Introduction (1)

1. Introduction to Public EconomicsULBProf. A. EstacheLecture 5Information Asymmetry: A look at Social Insurance

2. Introduction (1) This week: focus on the 3rd source of market failure => information asymmetry This will allow us to look at an additional role government can have Indeed, so far, we have seen that government can: Regulate (for instance to control the behavior of economic agents) Tax (to change the behavior of economic agents) Provide and charge for the provision of goods as it were private It turns out governments can also act as insurance companies…=> government as a provider of insurance services!

3. Introduction (2) • …When can government act as an insurance company….??? • when private insurance fails!!! • So when the market fails….government ends up being the formal or the de facto insurer against a wide range of risks • So….what does government insurance mean???? • Gvt provides benefits to taxpayers when undesirable shocks in their life take place (job losses, health problems, disabilities,…) • Insurance is part of a radical change in the nature and scope of gvt spending in the last half century. • Main example of such insurance: Social insurance programs… large share of gvt budgets in the world. • Figure 1 illustrates this.

4. Share of social expenditures in total expenditures in Europe

5. What do social insurance programs usually cover? • Some of the more important social insurance programs include: • Unemployment Insurance • Disability Insurance • Medical insurance • Pensions

6. What do these programs have in common? (1) • These programs have several common features: • Contributions are typically mandatory. • There has to be a measurable, enabling event that triggers payment to the beneficiary of the insurance. • Benefits are not necessarily related to the beneficiary’s income or assets (i.e. not “means tested”)

7. What drives and what limits government insurance? ADVERSE SELECTION (AS) the specific potential market failures that may force gvt to take over any of these insurances MORAL HAZARD (MH) is what limits the effectiveness of gvt intervention in trying to address these failures 7

8. What’s the core issue in this lecture? • Central issue is the existence of trade-offs in the design of the supply of these social insurances • There are MH risks associated with the solution to AS! • Gvt can improve efficiency if as a result of AS, some individuals are not insured privately and thanks to gvt, they become covered • BUT intervention has its own efficiency costs due to MH …and these can impact gvt equity and efficiency goals!

9. …so how much should gvt get involved?? Need to look at basic insurance theory to see why and how much • So…the general economics of insurance markets will help us understand the incentive issues underlying the social insurance programs • In practice, this means we need to know: • Why is insurance valued by consumers? • What forces may cause the insurance market to fail? • What precisely is the adverse selection (AS) issue? • What happens to social efficiency with AS? • What specific tradeoffs must be made in designing social insurance programs?

10. First, …back to basic micro concepts… • So…Central to this discussion are 2 key concepts you are supposed to know…: • Adverse selection: the fact that the insured individual knows more about her/his own risk level than does the insurer => risk of undersupply of insurance by private sector • …will gvt intervention, to deal with AS, crowd out any private intervention in practice? • Moral hazard: when you insure individuals against adverse events, you can encourage adverse behavior => risk of excess supply of insurance! • …Will insurance encourage undesirable behavior??

11. Next let’s see how exactly does an is insurance function? • You need some basic common features of an insurance to function • Which features? • Individuals pay money to an insurer, called an insurance premium. • In return, the insurer promises to make some payment to the insured party (or those providing services) if an adverse event occurs • There is a wide range of situations in which insurance can work • Obvious examples include health insurance, car insurance, life insurance, and casualty and property insurance.

12. Why Do Individuals Value Insurance? • Because of the principle ofdiminishing marginal utility of consumption • What’s that???? It implies that: • if given the choice between either (a) two years of “average” consumption or (b) one year of excessive consumption and one year of starvation, individuals would prefer (a) • Why that choice? • The reason individuals prefer choice (a) is that excessive consumption does not raise their utility as much as the starvation lowers it. • Thus, individuals want tosmooth their consumption, or move consumption from periods when it is high to periods when it is low.

13. Just to make it clearer…Smoothing consumption???? • When outcomes are uncertain, many (most?) individuals wish to smooth their consumption over possible states of the world. • The goal is to make a choice today that determines consumption in the future in each of these states of the world. • For example, two states of the world for next year might be “getting hit by a car” or “not getting hit.” • …how do you hedge against the outcome you don’t like?

14. So Insurance is a consumption smoother… • Individuals choose across consumption in states of the world by using some of their income today to buy insurance against an adverse outcome tomorrow. • By buying insurance, individuals commit to make a payment if the uncertain outcome is positive (no accident), in return for getting a benefit in the negative outcome case (the insurance payout).

15. Key insurance theory result to remember • Fundamental result from basic insurance theory: • Basic insurance theory suggests that individuals will demand full insurance in order to fully smooth their consumption across states of the world. • Full smoothing? That is, the level of consumption is the same regardless of whether the accident occurred or not.

16. Formalizing This Intuition: Expected Utility Model • Let p stand for the probability of an adverse event. Then expected utility is: • Where C0 and C1 stand for consumption in the good and bad states of the world, respectively. • => now max E(U) which means max U across ALL possible states of the world rather than across bundles of good (p318)

17. An example of the use of the expected Utility Model (1) • This model can be used to examine the individual’s demand for insurance. • Imagine, for example, that there was a 1% chance that Pierre will get into an accident that caused $30,000 in damages. • Pierre can insure from 0 to 100% of his medical expenses. • The policy costs m¢ per $1 of coverage. • If he buys a policy that pays him $b in an accident, his premium is $mb. • Full insurance in this case would cost m x $30,000. • In the state of the world where Pierre does get hit, he will be ($b - $mb) richer than if he hadn’t bought insurance. • If he doesn’t get hit by the car, he will be $mb poorer than he otherwise would have been.

18. An example of the use of the expected Utility Model (2) • =>the insurance policy translates Pierre’s consumption from periods when it is high to periods when it is low. • Pierre’s desire to buy the policy depends on the price that is charged. • DEFINITION: An actuarially fair premium sets the price charged equal to the expected payout. • This assumes that insurer has • No administrative costs • Makes NO profit (they just recycle premia into payments) • => sort of ok for a gvt …or a non-profit organization…not really that simple for a private firm

19. An example of the use of the expected Utility Model (3) • So how does one calculate that premium “m”? • Example: • what if there is a 1% chance that gvt must pay a damage of $30,000 and a 99% that it must pay 0 • Since the expected payout is $30,000 x 1%, or hence the premium should be $300 per policy. • => in this case, a $300 premium is actuarially fair. • With actuarially fair pricing, individuals will want to fully insure themselves to equalize consumption in all states of the world.

20. An example of the use of the expected Utility Model (4) • The Expected Utility Model is the standard model to treat the intuition analytically • But you need an explicit form for the utility function! • Consider the case of the utility function such as: • Also assume that C=30,000. • Now, consider 3 cases: • Without insurance • With full insurance • With partial insurance

21. What if no insurance? • Without insurance is, expected utility is:

22. What if FULL insurance? • If you bought actuarially fair insurance for $300, expected utility is: • Utility is higher, even though the odds are that the premium was paid for nothing. • This is because you would rather have equal consumption regardless of the accident, rather than a very low level in the bad state of the world. This is illustrated in Table 1.

23. Table 1

24. => What is the central result derived from the Expected Utility Model? • The central result of expected utility theory is that with actuarially fair pricing, individuals will want to fully insure themselves to equalize consumption in all states of the world. • Clearly Pierre’s utility is higher in row 2, with full insurance, than in row 1, with no insurance. • Yet, Pierre also prefers full insurance to any other level of benefits. • Row 3, which shows coverage for half of the costs of the accident, gives lower expected utility.

25. Intuition on the Expected Utility Model • AGAIN:…EVEN IF insurance is expensive, so long as the price (premium) is actuarially fair, individuals will want to fully insure themselves against adverse events. • SO WHAT???? Well the implication: the efficient market outcome is full insurance and thus full consumption smoothing.

26. BUT…Can’t forget the role of risk aversion • Risk aversion is the extent to which an individual is willing to bear risk. • Different people have different levels of risk aversion • Risk averse individuals have a rapidly diminishing marginal utility of consumption; they are very afraid of consumption falling and are hence willing to insure against that risk more than other would be willing to • Individuals with any degree of risk aversion will buy insurance when it is priced actuarially fairly. • BUT when the insurance is not fair, some will choose to not buy insurance.

27. So….what is the market failure that drives the need for government to offer social insurance as a subsitute to private insurerers?…Asymmetric Information! • Insurance markets are characterized by informational asymmetry between individuals and their insurers. • Each individual knows more about his/her likelihood of an accident than does the insurer.

28. Asymmetric Information (1) • For example, in the health insurance market, …likely that person buying coverage knows more about his/her health problems and expected utilization of that insurance than does the insurance company. • The insurer will be reluctant to sell the person a policy at an actuarially fair price, since she/he could be a “high risk.” • => even low risk people could pay higher premia because of the existence of high risk people not telling they are high risk • => low risk people refuse to pay and insurance premium is not enough to cover all risks • => private provider gives up => market failure! • See the example next

29. Asymmetric Information (2) • Assume there are 2 groups of pedestrians, each with 100 people. • The first group has 5% chance of injury • Careless people • The second group has a 0.5% chance. • Careful people • The payout is $30,000 when injured. • Table 2 shows how information affects the insurance market in this context.

30. Table 2

31. In this case, the company loses money, so it will not offer insurance. Thus, the market fails; individuals will not be able to obtain the optimal amount of insurance. Table 2 The insurance company collects $1500 x 100 from the accident prone, and $150 x 100 from the careful. Total premiums of $165,000 equal expected costs. With full information, the insurance company can tell the high risks from the low risks. It therefore charges separate prices to each group; competition forces it to charge an actuarially fair price. The premium to the accident prone is therefore 5% x $30,000. For the careful, it is 0.5% x $30,000. The insurance company collects $150 x 100 from the accident prone, and $150 x 100 from the careful. Total premiums of $30,000 are $135,000 less than expected costs. Now imagine the insurance company cannot tell people apart. This is a case with asymmetric information. The accident prone have no incentive to tell the company, however; they pay 10 times as much if they reveal truthfully about their status. Again, the company loses money, so it will not offer insurance. Thus, the market fails again with a pooling equilibrium. It could continue to charge separate premiums to the different groups, taking the person’s word that they are either careful or accident prone. Another potential alternative is that the insurance company understands it cannot tell consumers apart. Thus, it charges a uniform premium for all customers. With this price structure, none of the careful people buy the policy. The company collects $825 x 100 people, but pays $1,500 x 100 people in benefits. The average cost for the population as a whole would be $165,000 in claims divided by 200 people, or $825 per person.

32. Asymmetric Information (3) • This example illustrates how the problem of adverse selection plagues the insurance market. • People have the option of buying insurance, and will only do so if it is a fair deal for them. • Only the high risks take-up the policy so any insurance provider would lose money.

33. Does Asymmetric Information ALWAYS Lead to Market Failure? (1) • Will adverse selection always lead to market failure? • Not if: • Most individuals are fairly risk averse, such that they will buy an actuarially unfair policy. • The policy entails a risk premium, the amount that risk-averse individuals will pay for insurance above and beyond the actuarially fair price. • In our example, risk premium is 825 (total)-150 (fair) = 625 (risk) • This leads to a pooling equilibrium, which is a market equilibrium in which all types buy full insurance even though it is not fairly priced to all individuals.

34. Does Asymmetric Information Necessarily Lead to Market Failure? (2) • ACTUALLY: even without pooling, adverse selection could still be consistent with the existence of a market • INDEED, the insurance company can offer separate products at separate prices, causing consumers to reveal their true types (careless or careful). • This leads to a separating equilibrium, which is a market equilibrium in which different types buy different kinds of insurance products.

35. Does Asymmetric Information Necessarily Lead to Market Failure? (3) • HOWEVER… • The separating equilibrium still represents a market failure. • Insurers can force the low risks to make a choice between full insurance at a high price, or partial insurance at a lower price. • Although insurance is offered to both groups in this case, the low risks do not get full insurance, which is suboptimal.

36. SO…How Does The Government Address Adverse Selection? • The government can help correct this kind of market failure by: • (i) mandating, • (ii) providing, • (iii) subsidizing

37. SO…How Does The Government Address Adverse Selection? (2) For example: Impose an individual mandate that everyone buy insurance at $825 per policy from the private company =>efficient outcome since all are insured ..but seen as unfair by low risk people…worse off It could also provide the insurance directly, which would have similar effects.. It could as well subsidize purchase of private insurance but if financed through taxes… probably would be unfair again! All these policies could address AS problem…but would still lead to the low risks subsidizing the high risks…. =>efficiency vs equity trade-off, a core policy concern for gvts since could lead to electoral rejections! 37

38. OTHER REASONS FOR GOVERNMENT INTERVENTION IN INSURANCE MARKETS???? • Although AS is the key motivation for government intervention in insurance markets, … there are also other motivationsfor a role of government in providing social insurance: • Externalities • Administrative costs • Redistribution • Paternalism

39. Externalities and Administrative Costs • Externalities from underinsurance can be negative with the usual market failure dimension • If you are uncovered and hurt me in a crash • If you have a contagious disease and cannot afford to get medical assistance. • There are also economies of scale in administrative costs of running large insurance programs (Medicare in the US) • … one large firm, not necessarily the government, should provide the coverage. • If excessively high admin. costs, …low risk people who are not too risk averse may not buy insurance => market failure again!

40. Redistribution • With full information, insurance premiums are vastly different across individuals. • High risk people should pay a lot more • For example, genetic testing may ultimately allow insurers to more accurately predict health care costs and hence discriminate better! • This raises issues in terms of fairness • This is why gvts are often willing to tax low risk people to subsidize high risk people in terms of health, jobs or accidents

41. Paternalism • A final motivation relates to paternalism. • Individuals may simply not adequately insure themselves unless the government forces them to do so.

42. Now we agree that AS leads to a demand for government intervention in the insurance market… • …BUT • How much scope is there for social insurance to replace or complement private insurance… • Social insurance is what gvt offers • Private insurance is what you put in place yourself to smooth your consumption

43. SOCIALINSURANCE VS. SELF-INSURANCE:HOW MUCH CONSUMPTION SMOOTHING? • =>We know now that there is a number of reasons why private markets won’t insure risk averse individuals willing to pay for an insurance to smooth consumption over time • But there are ways for individuals to consumption-smooth on their own (even in the absence of private or public insurance markets) • People use own savings, overtime hours, family labor supply curve, friends…= SELF-INSURANCES • => Self-insurance is a private means of smoothing consumption over adverse events • => SO>>> the importance of social insurance as a way of smoothing consumption depends on the extent to which people can rely on self insurance • Keeping in mind that crowding out is always a risk!

44. Example: Publicly provided Unemployment Insurance (1) • Consider publicly provided unemployment insurance (PUI), which provides income to workers who have lost their jobs. • Although private unemployment insurance does not exist in most countries to smooth consumption, a person could: • Draw on their savings • Borrow, either in collateralized forms or uncollateralized forms. • Have other family members increase their earnings • Receive transfers from outside their extended family, friends, or local organizations.

45. Example: Publicly provided UI (2) • Issue: risk that public intervention can crowd outprivate provision and self insurance • Consequence? If social insurance simply crowds out these other mechanisms, IN NET TERMS, there may be no consumption smoothing gain or justification for government intervention. • This is important, since there are efficiency costs of raising government revenue to finance social insurance

46. Example: Publicly provided UI (3) • Consider the case of the UI replacement ratio • The UI replacement rate is the ratio of unemployment insurance benefits to pre-unemployment earnings. • Figure 2a shows some examples of the possible relationship between the UI replacement rate and the drop in consumption when a person becomes unemployed. • It shows how the drop in consumption (vertical axis) at increasing levels of unemployment depends on the specific level of the UI replacement rate (horizontal axis) • Keep in mind that a larger fall in consumption means less consumption smoothing.

47. Figure 2a Perfect SELF-Insurance 0% Imperfect SELF Insurance No SELF Insurance -50% % Change in Consumption -100% 0 100% 0 100% 0 100% UI Replacement Rate

48. Figure 2a In all of these cases, it is desirable to have no fall in consumption (0%). These 3 figures relate the UI replacement rate to consumption smoothing. The middle panel shows the case with imperfect insurance (such as a working spouse). UI plays a full consumption smoothing role here. There is NO crowd out. When no other forms of insurance are offered, and no UI is offered, consumption falls to 0. With full insurance, UI plays no consumption smoothing role. E.g., UI may crowd out savings. UI plays a partial consumption smoothing role here; (for instance, it crowds out spousal labor supply Consumption falls by less (50%), but each $1 of UI increase consumption by less than $1. Perfect SELF-Insurance 0% Imperfect SELF Insurance No SELF Insurance -50% % Change in Consumption -100% 0 100% 0 100% 0 100% UI Replacement Rate

49. Example: Publicly provided UI (4) • 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 PUI, consumption falls by 100%. • Each percent of wages replaced by PUI benefits reduces the fall in consumption by 1%, shown by the slope equal to 1 in panel A. • In this case, PUI plays a full consumption smoothing role: there is no crowd-out of self-insurance (because there is no self-insurance). • Each $1 of PUI goes directly to reducing the decline in consumption from unemployment.

50. Example: Publicly provided UI (5) • Consider the other extreme, in panel C. A person has full insurance (perhaps private UI or rich parents). • With no PUI, consumption falls by …0%!!! • Each percent of wages replaced by PUI benefits does not reduce the fall in consumption at all, as shown by the slope equal to 0 in panel C. • So when self insurance is total, PUI: • plays no full consumption smoothing role, but • plays a full crowd-out role. • Each $1 of PUI simply means that there is one less dollar of self-insurance.