[An updated version of this article can be found at Insurance in the 2nd edition.]
Insurance plays a central role in the functioning of modern economies. Life insurance offers protection against the economic impact of an untimely death; health insurance covers the sometimes extraordinary costs of medical care; and bank deposits are insured by the federal government. In each case a small premium is paid by the insured to receive benefits should an unlikely but high-cost event occur.
Insurance issues, traditionally a stodgy domain, have become subjects for intense debate and concern in recent years. The impact of the collapse of savings and loan institutions on the solvency of the deposit-insurance pool will burden the federal budget for decades. How to provide health insurance for the significant portion of Americans not now covered is a central political issue. Various states, attempting to hold back the tides of higher costs, have placed severe limits on auto insurance rates and have even sought refunds from insurers.
An understanding of insurance must begin with the concept of risk, or the variation in possible outcomes of a situation. A's shipment of goods to Europe might arrive safely or might be lost in transit. C may incur zero medical expenses in a good year, but if she is struck by a car, they could be upward of $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 the risk that remains. Consider A's shipment of, say, $1 million in goods. If the chance of loss on each trip is 3 percent, on average the loss will be $30,000 (3 percent of $1 million). Let us assume that A can ship by a more costly method and cut the risk by 1 percentage point, thus saving $10,000 on average. If the additional cost of this shipping method is less than $10,000, it is a worthwhile expenditure. But if cutting risk by a further percentage point will cost $15,000, it is not worthwhile.
To deal with the remaining 2 percent risk of losing $1 million, A should think about 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 A's standpoint, however, the insurance may be worthwhile because it is a comparatively inexpensive way to deal with the potential loss of $1 million. Note the important economic role of such insurance. Without it A might not be willing to risk shipping goods in the first place.
In exchange for a premium, the insurer will pay a claim should a specified contingency, such as death, medical bills, or shipment loss, arise. The insurer is able to offer such protection against financial loss by pooling the risks from a large group of similarly situated individuals. With a large pool, the laws of probability assure that only a tiny fraction of insured shipments is lost, or only a small fraction of the insured population will be hospitalized 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, 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 dictates that 1,100 people or more will have losses only one time in 1,000.
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 health insurance as well as homeowners' insurance, for example.
The Identity and Behavior of the Insured
To an economist insurance is 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 old folks at a price that is appropriate for young folks, 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 this 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 they 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. High-risk individuals, with superior knowledge of the risks they impose, 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.
In effect, the potential purchasers have "hidden" information that relates to their particular risk. Those whose information is unfavorable are most likely to be the purchasers. For example, if an insurer determines that 1 percent of fifty-year-olds would die in a year, it might establish a premium of $11 per $1,000 of coverage, $10 to cover claims and $1 to cover administrative costs. The insurer might expect to break even. However, insureds 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 insure. Health fanatics, by contrast, might forgo 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.
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 system. But no matter how careful the inspection, some information will remain hidden, and those choosing to insure will be selected against the insurer. So insurers routinely set rates high to cope with adverse selection. One consequence is that high rates discourage ordinary-risk buyers from buying insurance.
Moral Hazard or Hidden Action
Once insured, an individual has less incentive to avoid risky behavior. With automobile collision insurance, for example, one is more likely to venture forth on an icy night. Federal deposit insurance made S&Ls more willing to take on risky loans. Federally subsidized flood insurance encourages citizens to build homes on flood plains. Insurers use the term "moral hazard" to describe this phenomenon. It means, simply, that insured people undertake actions they would otherwise avoid. In less judgmental language, people respond to incentives.
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 flood plain. Collision insurance might not pay off if it can be proven that the policyholder had been drinking or otherwise engaged in reckless behavior. But given the difficulty of monitoring many actions, insurers merely take into account that once policies are issued, behavior will change 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. And if all students are ensured a place in college, they are, in effect, insured against bad grades. Academic performance may suffer.
The same insurance policy will have different costs for serving individuals whose behavior or underlying characteristics may differ. This introduces an equity dimension to insurance, since these cost differences will influence pricing. Is it fair that urban drivers should pay much more than rural drivers to protect themselves from auto liability? In some sense, perhaps not, but what is the alternative? If prices are not allowed to vary in relation to risk, insurers will seek to avoid various classes of customers altogether and availability will be restricted. When sellers of health insurance are not allowed to find out if potential clients are HIV positive, for example, insurance companies often respond by refusing to insure people in occupations in which an unusually large proportion of the population is gay. One way they do so is by refusing to cover males who are florists or hairdressers.
Equity issues in insurance are addressed in a variety of ways in the real world. Most employers cross-subsidize health insurance, providing the same coverage at the same price to older, higher-risk workers and younger, lower-risk ones. Sometimes the government provides the insurance itself, as the federal government does with Medicare and Social Security (an insurance policy that pays off heavily if one lives long), or it may set the rates, as many states do with auto insurance. The traditional public-interest argument for government rate regulation is to control a monopoly. But this argument ignores the fact that there are dozens of competing insurers in most regulated insurance markets. Insurance rates are regulated to help some groups, usually those imposing high risks, at the expense of others. The Massachusetts auto insurance market provides an example. In 1988, 63 percent of drivers were in a subsidized pool. To fund this subsidy, unsubsidized drivers, whose claims averaged $323, paid premiums that averaged $750.
Such practices raise a new class of equity issues. Should the government force people who live quiet, low-risk lives to subsidize the daredevil fringe? Most people's response to this question depends on whether they think people can control risks. Because most of us think we should not encourage people to engage in behavior that is costly to the system, we conclude, for example, that nonsmokers should not have to pay for smokers. The question becomes more complex when it comes to health care premiums for, say, gay men or recovering alcoholics, whose health care costs are likely to be greater than average. Moral judgments inevitably creep into such discussions. And sometimes the facts lead to disquieting considerations.
For example, smokers tend to die early, reducing expected costs for Social Security. Should they therefore pay lower Social Security taxes?
The traditional role of insurance remains the essential one recognized in ancient civilizations, that of spreading risk among similarly situated individuals. Insurance works most effectively when losses are not under the control of individuals (thus avoiding moral hazard) and when the losses are readily determined (lest significant transactions costs associated with lawsuits become a burden).
Individuals and firms insure against their most major risks—high health costs, the inability to pay depositors—which often are politically salient issues as well. Unsurprisingly, government participation—as a setter of rates, as a subsidizer, and as a direct provider of insurance services—has become a major feature in insurance markets. Political forces may sometimes triumph over sound insurance principles, but only temporarily. In a sound market, we must recognize that with insurance, as with bread and steel, the cost of providing it must be paid.
Richard Zeckhauser is the Frank P. Ramsey Professor of Political Economy at Harvard University's John F. Kennedy School of Government.
Arrow, Kenneth J. "The Economics of Agency." In Principals and Agents: The Structure of Business, edited by John W. Pratt and Richard J. Zeckhauser. 1985.
Arrow, Kenneth J. Essays in the Theory of Risk-Bearing. 1974.
Denenberg, Herbert S., Robert D. Eilers, Joseph J. Melone, and Robert A. Zelten. Risk and Insurance, 2d ed. 1974.
Huber, Peter W. Liability: The Legal Revolution and Its Consequences. 1988.