Social Insurance

Marco Faravelli
University of Queensland

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 Social Insurance Programs
• Social insurance programs are government interventions
in the provision of insurance against adverse events.
• Examples:
▶ health insurance (Medicare, Pharmaceutical Allowance)
▶ retirement insurance (Age Pension)
▶ disability insurance (Disability Support Pension)
▶ unemployment insurance (Newstart Allowance)

• Contrasts with welfare, which are usually means-tested

transfers.
• Social insurance is the biggest and most rapidly growing
part of government expenditure today.

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Australian Government Expenditure

Social security & welfare

Defence
18.7% Public order & safety
Health
Education
34%
General public services
Housing & community amenities
Mining, manufacturing &
construction
Recreation & culture
Fuel and energy
6.7%
Agri., forestry & fishing
5.5% Transport & communication
7.3% Total transport and communication
15.8% Other economic affairs
Other purposes

Chart Data: Australian Government Final Budget Outcome FY 2012-13

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 What is Insurance?

Insurance Premiums:
Money that is paid to an insurer so that an individual will be
insured against adverse events.

Examples of private insurance:

• health insurance
• auto insurance
• life insurance
• casualty and property insurance

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 Expected Utility Model
Utility function U(c):
• increasing in consumption c, i,e, U ′ (c) > 0
• concave in consumption c, i.e. U ′′ (c) < 0

U(c)

c
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 Expected Utility Model
Individuals maximize expected utility defined as the weighted
sum of utilities across states of the world, where the weights
are the probabilities of each state occurring.

Suppose an individual has income Y :

• if there is no adverse event, she consumes all of her
income Y ;
• if there is an adverse event, she loses L and only consume
what is left Y − L.

Let q be the probability of an adverse event, then expected

utility is written as:

EU = q · U(Y − L) + (1 − q) · U(Y )
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 Actuarially Fair

Actuarially Fair Insurance:

Insurance Premium = Insurer’s Expected Payout

Examples of private insurance:

• health insurance
• auto insurance
• life insurance
• casualty and property insurance

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 Insurance or Not?

• Suppose there is an actuarially fair full insurance contract:

▶ always pay premium p

▶ receive payout L only if adverse event happens.

• Actuarially fair means that

p = qL

• Would the individual be better off buying the insurance?

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 Insurance or Not?
• Would the individual be better off buying the insurance?

• To illustrate, let
▶ q = 1/2
▶ Y = 25
▶ L = 16
√
▶ U(c) = c

• Actuarially fair: p = qL = 8

√ √
No Insurance 25 9 EU = 12 25 + 12 9 = 4
√ √
Full Insurance 17 17 EU = 12 17 + 12 17 ≈ 4.12

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 Gains from Insurance
• Thus, having full insurance increases expected utility.

• A concave utility function means diminishing marginal

utility.

• Marginal utility is the extra amount of utility one gets (or

lose) if one increases (or reduces) a small unit of
consumption.

• The marginal utility is low when the consumption level is

high.

• Due to diminishing marginal utility, an individual would

like to smooth consumption across states.

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The utility from a certain amount of consumption at the
expected consumption level is higher than expected utility of
uncertain consumption:

U(c)

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 Full Insurance or Partial Insurance?

• In the previous example, there is full insurance:

▶ Consumption is the same in both states.
▶ And equals to Y − qL.

• If the insurance contract is partial insurance, the insurer

pays out part of the loss when an adverse event happens:

ρL, where 0 < ρ < 1

• For the same argument for income smoothing, the

individual would like full insurance (i.e. ρ = 1) to
maximize expected utility.

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The utility from a certain amount of consumption at the
expected consumption level is higher than expected utility of
uncertain consumption:

U(c)

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 Heterogeneous Risk across Individuals
• Suppose the adverse event is sickness.
• There are two types of individuals:
▶ healthy: qH = 0.1
▶ sickly: qS = 0.5

Symmetry Information:
Both insurance companies and individuals can observe healthy
and sickly types (for example by age).
• Then, insurance companies offer different policies to
different type of people.
• Both get full insurance.
• But if Y < qS L, Sickly person cannot afford insurance
and dies or starves if sick.
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 The Market for Lemons

• Lemons: bad used cars with hidden defects

• Peaches: good used cars without problems

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 The Market for Lemons
• A used car could be a lemon or a peach, with equal
probability (i.e., 50%).

• Asymmetric Information:
▶ Seller knows the car’s quality but the buyer does not.

• Buyer’s value of a car:

▶ good: $30
▶ bad: $10

• Seller’s value of a car:

▶ good: $25
▶ bad: $5
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 Buyer Seller
Good car $30 $25

Bad car $10 $5

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 Adverse Selection

• Not knowing the quality of the used car, the buyer is only
willing to pay for the average quality:
▶ $20 = 12 $30 + 12 $10

• But $20 is less than the seller’s value of a good car ($25).
So a seller with a good car would not sell.

• The market is left with lemons.

• Note that if the quality of the car is known to both seller

and buyer, a mutually beneficial trade could happen
regardless whether the car is good or bad.

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Adverse Selection in the Health Insurance Markets
Insurance Premium
Individual Insurance Company
Low Health Risk $500 $300

High Health Risk $1,100 $900

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 Heterogeneous Risk across Individuals

Asymmetry Information:
Only individuals can observe their own healthy and sickly
types. Insurance companies can not.

• If insurance companies continue to offer the same two

policies:
▶ pS = qS L for the sickly
▶ pH = qH L for the healthy

• Then everybody want to buy the healthy insurance which

is cheaper.
• Insurance companies will make losses.

• Cannot be an equilibrium.
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 Market Unraveling
• Individuals have 4 different levels of health:
▶ Excellent, Good, Fair, and Poor.
▶ They are willing to buy insurance with premium $300,
$350, $370, $400 respectively.
▶ For each level of health, the insurance companies could
insure at a cost slightly lower than the willingness to pay
(say $10).
▶ Each type of people accounts for 25% of the population.

• Unraveling (or death spiral):

1 Initially, the expected value of willingness to pay for an
insurance policy is $355.
2 But at $355, sellers of excellent car won’t sell.
Expected value drops to $373.
3 Again at $373k, sellers of good car won’t sell.
Expected value drops to $385.
4 Again at $385, sellers of fair car won’t sell.
Expected value drops to $400. 21 / 38
 Market Unraveling

Health Excellent Good Fair Poor

Willingness-to-pay $300 $350 $370 $400
Insurance Buyer’s Willingness to Pay for a Health Insurance
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Adverse Selection:
When individuals know more about their risk level than the
insurer and hence individuals with higher risk are more likely to
purchase insurance.

Example: people with high risk of getting into a car accident

more likely to buy car insurance than people with low risk of
getting involved in accidents.
With adverse selection, markets for health insurance can
unravel (“death spiral”):
• Health insurance is offered at average fair price, bad deal
for low risk people and hence only high risk people buy it
⇒ insurers make losses ⇒ insurers raise the price further
⇒ only very high risk people buy it ⇒ insurers make
losses again ⇒ no insurance contract is offered at all even
though everybody wants full actuarially fair insurance
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 Competitive Insurance Markets
• Consider a competitive insurance market with:
▶ many insurance companies earning zero profit; and
▶ many individuals with various health risks.

• Downward sloping demand curve: the lower is the price,

the more individuals are willing to pay for the insurance.

• With diminishing marginal utility, willingness-to-pay is

higher than the marginal cost to insure.

• Under information asymmetry, the average cost (AC)

determines the quantity of insurance being supplied for
each level of premium (price of insurance).

• When the demand curve meets AC curve, there is a

market equilibrium.
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 U(c)

• The utility from certain consumption at the expected level

is higher than expected utility of uncertain consumption.
• The willing-to-pay for insurance by an individual would be
higher than the insurance cost for that individual.
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Complete Market Unraveling

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Incomplete Market Unraveling

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Adverse Selection in the Insurance Markets

• An insurance market may completely unravels.

• Even when an insurance market unravel incompletely,

there may be a substantial missing market, which created
deadweight losses.

• So far, we assume that a single insurance contract is

offered to everyone.

• What if insurance companies are able to offer multiple

contracts?

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 Two Equilibrium Possibilities

• Pooling equilibrium
▶ Insurance companies offer a contract based on average
risk
▶ good deal for sickly, mediocre deal for healthy but better
than no insurance

• Separating equilibrium:
▶ Insurance companies offer two contracts: one expensive
contract with full insurance for the sickly, one cheap
contract with partial insurance for the healthy: each
type self-select into its contract
▶ Outcome not efficient as healthy as under-insured

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Screening in the Insurance Market

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How does the Government Address Adverse Selection?
• The government can address adverse selection and
improve market efficiency but this involves redistribution
• Natural solution is to impose a mandate: everybody is
required to purchase insurance
▶ If price is the same for everybody, the low risk end up
subsidizing the high risks

• From a social perspective, being high risk (e.g. having a

sickly constitution) is rarely consequence of individual
choices.
▶ Society might want to compensate individuals for this

• Explains why all OECD countries (except US until

Obamacare) have adopted universal health insurance
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 ObamaCare

• forbids insurers from charging based on pre-existing

conditions

• mandates that everybody needs to get insurance

• subsidizes health insurance for low income families

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 ObamaCare
• Individuals may not appropriately insure themselves
against risks if the government does not force them to do
so (myopia, lack of information, self-control problems)
▶ If individuals understand their own failures, they will
support social insurance (e.g., Medicare Health
Insurance for elderly is very popular)
▶ If individuals really want to be myopic, they will oppose
government social insurance (paternalism)

• Administrative Costs
▶ The administrative costs for Medicare (U.S.) are less
than 2% of claims paid.
▶ Administrative costs for private insurance average about
12% of claims paid.
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Moral hazard:
Adverse actions taken by insured individuals in response to
insurance against adverse outcomes.
• Example: If you receive unemployment benefits replacing
lost wages, you may not search as much for a new job ⇒
Insurance reduces incentives to remedy adverse events

• Moral Hazard exists with both private and social

insurance as long as insurer cannot perfectly monitor the
person insured ⇒ Insurers do not offer perfect insurance

• The existence of moral hazard problems creates the

central trade-off of social insurance: insurance is desirable
for consumption smoothing but insurance can create
moral hazard

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 Moral Hazard is Muliti-Dimensional

• Reduced precaution against entering the adverse state

(example: auto insurance)

• Increased odds of staying in the adverse state (example:

unemployment insurance)

• Increased expenditures when in the adverse state

(example: health insurance)

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 Optimal Social Insurance

• Optimal social insurance trades-off two considerations:

1 How hard it is to observe whether the adverse event has

happened

2 How easy it is to change behavior in get into or stay in

the adverse event

• Optimal social insurance systems should partially, but not

completely, insure individuals against adverse events.

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 Conclusion

• Asymmetric information in insurance markets has two

important implications:

1 It can cause adverse selection in private insurance

provision hence the need for social insurance

2 It can cause moral hazard (as insurer cannot perfectly

monitor behavior), hence the need to limit generosity of
insurance

• 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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