasNmption namch',thal
l'aulIt.rnal)sisissensilive
xrc sevenlPos
is
relir\cd'there
lfthat
assulnption
insurable
losses,
are
material
irg n onpsrchic
ofuninsurable
ellects
one.
To
sho\rthe
sis
only
sibleoutcomes,oftn'hichI'nuly
it isusefullo distiDguishtbur cascs'
Iosses,
p,, b 1 t)tly nt suhst' tht Pqrhic cost An examplc is suiciclc
Cdse): EnrlagcnoLts
Here thc problen of morat hazardis iDofe aPParcntthan rcal. It is possibleto in'
fluencerhi' probabilit,vof dvjng, but gencrallyonly at a high Lrtilitvcosl lo the Person
concerncd.Peopledo not conrmit suiciclc.rnl/ to nlahetheit lcgateesrich (It is lrrc
th.rt somconeirtending to commit suicldcIrr orlrerrea.sos night do so; brt that is a
proble of adverseselcctiotl,lo deal with thich most policiescxcludeco!'erduring
indiljdlirlscannolinsureagdinsttheps)chiccLrst
ihc firstIear of thepolicy).BcrLrsc
se
ofdelth,insurancei! irrcolnPlelel\{oralhazardin suchcascsdoesnot car'r
to themseh'es
p,,Irith no s bstdttLij'lpsy&i. cost Peoplcmight drivc lesscarcCdse2: E dogcnaus
cost
fulhil thc,v.rreinsurcd,orbu! fi\\'er fire cxtinguishers,sinceirsuranceredLrcesthe
rL'sultholds:
thc
Paulv
ln
this
case,
mc
er'
ents
unrselco
of
thosc
to the iisured individual
inel6ciencv,silrccPeoplc
iilpossible bLrtcaLrses
nroralhczarddoesrrot makiDsLrrrnce
thaniflhcvhad tobcarthelirll lossthernsch's
takelesscarc
Ctlse3: Endt)geousp,, tith substantit Psf.hic!di,-r' This is the cascof voluntarl
pregnirncyor eiectivchealthcarc (e.g.a hair trrnspl.tnt) Here the insure" '{)u1(olc ]s
e act of conslrmerdroicf lnd ivjdl''tls
s cvcnt bul ir cleliberal
not arr undesiredexogenlou
, in cquation(5 12)'rndtheirslrrancecoln..1nconlrolatsmallcosttheprobabilit,v,l
no r the I cllr.tr irl Pren ium This is afar cr,v
loss
cr
the
e-\pccted
l,.rnycancalculateleith
for indilidu']ls'thor'rgh
gencrall,vuniDsorabl
iiorn.rn nrsurablcrisk.Su.h activiljcsarc
rhc pnrbLun crn nltrlelimes be sidcsteppedlhere irsuranc i5 compulsory lf, for
the
schcnte,
rc join a Parlicular
*.rlnple.rJlrorhcrsin thcstcelirdu*ry arecornpelled
nullbr
ofbirths
criPecled
avercgc
based
on
thc
pooling
solutiolr
lnrpos.'.r
i:'urcr t,rr
ln .rintr.\r. il jrrrur.rncewercl'olurliln', a disProportiondlenunlber of inltelding par
ast'ell asmor:l hazarcl
ofadvelscselection
cirr. ishIoif . I.ri\ingissucs
.. ..f,r

118

nri .l l i TrrJ. !. !L,rrlt

l el rr).R r$i l 939l ,trl -ul t.rl l 99l i .

Meacdvirl,:,
t of view,rhc
tn in insured
monitor in_
ing on itL the n]aiD
nder-invesr

e psychic

s suicide.
Drto inIr is true
I thatis a
r durirrg

tllecost
tholds:
people
unlary

=*-5#f#,*+rr#r#*;if,
tr*Hfi,'#,,,";:

xtin:Tj:r:1,$"#F'.:}:}:$l:{:T:i
fi$d.}:j,'.|;
=;:"ru:nli:l*tiil{i*i.li##f

"".T""".dili[#*i[i::,":
'l,xr;::;,*:lir*it]:#.{'Jiltl.l*:l:;rj*iil$fi
H::::
:#::;T]:,
ixi",:.l;*:.{{*i:Ti*X",::
;*;n[i*i.:#Ji

*
ff
*J;*1ilHffi$*lilill
l-l*
t!,'.1
rl#".Tnl:
il:sfff
T:jJ:
::
::Ii:i:""Jllt'tl.,".f
tfl
t;;;;
fffi[J;i#'

':[i';:"J:::.1

."frft'ftr*tl*Ir*ii1x*-lrf
*f::**
. Frequentclaimants(e.g.
accident-pronecar drt_\,erc)
payhigherpremiums. Ded,rrible,make
rhcinsuredper,onpar rhefrr.ti_(ofanycl.rrn.
. w n,o/rsrrda./lhernsured
perronprr. r percenlotan) rldim.

races
theindividuar
niththerr r marsinar
nnanciar
cosr
or

iduais

):ffi::1'i:;iiff:""

ar cr,y
ough
f, for

t'TrnrT#fi
il.:,i:;::':':illii$i*l:r,:#::
ii'j,::::tIi+

inhs.
par

119

Conceots

4. Theinsurance
marketasa whole:Privateand
socialinsurance
4.1. The existenceand efficiencyof private
insurancemarkets
THE
ExtsTENcE
oFpFtvATE
tNsuBAr{cE
MAnKErs
requiresthreeconditions.
L Theremust be positivedemand.Fromequation(5.3)rhis requiresthar

v= y f*> 0.
This condition holdsonly if someindividualsarelisk averse.
2. It must be technicallypossibleto supplyinsurance that is,none of theproblems
previouslymust makc privateinsuranceimpossible.
discussed
3. It must bepossiblefor insuranceto besuppliedata price which rheindiriduai is
preparedto pay that is, the demandprice must exceedor equalthe net suppl),pric.
From equatioD(5.4)this requires

v= , - r . > Q.
Equation(5.6)delinesthenet premiumasthegrossprcmium,n, minustheexpected
beneft,pa:
0=t

--

pL.

Hence,tion,lequation(5.12),

+qs:
Q= oPL'

Thus,a marketfor inslrran

ceexistsonl) if
t

f' > dpL.

t5.t7)

Insurancecan be suppliedat an acceptable

price only lvherethe individual'srisk aver,
(reprcsented
sion
bythe differencebetweent andy*) k sulfcicnt to coverthe insurer's
idministrative costsand normalprofit, shownbydpL.
"=..
sHorJLD
rNsuMNcE
BEcoMpErlrvE?
ThethreeconditioDshold for theexamples
ofpivate insuran.e in ScctionL Considerthe caseofa headteacherwho wantsto insureagainstthe
Lossto tht' parish if it rainso n the da1'of fund raisingcvenr.Sinceshewantsto insure,
it tbllorri that sheis risk ar-erse,
hencethe demandcondition holds.Nor aretheretech
ni.,r1problens on the supplysidejthe probability ofrain on a givendayis known and
1s!thrn one:1hereri no ad\,erseselection(sinccshecannothiderainfall statisticsfrom
the in:urtr ;nJ no nroral hazard(sinceshe cannot influeneihe weather).FiDally,
't20

5.lnsurance
|tEi:rjrrative costsarelow, sinceit is easyto establishwhetheror not the weatherwas
r.! L-rJ'oir'ur.rncecinbeproridedat a low rrcrp'i.e. I hu' privarein"urrrr'cit tech
r=a-'possible.
! :rmpetitil'e insurancedesirable?It wasarguedin Chapter4 that an unrestricted
!:n i:. marketallocatesresourceseflicientlyprovidedthat the standardassumptions
**t: Theseconditionsappty equallyto insuraDce.Perfectifformation is relevantto
rr:r.e rrho bu1.insuranie,and to the companiesthat suPPlyit. where both sidesof
!E::arket arewell informed,competitionprovidesconsumerswith their desiredtype
proiits ln such
flr :r L\ of policiesand ensuresthat suppliersmakeno long-run excess
:r'e.. for eranrple.autumobilein'urdntednd burglarl in'urance-comperilion i'
rr: possibleand desirable.
condi
:---ertrengthofthis argumentis not diminishedbythe factthat the necessaiy
insur
actuarial
rlj.ido notalwayshold,creatingareaswherethe casefor comPetitive
ri\: r! tleakerol non-existentThreetypesof problcm standout'
laee4?'h nlormed L^uncr< \\ilh long-le'mcontra't' hurersmrr not be
.:i! informedabout the detailsofthe coverthey willneed manyyearshence(e g long
E:::1 residentialcare insurarce); and with technicallycomplcx contracts(eg pen
nrri )peoplemay not understandthe issuesfully. In someinstancesthe market may supPly
:e relessaryinform ation,for example,th rough insurancebrokersWhereinformation
:r.-blemsareserious,however,th e benentsfrom comPetitionarediminishedand may
,.r-gelvdisappear.Competitiveinsuranceis likely to be ineflicjcnt;it may also create
aretaken
pensionspolicies) Theseissues
-:equities(iorexample,inappropriatelysold
:; in laterchapters(seealsoBurchardtand Hills 1997).
). Inpert'ealyinformeclinsarersThe resultingproblemswere discussedin detail in
cancteateproblemsin the fonn ofcream skimming'
:cltion 3. Competitivepressures
and third-Party incentivesto inefficienttyhigh spending'
:.apsin coverage,
From equatior (5 12), the higherthe administrativeload3. A()ministrutirecosts.\'
xg, d, tbe lesslikely that peoPtewill buy insuranceAs equation( 5.17) shows,the eflect
ot ais tod.i,r. aweig.b.tween people\ riskaversion,t /*' andthe netrctum,pr, thcy
ierive from insurance.As a result, risk-averseindividuals,whose welfare could be
:ncreasedbyinsuring,do not tluy insunnce
This orltcome is not necessarilyineflicicnt: an individual's risk aversionmay be
rnd snm.idmini'rrrtir r cn't. areun.roid.rblclh(,rdmini'lrrli\e(o'l''r'\u(i
'liehl.
ai;d with individual policjesincludei
. marketingcosts,e.g.advertising,serdjngoutappiications'etc'i
. processingcosts,e.g.the costsof matchingpremiumsto individual risk;
' reimbursementcosts,i.e the costsofprocessingindividual claims;and
. forgoneeconomiesof scalewhich a largercornpanymight enjoy'
(199,1:
156 7l
'" Fortulierdi$u$i1.,seeCul,vcr

121

Conceots
Thesecostsare efficient (and helce competition is desirable)if they generatestgntpre
ficant welfarcgainsby erablinSinsurersto offerpolicieswhich match individuaiTheyare ineffrcient,however,if (d) their costsoutweighthe
f..e[ce"
-ore"a..uratclv
from individuallytailoredpoliciesor (!) someotherform oforganization
welfaregains
gainsfrom
would b"echeaperWithbadlyinfbnnedconsumcrs,forexanple,thewelfare
uhi'h ha' no
inororcd indiriJu"l ' hoi,e dre lilel) to be low: thu' tcial in'urancc'
reimhur\e
ofproce\\ingdnd
\trndJIdi/rlion'
(beLau'col
.o't\
rn.rrleLrneco'ls,lo\\
ment. anJ economiesofscale,may be nole effrcient'
(d) inefncient or (')
where any of theseproblemsarises,prir'ate insurancemay be
not suppliedat all. Tie centralpoint oflater disctlssionis that difiiculties oflen arise
policy-do
bc.uosei*o setsof,teeds-thoseofactuarial insunnceand thoseofsocial
social-policyobjecto
meet
for
failjng
insulers
not match.The solutionis not to berate
reasons'
tives,still lessto ignore social policy needsbecauseinsurance,for technical
\uch
of
obre'tivc'
cdnnolmeerrh(m.\\ftat i. reeJedi. d bridgeb(l!\eenthe l\o 'el'
puDrlc
or \ub'idi/in8Pri\Jlein'urdn.tor rl mry,rn\ol\e
a bridgemayinvolvcregulrrin!,
parlrcularlv
The\ei'\ue' drr\erepeatedl)
tundin8,lhrouSh'ocirlIn'urinLeorlrrJlion
against
ofpensions
protection
the
for uncinployient insurance( Chaptcr8, Section2 2),
3
l )'
(
2,
Section
inflation iChapter 9, Section3. 1) and medicalinsurance ChaPter1
pRtMluM
LarlierJi'cu-iun of a,l'cr'e 'elcctionPo'e\ lhe que'lion of
DrffEnENTlAls.
result
whether efiiciencyrequiresthat differencesin individual probabilities should alv'ls
could
This
mybrother
than
often
more
I
am
burgled
in differentpremjums.Suppose
f"b..uu." iu-unlu.t y (i randon difference)' or becauseI live in London'whichhas
ahish crime rate,and he livesin the country (a s],Jtematicdifferctce)'
supTi de6nemore preciselywhatwe meanby rardom and sFtematic differences'
posethat ildividual probabilitiesvary randornll"i e

p,= P+ e

(5 .t 8 )

a true'
probabilityof theith individualbeingburgled'comprises
wherep,,theobserved
lf istruiyrandom'andheYfas
andarandomcomponent'
or averaleprobability,ii,
p'
meanofthe observed
the
is
simPly
Probabilprcbability,
u r"ro d.*, tlr.
"u".uge
ities,li i.e.

r =|r,r

( 5r.e )

p v dIerheob\er\edprobabilN.\.,n'iJerrl'oSroup'or rndi\idudl':P .P .
In
p liose ol lhe r\ Peopre
rric'f".ingrhc.VrnJividual'inglouPl.JndP P.
group
in
individual'
k-rr
srouoi. lion t ..lo te.dnLrl.uldlclh(a\crdgefrobabilil\
in
r. p, ;nd'im'l'rlr fo' Sruup/. \\e cin lhen JrguelhJl if p - p anv diFference
o.oUabititi., bet*..u;ndiviauals inthe two grouPsis random Howeve{'ifP, issi8n1hcantlygreaterthanI , differencesin the probabilitiesares/stcmdfrclt is then apPro

122

5.Insurence
rate signiidual pre$'eigh the
Fnization
pins from
cb hasno

nr o r (& r
ftenarise
fic-do

ves.Such
rpublic
mcularly
tsagainst
3.t ).
stron o[
c/Jresult
tis could
hich has
resisuP
(5.18)
3a trueobabil

15.19)
obabilDple m
I grouP
mce in
i signiaPpro-

to talk ofhigh- andlow-risk individuals,withaveragcprobabilitieslH(=t )and

=P.),
'l'hus:
-:ate
respectivcly.
..
CincLusiotl
l. The cflicientprice of insuranccshouldnotreflcctrandom diflerences
r obabilities.
Canclusion2.Uut wherethe decisionto insureisvolrnury, efficiencyrequiresthar
jippliers shouldseektodiscoverlvho is higb and who is low risk,and chargepreniums
rr.ordingly,asin equations(5.14)and (s.l5).
In contrast,whereinsuranceis compulsory,itmightbe possibleto pool bigh andlow
.iis and chargeeveryonethe averagepremium (equarion(5.16)),sincelow risk peo..i .annot choosenot to insure.Thus, for exanple, thc t946 National InsuranceAct
ah.rpter2, Scction5) appliedpooling cxplicitly both ro individualsand to risks.All
::nployedmcl ofworking agepaidthesamelump,sum cont bution to buy enritlemcnt,
:::.'rrlid, to thesamunemploymentbenelit,eventhough somegroups(e.g.doctors)
;ere lesslikely to be unemployedthan others (e.g.construcrionworkers).All indi
.:Juals paid an averagcpremium (equarion(5.I6)); and,becausecontriburionswere
:rmpulsory, it was not possiblefbr overchargcdlow risk individuals to opt our.
rral!-tically,the lor!' risk group paid an actuarialpremium (equation(5.11)) plus an
r:a\oidablelump sutn tax,and rhehigh-risk group paid an actuarialpremiurn shown
:!cquction (5.15)arldreceivedalumpsumtransfer.Thusa s,vsrem
which charges
a comrulsoryaveragepremiumirrespectiveofriskcanalleviateproblemsofadverscselection.'
\nother examplc(Chapter9, Secrion4.2) is the poolingofmen andwomcn in pension
despitethe factthat on averagewonrenlivelongcr
ln contrast,automobilein'.hen1es,
luranceis alsocompulsory,butthere is no pooling acrossgroups-people with worse
:ccident recordsgenerallypayligher prcmiums.We can thereforeadd:
Conclusion3: if insuranceis compulsory,chargingall categoriesof risk the same
prcmium causeslittle iiefficiency in i,i'] rdr.ir markets,though it might ciruscsecontl
,1rvinefficiencyin relatedactivities.
FALLAcrous
EoufiyAFGUMENTS
appearin a nrnnberof guises.The lirst is that insuranceis
inequitablebecause
itrcdistributesfrom rhosewhodo notmakeclaimsro lhosewho do.
Thisassertionmeritslitde discussion.l he wholepoin! of iNurance is th al peopledo nor
howwhether theywillneedto claim(i.e.whethcrrhe'good'orrhe.bad,outcome
will
occur). A rational risk averseindiridual increasesher utiliry bv choosinga lower
incomewith certainty(]" in Figure5.1),in preference
ro a higherexpecredincome,t.
Insurancecanbringaboutthisincreaseinutilitypreciselybecausethe
individualisanet
contributor in a'good'yearand a llet beneliciaryin a'bad'vear.
A secondlallaciousargument is that'private insuranceis irequitable bccdusethe
poorcannotaffordadequatecoverlThis
propositioncanbea ackedinanumberofways.
It'ni!ht,borveveicaus.inel6.ie.siiorlHwry\:ftndrrdtoli.iEstlonotaltowfordiff.ren.csinp,eFren.esiand
iromnnnrstN.rreoarre'niumsloremplortrmillrlerdr,inefi.icnr.xprnjonotriskyttrnr$ries.

123

Concepts
First,if theorll, diflicultyisthatthepoorcannot affordcover,theproblemisonenot .:
narketallocatiollbutofincomedistribution,andcanbesolvedby cashredistribulior
Secondll-,
who decidesNhat levelof coveris'adequate'?
I'ublic provisionon thes
groul]dscallbejustified
onlywherethere
areeflicienq,problenrs
wilhprivateinsuran..
oi if the poor haveinperfectinformation.lhe arguments
developed
earlier,in pr.ticularthetwotrropositions
itl Chapter4,Section7.2,applyequal],v
to insurance.

4.2. Socialinsurance
FATLURE.
soctAL
tNsuFANcE
AsA REspoNsE
TotNFoFtvtAroN
Arrow argucsthat, where marker\
fail,otherinstitutionsn]ayariseto mitigatethe rcsultingproblenT
s,sonetimesthrough
publi.produ.tiorrand'om<,ime.throughprival(inrirulion'u'.n!,non.on-leliri\.
'the failure of the market to insure agairst urcertaintieshas
allocationmechanisrns:
createdmanysocialinstitutionsinwhichtheusualassumptions
ofthemarketaretoson1e
exlentcontradicted'(Arro1\r1963:967). In otherwords,asdiscussed
in thefirst paragraph
(public
of this chapter institutions
or private) may arisewhich are insurancein the
senseof protectingagainstrisk, even if they are not insurancein a narrow actuarial

rn,i! 11

TheArrow argLrments
and their subsequcntclaborationcontraststronglywith those
of Hayek(1945).Both writersstartedfiom theassurnptionof asymmetricinformation.
To Hayekthe fact that differentpeoplekrow differert thingsis an argumenti, r{rrorlr
ofmarkets.He lrgued (amlogousto the existenceof skill differences)that the market
makesberelicial useof suchdifferencesbI allowing gairs fiom trade to be er?loited. Arrol
showedthatthemarket is an inefficientdevicefor mediatingcertainim portant classes
of differencesin knowledgebetweenpeople.Nor is the Arrorv view id iosyncratic.l he
Rothschildand stiSlitz (1976) and similar argumentsrverediscussetlin Section3.2.
Lucas(1987:62),in discussingunemployment,reachedan identicalcorclusion:
Snlce. . . with privatinLnnation,conpetitivelydctcrnincdarrnngcmcnls
wili f. i shortof
completcpooling,thisclnss
ofmodelsalsoriiscsthcissucofro.irl trsrrdr.s poolingarrange
mcntsthatarenota.tuariallysound,md
henccrcqunc
supporlfromcompulsorytaxation.The
mainclements
of KeDneth
Arrow\ analysis
ofDlcdicalinsurance
arercadilytransferable
to this
cr!ploynent.ontext. (emphasn
in orignral)
Social insurancethus derives fro two sources.The need for insurance arises
becauseinhdustrialized countriesemploynent islargelyabina4 phenomenon(i.e.a
personis eitherenplol'ed or unemployed)ard retirenert, similarl,y,
is a discreleevent.
Thus the risks agaimt rvhich socialinsuranceoffersprotectiol are to some exlent a
socialconstru.t.'r Sccond,on thc supplyside,information failuresprovideboth athe
orcticrljrn,fi.d/io, d andan explanation
lor, a wcllarcstatewhich is much nore than
A||m$n i 199j,: !h I I i {rt$es the inpodrn.e ol lxb.u

'124

drkel,nnnudons. On i.ft.m.rl,

sccH.nnah ( ] 936)

: . ! , f 1, r r

5.Insulance

ibution.

:, in par

a safetynet.A centralargumentin laterchaptersis that privateinsurancecannotcover

contirgenciessuch as ;employment, inflation, and inportant medicalrisks Social
insurancels one resPorNe.
oFrHEBEAsrAn importan! characteristicof most social insuranceis that
THENArrlRE
is compulsory,thus Prcventinglow risksfrom optingout (though Partial
tnen'Ibership
threegener
makespossiblethe
optirg out maybeallowedfor somebene6ts).ClomPulsion
are
insurance
ic forms oforganizationdescribedin ChapterI ' Section2 1,all ofwhich
frorn insurancein con
in the senseofofferingprotection,but lvhichdivcrgeincreasingly
ventionalactuarialterms.

through
npetrtrve

|ragraPh
cein the

iti those

.tic. The
tion 3.2.

I shortof
fion.The
blerothis

th a the-

. Socialinsurance(.i.e.benefilsbasedon a contributionsrecordand the occurrence

ofa specifiedcontingency)takestlt'o broad forms Quasi actuarialcontributions
are relatedto the averagerisk (e.g the flat-rate weeklycontribution of the UK
schemebetween1948and 1975); this is a pure Poolingequilibrium lncome-retated
contributions break the link rvith individual risk; the contribution in this case
looksiike an earmarkedta{.
. 'Llniversol'befieftsabandonthe attemptto mimic PrivateinsuranceTa'\_6nanced
without a co[tributions
beneEtsarea$'ardedon the basisof speciliedcontingencies
healthcarein some
countries,
or incometest(theflat-rateretirementpensionin some
couniriesin cludingthe UK).
, social-assistancebenelits
on thebasjsofspeciiedcontingenciesand an
arearvarded
Administrationcanbeby the stateat centralleveL(asmostlyin the UK) or at a lower
Ievel(asfor mostprogrammes th eUSA' and for healthcarein Australia'Canada'and
hivedoffto private sectorinstitutionsslrch
Alternativelnadministrationcanbe
Swe,lelr).
asfiiendt,vsocietiesor tradesunionslaswith unemploymentcompensationin Sweden
and medicalcareinGennany)iiDs[ch casestheprjvatesectorisacting'in effect'asan
agentofthe state.
The social insurancearrangcmentsjust describedarebasedoDptivate institutions:
on the
benelitsare conditioned on an inplicit or erplicit contributjons record and
one of
in
that
status'
occurrenceofa specifiedelnt,frequently relatedto enrPloyment
their ajorpurposesisto rePlacelost earnings
Sociali nsura[ce,ho$'ever,differsfrom privateinsurdnceintwo nnportant rcsPects'
compul'or\.r' i' l"rrlr/' rhoughnor e*enridll
I irrr,be(ru.enr(n'l'er\hip'' gencrallv
lo bredkthc l:llk bcr\\eenPremiumirrd indi! idu.rlri'kr a pooling'olurioni' lherelofe
ar option. Secondl)',the contract is usuallylessspecilicthan Privateinsurance'wrth
two ;dl,antagcs:protectioncanbe givenagainstriskswhich theprivate marketcannot
insure (Chaitcr 8 arguesthat unenPiolnent is one); ald the risks can changeover
overwhich people
time.Atkins;n ( 1995;:2 l0 ) points out that'the setol contingencies
fbrmedprobabilitiesyearsagomay haveexcludedthebreakdownofthe extendedfamil,v,or rhe developrrentofmodern rnedicine,sifrPly becausetheywereinconceivablel

Concepts
Thus socialinsurance,in sharpcontmstwith actuarialinsurance,cancovernot onlv
y.\ociJ in\umnce,
r/sftbuldi5ol/r. errdlt]I
in \ ariou\gur\e5.will
appe,jr
r(pejredl)In li tcr
chapten.

FURTHER
READING
BurchardtandHils (l997rch.I ) givean excelent,non-technicalhtroductiontorhecconomics
of;nsurance.Seealso,in asceDding
order offormalitn Stiglitz(1993r:ch.6), Estrin and Lajdler
( 1995:ch.8), Varian (1996:c!. 12),Rees(1989),or Varian (1992:ch. I l).
For discussionin tjre
context of cashbenefits,sce Stiglitz ( 1988:ch. r 2 ), and in rhe conterl of rnedicatinsurance
jmplicationsofgeneticscreeDing
Culyer(Ie93). Barr (199s)discussesrhe
for insurance.
On infornarionproblenN moregeneralty,seeVarian
(tee2rch.25)for an oveniew ror com_
pen<liousdiscussion,seeHnschleiierand Ritey(1992)and Stigtitz(1993d).The ctassicartictes
are byArrow (le6l) (who discusses
nedicat insurancc),on adveBeselecrionby Akerlof (1970)
and Rothslhild andStiglitz(1976),andonmoralhizard by pauty(r974) and Stiglirz(r9s3).Ior
surveysofthe lirenture on imperfectinformation about quality,seeSrigtirz(ttS71 1993a)
and
Phlips(1e88:ch.3), and on imperfed information about price,phlips (i9s8: ch.2).

.c
-in
:1

;{'.

at

5.Insurance
onh

Appendix:
Non-technical
summary
of Chapter
5
L Cbapter5discusscsthedemandand
nrpplyofinsMance,andsoneprobtemswhichcanarise
on the suppl)-sideofa private insuranccmarket (1ora simplc introduction, seeBurchardtand
Hil l s(1 9 9 7c: h . l ) ).
idl. r

9;n

L The term insurance'is usedby diftbrent people to mean differenr rhings.T$,o meanings
aboveall shouldbe distinguishcd.Insurancecanbe dcfiDed(a)as a dclic$ehi.h offen indnidlatsprotenion ngdinsttitk, and/o. (b) asan dctr.r/tai ne./ur6
(asdcfindnrequarion(5.12),
below)which theprivatesectorcaD
organize.Thc lirst delinesinsurance
in ternrsofitspurpose,
rlresecondiD terms ofa mcthod b,rw]rich thar purposenright bc pursued.r_1,en
whereinstitu
tlonsarc not inslrranceir ihe seDse
of (l'1,thcl might still be regrrdedasjnsuranccin rhat thq,
offer protcctioDagainst risk-

Thedemand
andsupply
of insurance
I Uncenajntyreducsthe utilityofar nldividualwho is riskaveNeihenceccrtrintyhas a posrtn value,anda risk-averseindividualwill bepreparedro pava posirir-epriccfor it_U/henI takc
i,ut insurance,(hc comDrodityI am buying is ..rrrirry (c.g.that if my crr is stolen it will bc
.cphced).The fornal a.gument h prcsentedin Secrion2.I
i. Thc supplyofinsuranccis discussed;nSectjon3.1.Supposerhat thc probabil;ty,t, ofbeing
rurgled is I per centjand that ifI atn burgledfly loss,I,willbe tl,000. On average,
thercfore,I
in expccta lossoft1,000 oDceeveryl00tears.In aDnualter'rs my cxpectedlossis, xI = t%
r ! 1 ,0 0 0 = !1 0 th a l i s ,th c i n s u ra n ceconrpanyknow sthaton
averagc
i tw i l t haveto pal mc!t0
r.r ),c.Lfonnally,ao d.t,arialprczia n, 4 is dcfinedas

E=ll+o.)pL

(s.r2)

r herepL thecxpectedlossofthe indiv ualbryinginsurance,aDd0+a)isrhci

's
of.lper centto coverits adminisrraiivccostsandnormal protit. ,risthepricear
tanr\ nrark-up
trhic| insurancewill be suppljedin a coDrpetitivemarker.

Technical
probemsonthesupply
side
: P r"r. irs,rai.ew ll b. rrm.ie , . . r o n -c ri. r. nurn t e * , h cp r" b . rbiru
i p . n e q -. rr. , r
:. l2 ) Dleetsfiveconditions(Se.tionsl. I and3.2).fnst, theprobabiliryofa givenindividualbcing,
:or.xrnple,burgled must bet'deprr.lertofthcprobabilityofanyonc elsebenrgburglcd.Wtat
: hs neans toughly speaking)isthat insuranccdcpendsfo r irsfinanci.l viabiliryon the existcnce
:n ary 1-earofa predictablcnumberofwinners and rGers.
.. Secondli,pnustbe lerr tla, o,e.Ifp = I it is certainthar mycar will besrolenjhencethereis
.o possibilitvofspreadingrisk, aDdrhe insuraoccprcDirun wiU equalor cxceedthe cost ofa
nei! cal This problem can arisefor the chronicallyorcongenitalll ill, for lvhom the probab;lity
.)aillhealth equalsone unlcssirNuaDceis rdkenour 1/4ol.rhe .ondirion is diagnosed.

127

Concepts

bek'ow'o/ernm:,'#ft;t,'j.:::JTliilffi'*ffi:1ilti
isthatpmust
7.Athirdcondition

:ii.i:jilitii''iiil{ttiil*:
;*'i:fi
hil:3:f
}:11*.*iilfiiT}*ii:il
i'lir*.i**r' r"*'
I".,il;;;0..'uii:r,,.i
"r

*:$;l*:::::n''',i[1x["i];jl'
estimatcd
cannotbe
priceincreases

:;iil:i}'Ji"::"i:*iil1i1i:'.',"ffj:ixl";:'jl."':il?H::j'fi'.
:{ru'l:l**::;s':i#:":illill'ffi
*"
*::T:iil:1.::::ii:;'::i::[*u:::*
"-:iT:".'J;l[H.'5.\:l"r;iliildi1
:Tl.1ij,';Ti':J*[:l*,*,":i
j"",TJjjIJffi
illifr",f;ilj::"!:1,:#l$::j1",lfrfit*
:;j:rtTft
*.,fi
'i}il
c
wherethecustomer
wil occur:and,secondlv,
prcbl
en'
ft
a
rhn'lP f ' pavtrte11t
iin."r," r'."**,.""ltv .a[ed'ttte

isjtT,fitril.***;rH*ti'a
ffi+i:lffi
f,
j[iJ]'
:ffi
ii,T',:'y"';;t1l'it;";::i"T[::,ffi:'i"fi
'#;'ff.:::kri:"*]:

mdl ei n{ tj n
rl . l h e tl ' i td P a rr)-p d ' me rrrprcbl enrdoc\ro1

( rmoo} i bl e burcau\c\o\er

:il;i illrii:'li;'i1,::iI:

iill:.:i]*.'#
l::tk'.g+:':*nil::
*:il::lx
:::'i*;""::,':r;ilT
l:iffi
-:*$j$i*;:'r;l'.r.rl;;:u";:lri
' u re

o n i n ' u rd n c eP' e m i u n '

r;r',;ix [#{tITni[il"nttr]::i1':;,1#:
3 l )'
(Chapter12,Section
insurance

-:t

128