Public Finance and Public Policy Jonathan

CopyrightGruber
© 2010 Fourth
Worth Edition
Publishers
Copyright © 2012 Worth Publishers 1 of 38
 Social Insurance: The New
Function of Government 12
12.1 What Is Insurance and Why Do Individuals Value It?
12.2 Why Have Social Insurance?
12.3 Other Reasons for Intervention in Insurance Markets
12.4 Social Insurance versus Self-Insurance: How Much
Consumption Smoothing?
12.5 The Problem with Insurance: Moral Hazard
12.6 Putting It All Together: Optimal Social Insurance
12.7 Conclusion PREPARED BY

Dan Sacks

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Social Insurance: The New Function of Government

• Preamble to the United States Constitution:

Establish justice, insure domestic tranquility, 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, emphasis on
“common defense.”
• Since 1950 or so, shift toward “the general welfare.”

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Government spending, 1953 and 2010

1953 2010
Defense 69.4% 19.1%
Income security 5.0 20.1
Social Security 3.6 15.9
Health 0.4 25.2
Other 21.6 19.7

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Social Insurance: The New Function of Government

• Government spending now focuses on social insurance

programs.
o Social insurance programs: Government
interventions in the provision of insurance against
adverse events.
• For most programs, eligibility is not means-tested.
o Means-tested: Programs in which eligibility
depends on the level of one’s current income or
assets.

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12.1
What Is Insurance?

• Insurance is a promise to make some payment in case

of a particular event, in exchange for a payment, called
a premium.
• Insurance premiums: Money that is paid to an
insurer so that an individual will be insured against
adverse events.
• Insurance products in the United States include: health
insurance, auto insurance, life insurance, and casualty
and property insurance.
• Annual private premiums for these products totals
more than $1.5 trillion.

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12.1
Why Do Individuals Value Insurance?

Insurance is valuable because it helps individuals

insurance consumption across states of the world.
• Consumption smoothing: The translation of
consumption from periods when consumption is high,
and thus has low marginal utility, to periods when
consumption is low, and thus has high marginal utility.
• States of the world: The set of outcomes that are
possible in an uncertain future.

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12.1
Why Do Individuals Value Insurance?
Diminishing marginal utility

• Diminishing marginal utility means that the fourth slice

of pizza is less important than the first.
• Always having two slices is better than having four and
sometimes having zero.
• Always a moderate amount of consumption for sure is
better than a 50–50 chance of having a lot or nothing.
• Individuals will demand full insurance in order to fully
smooth their consumption across states of the world.

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12.1
Formalizing This Intuition: Expected Utility Model

We formalize these ideas in the expected utility model.

• Expected utility model: The weighted sum of utilities
across states of the world, where the weights are the
probabilities of each state occurring.
• Suppose an adverse event occurs with probability .
Expected utility is

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12.1
The Expected Utility Model: Health insurance

• 1% chance that Sam gets hit by a car, resulting in

$30,000 in medical expenses.
• Insurance costs b for each dollar of coverage.
o If Sam buys $m of coverage, his premium is $mb.
• To analyze Sam’s choice, assume , and premiums are
actuarially fair.
o Actuarially fair premium: Insurance premium that
is set equal to the insurer’s expected payout.

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12.1
Full Insurance Is Optimal

Purchase Hit? C Expected Utility

No Yes 30,000
insurance
No 0 0

Full Yes 38,700

insurance
($300) No 38,700

Partial Yes 38,850

insurance
($150) No 14,850

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12.1
Full Insurance Is Optimal

No Insurance Full insurance Partial Insurance

Premium 0 300 150
C if not hit 30,000 38,700 38,850
C if hit 0 38,700 14,850
U if not hit 173.2 172.34 172.77
U if hit 0 172.34 121.86
Expected 0.99 × 173.2 0.99 × 172.34 0.99 × 172.77
utility + 0.01 × 0 + 0.01 × 121.86
= 171.5 + 0.01 × = 172.26
172.34
= 172.34

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12.1
The Role of Risk Aversion

• Risk aversion: The extent to which individuals are

willing to bear risk.
• Risk-averse people may still want to buy some
insurance even if it is not actuarially fair.
• People may differ in their risk aversion, and if
insurance premiums are extremely unfair, then only
the most risk averse will want to it.

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12.2
Why Have Social Insurance? Asymmetric
Information and Adverse Selection

Why should the government provide insurance?

• Information asymmetry can lead to a key market
failure called adverse selection.
o Information asymmetry: The difference in
information that is available to sellers and to
purchasers in a market.
• Individuals may know much more about their riskiness
than do insurers.
• This has profound implications for insurance markets.

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12.2
Adverse Selection Example

• Two kinds of people:

o Careless people have a 5% chance of being in a car
accident (half the population).
o Careful people have a 0.5% chance (half the
population).
• If the insurance companies knows each person’s type,
it can charge them separate prices.
• If the insurance company doesn’t know their type, it
could try charging a price that is fair on average, or try
charging separate prices.

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12.2
Insurer Breaks Even with Full Information Pricing

• What happens if the insurance company could charge

each type their actuarially fair price?
o Charge careless people $1,500.
o Charge careful people $150.
o Earn $150,000 per 100 careless people, pay out
$150,000.
o Earn $15,000 per 100 careful people, pay out
$15,000.

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12.2
Asymmetric Information Pricing: Separate

• What if the insurance tries to charge different prices

but cannot tell who is careless?
o Careless people pretend to be careful, pay $150.
o Careful people pay $150.
o Earn $15,000 per 100 careless people, pay out
$150,000. Lose $135,000.
o Earn $15,000 per 100 careful people, pay out
$15,000.

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12.2
Asymmetric Information Pricing: Separate

• What if the insurance company tries to charge average

price?
o Average price: $825.
o Insurance is a great deal for careless people, so
they buy it, pay $825.
o Careful people decline it.
o Earn $82,500 per 100 careless people, pay out
$150,000. Lose $67,500.
o Earn nothing from careful people.

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12.2
The Problem of Adverse Selection

• Adverse selection: The fact that insured individuals

know more about their risk level than does the insurer
might cause those most likely to have the adverse
outcome to select insurance, leading insurers to lose
money if they offer insurance.
• Selling to both requires that low-risk people subsidize
high risk people.
• Low-risk people may not want to do this.
• Sometimes, only high-risk people end up with
insurance.

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12.2
Does Asymmetric Information Necessarily Lead to
Market Failure?

If low-risk people have a high enough risk premium, they

will subsidize high-risk people in a pooling equilibrium.
• Risk premium: The amount that risk-averse individuals
will pay for insurance above and beyond the actuarially
fair price.
• Pooling equilibrium: A market equilibrium in which all
types of people buy full insurance, even though it is
not fairly priced to all individuals.
• Separating equilibrium: A market equilibrium in which
different types of people buy different kinds of
insurance products designed to reveal their true types.

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12.2
APPLICATION: Adverse Selection and Health
Insurance “Death Spirals”

• In 1995, Harvard stopped subsidizing its most

generous plans, which were experience-rated.
• Experience rating: Charging a price for insurance that
is a function of realized outcomes.
• Before 1995, there was a pooling equilibrium.
o Healthy employees chose the cheap, generous
plan.
• After 1995, there was a separating equilibrium.
o Healthy employees dropped the now expensive
generous plan.

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12.2
APPLICATION: Adverse Selection and Health
Insurance “Death Spirals”

• Because the less-healthy employees used much more

medical care, the experience-rated premiums of the
more generous plans increased substantially.
• By 1998, the most generous plan had gotten so
expensive that it was no longer offered.
o Adverse selection had led to a “death spiral” for
this plan.
o It kept getting more expensive, and healthy people
kept leaving, driving its price ever higher.

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12.2
How Does the Government Address Adverse
Selection?

Adverse selection leads to market failure since healthy

people may not be able to buy insurance.
• The government can address adverse selection, and
improve market efficiency, in a number of ways…
• …but they involve redistribution from the healthy to
the sick, which may be quite unpopular.

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12.3
Other Reasons for Government Intervention in
Insurance Markets

• Externalities: Vaccines have positive spillovers; car

crashes negative ones.
• Administrative costs: Government-run Medicare has
much lower administrative costs than private
insurance.
• Redistribution: Governments may want to redistribute
from healthy to sick.
• Paternalism: Governments may feel that people would
choose to buy too little insurance for themselves.

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12.3
APPLICATION: Flood Insurance and the
Samaritan’s Dilemma

The Samaritan’s Dilemma is another rationale for

intervention.
• Compassionate governments want to bail out hard-hit
citizens.
• But, knowing this, citizens may not buy insurance,
making bailouts expensive.
• This is especially important for floods.
• Congress established National Flood Insurance
Program (NFIP) in 1968 to address this.

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12.3
APPLICATION: Flood Insurance and the
Samaritan’s Dilemma

• NFIP has paid out $11.9 billion since 1969, and lead to
improved building standards.
• But nearly half of the victims of Hurricane Katrina in
2005 did not have flood insurance, and the claims of
people with insurance bankrupted the system.
• The program is underfunded but would benefit from a
mandate (at actuarially fair prices).
• Developers oppose the mandate because it would
drive up the cost of ownership.

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12.4
Social Insurance versus Self-Insurance: How Much
Consumption Smoothing?

• Even if private insurance markets do not function well,

people may still be able to insure with self-insurance.
• Self-insurance: The private means of smoothing
consumption over adverse events, such as through
one’s own savings, labor supply of family members, or
borrowing from friends.

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12.4
Example: Unemployment Insurance

People can insure against unemployment in many ways:

• They can draw on their own savings.
• They can borrow, either in collateralized forms or in
uncollateralized forms.
• Other family members can increase their labor
earnings.
• They can receive transfers from their extended family,
friends, or local organizations.

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12.4
Example: Unemployment Insurance

• Unemployment insurance provides benefits through

the replacement rate.
• UI replacement rate: The ratio of unemployment
insurance benefits to pre-unemployment earnings.
• A higher replacement rate corresponds to more
generous insurance.
• But private insurance reduces the consumption-
smoothing value of this insurance.

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12.4
Example: Unemployment Insurance

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12.4
Lessons for Consumption-Smoothing Role of Social
Insurance

The importance of social insurance for consumption

smoothing will depend on two factors:
• Predictability of the event: Easier to self-insure
against predict able events.
• Cost of the event: Easier to self-insure against low-
cost events.

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12.5
The Problem with Insurance: Moral Hazard

The cost of insurance is moral hazard.

• Moral hazard: Adverse actions taken by individuals or
producers in response to insurance against adverse
outcomes.
o “Nothing emboldens sin so much as mercy.”
• The existence of moral hazard means that it may not
be optimal for the government to provide the full
insurance that is demanded by risk-averse consumers.

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12.5
APPLICATION: The Problems with Assessing
Workers’ Compensation Injuries

• Prison guard Ricci DeGaetano

o Supposedly injured by an inmate. Collected
$82,500 in claims over three years while
operating a karate school.
• Waitress Christina Gamble
o Too injured to “stand” and “change positions.”
Received $360/week in insurance payments while
working as a stripper.
• Detective Rockey Sherwood
o Injured in traffic accidents. While claiming
workers’ compensation, coached little league
team to California World Series victory.
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12.5
The Problem with Insurance: Moral Hazard

What determines moral hazard?

• How easy it is to observe whether the adverse event
has happened.
• How easy it is to change behavior in order to establish
the adverse event.

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12.5
The Problem with Insurance: Moral Hazard

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 expenditures when in the adverse state.
• Supplier responses to insurance against the adverse
state.

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12.5
The Consequences of Moral Hazard

Moral hazard is costly for two reasons:

• The adverse behavior encouraged by insurance
lowers social efficiency because it reduces the
provisions of socially efficient labor supply.
• When social insurance encourages adverse events,
which raise the cost of the social insurance program,
it increases taxes and lowers social efficiency further.

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12.6
Putting It All Together: Optimal Social Insurance

• Optimal social insurance systems should partially, but

not completely, insure individuals against adverse
events.
• The benefit of social insurance is the amount of
consumption smoothing provided by social insurance
programs.
• The cost of social insurance is the moral hazard caused
by insuring against adverse events.

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12.7
Conclusion

• Asymmetric information in insurance markets has two

important implications:
o It can cause adverse selection.
o It can cause moral hazard.
• The ironic feature of asymmetric information is
therefore that it simultaneously motivates and
undercuts the rationale for government intervention
through social insurance.

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