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The Economics of Risk Management and Insurance

Preprint · August 2018

DOI: 10.13140/RG.2.2.24248.80648

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The Economics of Risk Management and Insurance

By Robert W. Klein, Ph.D.1

Reading Objectives
1. Provide an overview and elementary explanation of certain economic concepts
relevant to risk management and insurance.

2. Explain the concept of risk aversion and its importance to individuals’ and firms'
demand for risk management and insurance.

3. Discuss other factors influencing the demand for risk management and insurance.

4. Discuss other important risk management and insurance principles and the problems
of adverse selection and moral hazard.

5. Discuss how the interaction of supply and demand determines the quantity of
insurance purchased and its price.

6. Review the different types of market structures and their implications for firm
behavior and performance.

7. Explain the concepts of public goods, externalities, and principal-agent conflicts and
their relevance to the study of risk management and insurance.

I. Introduction
Understanding the economics of risk management and insurance is essential to

understanding how insurance markets function as well how individuals, firms, and the

government approaches risk management. This reading provides a high-level, elementary

overview of important economic concepts and principles relevant to insurance and risk

management. We begin with the economic theory underlying risk aversion and

maximizing expected utility under uncertainty and how economists use this theoretical

1
construct to explain why individuals are willing to pay a risk premium (over the expected

payout on an insurance policy) for insurance. We then move to the standard economic

framework for analyzing the interaction of supply and demand for a given good or

service and how it lays a foundation for understanding how insurance markets work. This

is followed by a discussion of the special problems of moral hazard and adverse selection

and their significant implications for the terms under which insurance is sold and

purchased as well how they influence risk management decisions. The final concepts that

are examined are public goods, externalities, and principal-agent conflicts which are

relevant to certain aspects of risk management and insurance.

II. Determinants of the Demand for Insurance

A. Risk Aversion and Expected Utility
Economists have been intrigued by the question of why people would buy

insurance if the premium they would have to pay would exceed the “expected payout”

that they would receive on the policy. The expected payout is equal to the expected loss

or claims payments that an insured would receive, i.e., the probability of having a loss

multiplied times the amount of the loss that might occur. For example, if a person faces a

10 percent probability of having a $10,000 loss, their expected loss or payout on an

insurance policy would be $1,000.2

1
Dr. Klein is an Associate Professor of Risk Management and Insurance and Director of the Center for
Risk Management and Insurance Research at Georgia State University. He can be contacted at
rwklein@bellsouth.net.
2
In reality, people and firms face a range of possible losses, each with an associated probability. In such a
situation, the expected loss could be calculated by multiplying the probability of each potential loss times
the loss and summing all of these calculations. Probability distributions can also be used to estimate the
expected loss for a given risk exposure using established parameters and a functional form that determine
its characteristics.

2
 Obviously, an insurer offering such a policy would have to charge a premium

equal to this expected loss plus a “loading” for the insurer’s expenses and cost of capital

in servicing the policy. At first blush, in pure monetary terms, it might seem that people

would be neutral about a purchasing an insurance policy at a premium that would equal

the expected payout that they would receive on the policy. Further, it might seem that

people would not be willing buy a policy that would cost more than the expected payout.

It would be comparable to asking someone to bet a dollar on a coin flip but if she wins

she gets less than a dollar.3 However, if we make certain reasonable assumptions about

how peoples’ utility varies with the amount of wealth they have or would have under

different scenarios, we can develop a plausible explanation for why they would buy

insurance, even if the premium exceeds the expected payout they would receive.4

Utility theory is the foundation for analyzing people's preferences and demand for

things they value. In theory, people allocate their expenditure of resources to maximize

their utility, i.e., the satisfaction or pleasure they derive from anything that has value,

including leisure. Economists use utility functions and budget constraints to determine

peoples' demand functions for a good or utility and how much they would be willing to

pay for it.

The key assumption underlying the demand for insurance is that most peoples’

utility curves (plotting utility against wealth) are concave, i.e., the slope of the utility

3
This would be equivalent to equalizing the amounts that would be won or lost, but changing the odds so
that the probability of winning is less than the probability of losing. Actually, organized gambling offers
negative expected payouts. For example, state lotteries pay out much less in winnings than they receive in
revenues in order to fund their operating expenses and return money to the state treasury for various
purposes. Presumably, gamblers accept this because they derive utility from gambling, e.g., entertainment
value, in excess of the expected payouts on their wagers.
4
We note here that the a firm's demand for insurance would be expected to differ from that of an individual
or household. Nonetheless, there is a stream of literature that indicates that firms also will often find

3
curve becomes flatter as wealth increases. In other words, a person's utility increases as

their wealth increases but it does so at a diminishing rate. The intuition is that the

marginal increase in utility derived from a given increase in wealth decreases as wealth

increases. In other words, a poor Bill Gates derives more utility from an extra dollar than

a wealthy Bill Gates. This is illustrated in Figure 1.

Figure 1
Risk Averse Utility

Utility

0 1 2 3 4 Wealth

Economists apply this concept to the demand for insurance. If someone is risk

averse, they are willing to pay something for insurance to keep what they have rather than

take the chance of having a loss. What they are willing to pay for this security or

reduction in uncertainty, i.e., “objective risk,” is called a "risk premium." It is the amount

insurance to be worth buying as an element of their overall risk management strategy (Harrington and
Niehaus, 2002).

4
above their expected loss or the expected payout on an insurance policy that someone is

willing to pay to have insurance.

This can be illustrated with the following example depicted in Figure 2. Fred has

$50,000 in the bank and a house worth $500,000 with a 2 percent chance of fire that will

totally destroy the home (there is no chance of a partial loss). His total wealth is

$550,000. In the absence of insurance, Fred will experience one of two possible

scenarios: 1) there is no fire and he retains his wealth of $550,000, or 2) there is a fire, he

loses his house, and his wealth decreases to $50,000.

Now, let us assume that Fred has the option of buying an insurance policy that

will pay the value of his house if it is destroyed by fire. Further, for the moment, let us

assume the premium for this policy is equal to the expected loss or pure premium, which

is $10,000 (.02 x $500,000), i.e., there is no loading for the insurer’s expenses. Fred will

choose to buy insurance if his expected utility from doing so exceeds his expected utility

from not buying insurance.

To determine what Fred will do, we need to postulate a utility function for him. Let us

assume that he has the following utility function:

U(W) = ln(W)

where U = utility
W = wealth.

5
 Figure 2
Maximizing Expected Utility

This functional form, where the amount of utility is equal to the natural log of the

amount of wealth, results in a concave utility curve, consistent with the assumption of

diminishing marginal utility and risk aversion. Using this functional form and the other

information we have, we can calculate and plot Fred’s expected utility without insurance

and with insurance, and, hence, determine what choice he will make to maximize his

expected utility. The expected utility if Fred does not buy insurance is:

EUNI = 0.98 x ln($550,000) + 0.02 x ln($50,000)

= 0.98 x 13.22 + 0.02 x 10.82
= 13.17

The expected utility if Fred does buy insurance is:

EUI = ln($550,000 - $10,000)

= 13.19

Fred will buy insurance if his expected utility from buying insurance exceeds his

expected utility from not buying insurance, i.e., EUI is greater than EUNI. In our example,

6
Fred will buy insurance because EUI (equal to 13.19) is greater than EUNI (equal to

13.17).

Note, in this example, we started with an unrealistic assumption that the insurer

would charge a premium equal to the expected loss on Fred’s policy with no loading for

expenses or profit. We know that, in reality, insurers have to charge a premium that

includes a loading to cover their costs for servicing policies. This raises the following

question. What is the “risk premium” or loading that Fred would be willing to pay for

insurance, i.e., how much more than the expected payout on the policy would he be

willing to pay? We can determine this amount (in dollars) by calculating the difference

between the money equivalents of EUI and EUNI. By subtracting the amount of wealth

(W*) that would be needed to generate EUNI from the amount of wealth (W**) needed to

generate EUI, we are calculating the risk premium or the additional amount Fred would

be willing to pay for insurance. Since EU(W) equals the natural log of W, we can

calculate W* and W** by taking the anti-logs of EUNI and EUI. Hence:

Fred’s risk premium = W** - W*

= $540,000 - $524,246
= $15,754.

This means that Fred would be willing to pay up to $15,754 more than the

expected payout on his policy, or a total premium of $25,754 which is equal to the sum of

the expected payout or loss and Fred’s risk premium ($10,000 + $15,754). If an insurer

charges less than $25,754, Fred will buy insurance. If the insurer charges more than

$15,754 (this would be necessary if the insurer’s loading for expenses was more than

$15,754), then Fred would not buy insurance.

7
 The concept of risk aversion and its implications for insurance demand is

important because it tells us the circumstances and terms under which people would be

willing to buy insurance. In order for there to be a viable market for insurance, enough

people have to be risk averse and willing to pay "risk premiums" sufficient for insurers to

cover their expected claims payments and their expenses. If people were not risk averse,

no one would buy insurance unless they were coerced to do so. Further, the more risk

averse someone is, the greater will be his demand for insurance, all else equal.

This concept has further application in understanding when it is economically

feasible to sell some types of insurance to some people and not others. When insurers'

expenses are relatively low in relation to the expected losses from covering a particular

risk, people are more likely to buy insurance and the premium is more likely to be

economically feasible. This helps to explain insurance experts' advice that it is generally

a better use of one's money to purchase higher liability limits than low deductibles on

their auto insurance policy. It also explains why it does not make sense for very old

people to buy life insurance – the premium they would have to pay (the expected loss

plus the insurer's loading for expenses) would exceed the face amount of the policy.

B. Other Factors Influencing the Demand for Insurance

It is reasonable to surmise that other factors may influence peoples’ demand for

insurance besides their degree of risk aversion. One important factor is the information

they have and their perception of the risks they face. In the above example, we implicitly

assumed that both Fred and the insurer knew that there was a 2 percent chance that his

house would be totally destroyed by a fire. However, if Fred believed that his probability

of loss was less than 2 percent, the premium he would be willing to pay would be less

8
than $25,754. The lower Fred’s perception of his risk, the less he would be willing to pay

for insurance, i.e., the lower would be his demand for insurance. Depending on the

disparity between Fred’s perception of his risk and what insurers perceive it to be, it is

possible that Fred would not buy insurance at the premium insurers would need to

charge. Hence, relatively low consumer demand for certain types of insurance (e.g.,

earthquake and flood insurance) could be partially caused by consumers’ underestimation

of their risk. Conversely, relatively high demand for demand for certain types of

insurance, such as flight insurance, could be due, in part, to travelers’ overestimation of

their risk of being killed in a plane crash.

Peer behavior may further influence a person’s demand for insurance. Your

perception of risk may be affected by your neighbors’ or friends’ perception of risk.

Further, if your relatives or friends purchase insurance, you may be more likely to

purchase insurance and you are less likely to purchase if your neighbors and friends do

not buy it.

Other psychological factors and the ways in which people perceive and react to

risk can affect their demand for insurance and their willingness to invest in risk

mitigation. Kahneman (2011) distinguishes between intuitive thinking and deliberative

thinking. When people engage in intuitive thinking, they tend to make decisions

automatically and quickly with little thought; such thinking is often guided by emotional

reactions and rules of thumb based on personal experience (Kunreuther, 2015). When

people engage in deliberative thinking, they devote more time and thought to the choices

they make. When faced with the possibility of loss causing events that occur rarely,

individuals are more likely to engage in intuitive rather than deliberative thinking

9
(Kunreuther, 2015). Intuitive thinking is likely to result in people underestimating their

risk and being more reluctant to buy insurance or invest in risk mitigation. Such thinking

also tends to be associated with myopia where people tend to focus too much on the

short-term and not enough on the long-term.

Wealth and income also influence the demand for insurance. This happens in two

ways. First, wealth and income determine consumers’ budget constraints in purchasing

various goods and services, including insurance, and what they can afford to pay for

insurance. Second, a person’s wealth and income can determine what they stand to lose if

they have an accident or are sued, as well as their ability to fund their losses from the

assets they hold. The effects of these different considerations can move in different

directions, so one cannot say that wealth and income will always have a positive or

negative effect on the demand for insurance. However, observation suggests that greater

wealth and income tend to increase a person’s demand for insurance.

Of course, even if someone can afford and would be willing to buy insurance, we

might expect a person to compare the relative costs and benefits of different risk transfer

options and choose the one that maximizes their utility. More specifically, if a person can

find a less costly way to transfer risk than insurance, they would presumably choose this

low-cost option over insurance. There are various forms of non-insurance risk transfers,

such as defaults on debt obligations, charity and government financial assistance.5 For

example, some people might choose to go without insurance if they can declare

bankruptcy and escape their debts if they suffer a major financial loss. Similarly, if

5
Non-insurance risk transfers also can be attempted through contractual provisions that would require the
other party to indemnify the first party or assume some risk involved in the transaction.

10
people believe that their financial losses or expenses would be covered by the

government or charity, they might forgo insurance.

A good example of this kind of thinking is the decision by some people to not buy

health insurance, even though they could afford to pay for it. Some of these people may

believe that hospitals and/or the government will cover their medical costs if they do not

have health insurance. Similarly, some people with few assets might consider themselves

“judgment proof” and will try to avoid buying auto liability insurance. They have little to

lose if they cause an accident and are sued for the damages they inflict on others. As

discussed below, the ability to externalize risk to others can have a negative effect on a

person’s demand for insurance.

Consequently, the government or other entities at risk may force people to buy

certain kinds of insurance. Obviously, this will increase the demand for insurance. For

example, most states require drivers to purchase minimum amount of auto liability

insurance so that there will be at least some coverage for any damages they may cause.

Also, on home mortgages, lenders will typically require borrowers to insure their home

because the home serves as collateral to back the loan.

C. Application to the Demand for Risk Management

The preceding discussion on the demand for insurance has implications for the

demand for other risk management generally and risk mitigation specifically. The risk

management methods other than risk transfer are: avoidance, retention, and risk

prevention and reduction. Here we are interested in persons' and firms' willingness to

invest in measures that effectively mitigate their risk, either decreasing the likelihood of

their having a loss or reducing the severity of a loss if they have one. Note, investments

11
in risk mitigation can either be a substitute for or a complement to risk transfer (e.g.,

insurance).

To illustrate this point, consider the following example. Frances owns an older

frame home in the Florida Keys, which has a high exposure to damage hurricanes not

only due to wind but also due to flooding (coastal surge). She does not have a mortgage

so there is no lender to force her to buy flood insurance. Additionally, her home has not

been elevated. In this example, Frances is considering whether to elevate her home to a

level that would reduce the risk of her home being flooded to zero. Consequently,

Frances has four choices: 1) not buying flood insurance nor investing in elevation, 2)

buying insurance with no elevation, 3) investing in elevation and not buying insurance,

and 4) buying insurance and elevation. To simplify matters, let us assume that Frances

can only choose between Option 1 and Option 3, i.e., no company (nor the NFIP) will sell

her flood insurance. Hence, she has to decide whether to invest in elevation or not.

We need to make more assumptions.: 1) the probability of Frances' home being

flooded in any given year is one percent and she knows this, 2) the replacement cost of

her home and the actual cash value of its contents are $750,000, 3) the cost of elevating

her home would be 30% of its replacement cost ($150,000), and 4) she has a 20-year time

horizon and she does not plan to sell her home over this time horizon. To further simplify

matters, let us assume that Frances has just inherited $200,000 from a rich aunt who has

passed away, which she can invest in a risk-free asset that would pay her a 3% annual

return or spend on elevating her home.6 We will also assume that the ACV of her

6
We will assume that spending her inheritance on something other than elevating her home is not an option
she wants to consider.

12
contents will not change over this period. And, we will assume that Frances' home will

only flood once over the next 20 years.

Based on these assumptions, Frances' expected loss over the next 20 years is

$150,000 (.01 x $750,000 x 20) before discounting. With discounting (at a 5% rate), the

present value of Frances' expected loss is $111,581. If Frances is not risk averse, she will

invest in her inheritance rather than spending it on elevation. If she is risk averse, she

may be willing to spend her inheritance on elevation. If the latter is the case, she will

spend her inheritance on elevation if her risk premium exceeds the difference between the

present value of her expected loss and the cost of elevation.

III. Other Important Insurance and Economic Concepts

A. Diversification of Risk and the Pooling of Risk Through Insurance
The principal purpose of insurance is the spreading or diversification of risk.

Risk is endemic to life and business. Individuals and firms face a number of perils that

threaten them with financial losses. As defined by insurance experts, pure risk involves

no chance of economic gain and uncertainty about whether a financial loss will occur and

possibly how much that financial loss will be. Speculative risk involves the chance of

gain or loss and is not considered insurable. Arguably, these are theoretical abstractions

in the sense that many activities in which people or firm engage that expose them to what

insurance experts consider to be pure risks do so because they expect to gain something

from these activities if there is no loss. In practice, insurance experts and insurance

companies draw the line between activities in which people and firms are unlikely to

significantly increase their risk because they have insurance (e.g., driving their car to go

13
shopping) and activities where people would significantly increase their risk if they had

insurance to cover their losses (e.g., investing in the stock market, gambling, etc.).

The chance of damage to one’s home from a fire or storm is an example of a pure

risk. The cause of such a loss is accidental and uncertain. Homeowners do not know

whether they will have such a loss and when it would occur if they did have a loss.

Homeowners only know that such a loss might occur because of a random act of nature

or other event largely outside of their control. Moreover, homeowners have nothing to

gain from losing their home, although they do have something to gain from owning it and

engaging in certain activities that would increase their chance of loss (e.g., having a

barbecue in their backward).

Individuals and firms can reduce the pure risks they face through insurance

mechanisms designed to diversify or spread this risk across a wider base of exposures

and/or over time. This is accomplished by pooling losses for a group of risks in some

manner. Members of the group share all losses that are incurred by its members. In effect,

members of the group exchange a smaller, more certain financial contribution for

protection against a larger, uncertain loss. Combining losses for a group and sharing them

in some manner among group members makes this possible. In this sense, insurance is a

mechanism by which pure risks are transferred through pooling. Assuming that pool

members are risk averse, i.e., they value greater certainty and the reduction of risk, pool

members will be willing to pay a risk premium to cover the administrative and

transaction costs of the pool in return for the reduction in risk. This concept of risk

pooling underlies insurance purchased from an insurance company as well as other forms

of risk sharing among members of a group.

14
 Uncertainty and the law of large numbers make insurance valuable as well as

feasible. Insurance experts refer to the difference between actual losses and expected

losses as objective risk. As the number of members of an insurance pool increase, the

random or uncertain aspect of the occurrence of accidents and claims for benefits, i.e.,

objective risk, is reduced and there is greater certainty about the total losses that the pool

will suffer.7 This allows the pool to allocate its costs among its members in the form of

smaller, certain premiums or assessments. In effect, pool members exchange their fair

share of total pool costs in return for protection against the risk of loss that they would

otherwise face individually. Uncertainty and risk is reduced through sharing all losses

among the group members and the greater predictability of losses achieved by increasing

the number of members in the pool.

It should be stressed that pooling losses does not necessarily mean that every pool

member will make an equal contribution to the pool. In theory, equal contributions only

make sense if every member of the pool has the same risk of loss. In practice, most pools

contain members whose risk varies. Individual pool contributions can be based on

members’ relative degree of risk so that individuals with greater risk pay higher

premiums. As explained below, this maintains low-risk pool members’ incentives to

remain in the pool. Pools can be organized in various ways (e.g., group self-insurance,

insurance companies, etc.) but the basic concept is the same.

7
The law of large numbers can be illustrated by a coin tossing experiment. We know that the on any given
toss of a coin the probability of it turning up “heads” is 50 percent (.5) and the probability of it turning up
“tails” also is 50 percent or .5. However, if we toss the coin twice, we may get heads both times, tails both
times, or one head and one tail. If we toss the coin 10 times, we may get seven heads and three tails.
However, if we toss the coin a 1,000,000 times the frequency of heads is likely to be close to 500,000 or
one-half of the tosses. The more times we toss the coin, the more closely will the frequency of heads
approach one-half of the tosses.

15
B. Efficiency and Equity
Efficiency is a concept that is more often discussed by economists than insurance

experts, but it is relevant to all markets and insurance systems. The highest level of

efficiency is achieved when resources are utilized in the best way possible to maximize

social welfare (i.e., the combined utility of all members of society). This means that the

benefits of an activity should at least equal its cost or the activity should not be

undertaken and that all activities are performed at the lowest cost possible. When this

occurs, society reaps the maximum value from the employment of its resources. With

respect to insurance, this means that people and firms are managing risk in the best

manner possible, from their perspectives as well as society’s perspective. Managing risk

efficiently requires selling and purchasing optimal insurance contracts as well as

retaining and controlling losses to the extent that it is cost effective to do so.

Equity is another word for “fairness”; these are terms that can imply different

things to different people. Some might interpret equity to mean that all insureds should

pay the same premiums or receive the same benefits from insurance contracts, regardless

of their relative risk. A variation of this view of equity is based on the ability to pay;

those with greater resources would be expected pay more than those with fewer

resources. Alternatively, others define equity to mean that individuals should pay costs

according to the benefits they receive. Based on this interpretation, equity in insurance

markets is achieved when individuals pay premiums commensurate with their relative

risk, i.e., high-risk insureds pay higher premiums than low-risk insureds.

There is a tradeoff between the first interpretation of equity and efficiency. Equal

premium payments among insureds with different levels of risk will reduce efficiency.

16
Low-risk insureds will be induced to buy too little insurance and high-risk insureds will

be induced to buy too much. Incentives to mitigate losses also will be distorted by

equalizing premium payments. Individuals who do not pay the full cost of their insurance

will have less incentive to reduce their risk to lower their premiums, i.e., they will be

induced to act less safely than what would be in everyone's interest.

The second interpretation of equity is consistent with maximizing economic

efficiency. Allocating the full costs of activities to their beneficiaries will encourage

insurance and loss prevention expenditures that maximize social welfare. Individuals and

firms will be induced to reduce their risk of loss if the resulting premium savings exceeds

their cost of reducing risk (e.g., investing in loss prevention). Consequently, there is no

tradeoff between this notion of equity and efficiency.

C. Adverse Selection

Adverse selection occurs when high-risk individuals are more likely to purchase

insurance than low-risk individuals (Rejda and McNamara, 2016). This assumes that

insureds have better knowledge of their risk than insurers. Insurers seek to avoid adverse

selection through accurate risk classification and pricing and declining to sell insurance

for risk exposures for which they cannot determine or charge an adequate premium.

Efficient or risk-based insurance pricing discourages adverse selection, but insurers may

face constraints in obtaining adequate information and accurately assessing an

individual’s risk (Rothschild and Stiglitz, 1976). This leads to potential adverse selection

because insurers cannot accurately distinguish between insureds’ risk levels and are

subject to selling insurance to high-risk insureds at a price less than their expected cost.

17
This will induce high-risk insureds to purchase more insurance and low-risk individuals

to buy less insurance. Charging equal premiums to pool members with different risk

levels will induce low-risk individuals to leave the pool and high-risk individuals to stay

in the pool. When this occurs, an insurance pool tends to shrink to smaller and smaller

groups of high-risk insureds until the pool eventually collapses.8

Adverse selection is potential problem for almost any type of insurance but health

insurance is one type of coverage where it is readily apparent. Assume, for the moment,

that insurance companies would be prohibited from rejecting any applicant for insurance

and/or charging them a premium based on their risk level. This is not just an abstraction

as, currently, under the Patient Protection and Affordable Care Act (PPACA) in the U.S.,

this is effectively the case. Absent anything that would compel people to buy health

insurance, many might wait until they got sick or developed a serious health condition to

buy it. This would expose insurers to severe adverse selection and, essentially, make the

prohibition against risk-based underwriting and pricing unworkable. This is one of the

principle reasons why the PPACA also contained a provision that sought to compel most

people to buy health insurance (they are charged a financial penalty if they do not have

health insurance) known as the individual mandate. In 2017, the Congress repealed the

mandate so that, beginning in 2019, it will no longer exist.

Another example an attempt to mitigate adverse selection is the provision in the

federal flood insurance program that, in most instances, imposes a 30-day waiting period

on coverage taking effect after a property owner has purchased coverage. Without such a

8
In theory, insurers might attempt to get individuals to reveal their risk level by offering policies that
provide full protection and others that do not. Presumably, high-risk individuals will have a greater
preference for full insurance coverage at an appropriate price. However, in practice, there are impediments
to the success of such a strategy and it does not appear that any insurers actually employ it.

18
provision, many property owners might wait till flood waters were literally lapping at

their doorstep before they purchased coverage. As with health insurance, this kind of

adverse selection would make the flood insurance program infeasible.

Adverse selection constitutes a “market failure” in that the informational

constraints faced by insurers cause the market to provide a less than an optimal amount of

insurance and eventually collapse in the extreme case. Consequently, insurers strive to

obtain information on insureds’ risk and employ pricing, underwriting and policy design

measures that discourage adverse selection and help the market function more effectively.

However, regulators and other government officials may or may not approve insurers’

efforts to avoid adverse selection, depending on regulators’ perceptions of what is

efficient and equitable.

D. Moral Hazard

Moral hazard is another type of market failure that occurs when having

insurance causes insureds to expend less effort to avoid losses and, under certain

circumstances, intentionally cause losses. Insurance experts draw a distinction between

“moral hazard” and “attitudinal hazard” (Rejda and McNamara, 2016). According to

insurance experts, moral hazard constitutes a “defect in character” that would prompt an

insured to cause a loss. This might occur when the insured stands to gain financially from

causing an accident and filing a claim. For example, this could happen if a homeowner

could insure a home for more than its market value and gain financially from its loss due

to the insurance payment they would receive.

19
 Attitudinal hazard arises when an insured has diminished incentives to prevent

losses but would not gain financially from an insured event. When this is the case, the

insured may exercise less care in preventing or controlling losses, but would not be

induced to cause a loss. An example of attitudinal hazard would be a situation where an

insured homeowner would be more careless in preventing losses, such as failing to lock

his/her doors when he/she leaves his/her home.

Economists tend to use the term moral hazard to cover both phenomena and this

how most people use the term in practice. Economists focus on the role of incentives and

how rational people will respond to incentives. Hence, a rational person might be tempted

to cause a loss if their insurance would pay them more than the value of the item he

would lose. Of course, a person’s ethics or awareness of other costs (e.g., criminal

sanctions) could dissuade him/her from such behavior. The tendency for insurance to

prompt an insured to exercise less care is probably more significant, as this could occur

consciously or even subconsciously and the non-insured costs associated with an

accidental loss may be less significant or apparent.

Insurers combat moral hazard by imposing deductibles, policy limits, co-

payments, and co-insurance provisions that force the insured to bear some portion of his

or her loss.9 Additionally, the pricing of insurance contracts that consider an insured's

past loss experience can also encourage insureds to prevent or avoid losses and, hence,

reduce moral hazard. Insurance contracts also will typically become void if it can be

proven that the insured intentionally caused a loss. Retaining some portion of the

potential loss increases the insured’s incentive to decrease the chance of loss. While such

9
Certain insurance contracts (e.g., ones that are retrospectively rated) contain other risk or cost-sharing
provisions that should have the effect of reducing moral hazard.

20
measures have a desirable effect on insureds’ incentives, they result in incomplete

insurance and diminish the amount of protection. Alternatively, insurers may seek to

improve safety incentives by offering discounts for loss prevention measures and

declining to sell insurance to individuals who do not demonstrate a commitment to safety.

Again, regulators may find some of these measures acceptable and others to be

problematic.

E. Indemnity and Insurable Interest

The principles of indemnity and insurable interest govern the design of many

insurance contracts to mitigate the moral hazard problem. Under the principle of

indemnity, insureds should not profit from a covered loss and should be restored to no

better than their financial position prior to the loss (Rejda and McNamara, 2016). The

objective is to ensure that insureds do not gain financially from losses and reduce moral

hazard. If insureds could profit from insurance coverage of a loss, they would have an

incentive to cause losses and a disincentive to take precautions to avoid losses. Most

property and liability contracts are contracts of indemnity. Losses in such contracts are

typically settled on the basis of actual cash value (e.g., replacement cost less

depreciation) or fair market value.

However, there are some insurance contracts that do not strictly adhere to the

indemnity principle. A valued policy pays the face amount of insurance regardless of the

actual cash value of the loss. Valued policies are sometimes used to insure items for

which it would be difficult to determine the actual cash value or market value, such as

21
rare antiques. Some states have valued policy laws that require payment of the face

amount of insurance in the event of total losses to real property from certain perils.

Certain coverages are offered on a replacement cost basis where the cost of

replacing the insured property is paid with no deduction for depreciation. For such

contracts, insurers typically require a minimum ratio of the market value to replacement

cost (e.g., 80 percent) be met to diminish moral hazard. Also, insureds are actually

required to repair or replace the damaged property; they cannot take the full replacement

cost as cash to be used for other purposes. Finally, life insurance contracts are not

contracts of indemnity, but rather are valued policies that pay a stated benefit in the event

of the insured’s death.

The second important concept is the principle of insurable interest. According

to the principle of insurable interest, the insured must suffer some form of loss or harm if

the insured event occurs (Rejda and McNamara, 2016). Insurable interest is necessary to

prevent gambling, reduce moral hazard, and measure the insured loss. Otherwise,

individuals could purchase insurance contracts as a matter of speculation (e.g., insuring

another’s home in which the insured did not have a financial interest) and/or gain from

causing a loss. The same principle applies to life insurance contracts. Allowing someone

to purchase a life insurance policy on a person with whom they had no family

relationship or pecuniary interest would raise obvious questions about the insurance

buyer’s intentions.

22
IV. Supply, Demand and Competition
A. Supply, Demand and Market Equilibrium
The economics of insurance markets are driven by the supply of and demand for

insurance coverage (see Varian, 1992). Insurance markets, like other markets, tend to

settle at a price and quantity where the amount of insurance that insurers are willing to

supply equals the amount that insureds demand at a price agreeable to both. Changes in

the supply of and/or the demand for insurance will change this point of equilibrium.

Regulation or other external interventions in the market also can affect supply and

demand, changing the point of market equilibrium or causing an imbalance between the

amount of insurance that insurers are willing to sell and the amount that consumers wish

to purchase.

When economists use the term supply, they think in terms of a schedule of the

quantities of a product or service that firms are willing to supply at different prices. The

supply function for a market is the sum of the supply functions of individual insurers. The

supply of insurance is determined primarily by the cost of providing coverage (i.e., the

present value of expected claim costs or benefits paid to insureds, expenses, and the cost

of capital). Insurers’ costs include a “risk load” or “risk premium” to reflect the cost of

uncertainty about their future liabilities.10 In the short run, the supply function for

insurance is likely to be upward sloping, i.e., insurers require higher prices to provide

larger quantities of insurance coverage, because their per-unit costs increase with the

quantity of insurance they provide.

10
Note, that if an insurer is able to reduce objective risk through pooling a large number of exposures, then
the “risk premium” that the insurer would require would be less than the sum of risk premiums that its
insureds are willing to pay to transfer risk to the insurer.

23
 In the long run, the supply function for most insurance markets should be

relatively flat or price elastic. That is, the quantity of insurance that insurers are willing

to supply should expand to meet increased demand without a significant increase in

average cost that would require an increase in the market price. In the long run, insurers’

costs are generally variable, i.e., fixed investments in their facilities can be adjusted to

produce a given amount of insurance at the most efficient scale of operation. This

assumes that, ideally, there are no significant barriers to entry and that capital can flow

easily into a market to meet increased demand for insurance without an increase in per-

unit costs.

As discussed above, the demand for insurance is determined principally by

consumers’ risk (actual or perceived), degree of risk aversion, income and assets, other

options for managing risk, and compulsory insurance requirements. Generally, the greater

risk that an individual or firm faces, and the lower their ability to accommodate potential

losses using other financial resources, they greater will be their demand for insurance. To

the extent that consumers are risk averse (i.e., they gain additional utility from reducing

their risk), they will be willing to pay a premium that exceeds their expected loss (without

insurance) that is necessary to cover insurers’ expenses, transaction costs, and cost of

capital. The demand for insurance is somewhat sensitive to price, i.e., the higher the

price, the less insurance consumers will want to purchase, all else equal. At the same

time, this price sensitivity or elasticity may be somewhat low for some coverages that

consumers perceive to be essential or are mandated by government or lenders (e.g., auto

and homeowners insurance).

24
 Figure 3 graphs the determination of the price and quantity of insurance sold in

the long run in a given market. The downward-slanted line D represents the market

demand curve for insurance, indicating the total number of policies or amount of

insurance demanded at various premium levels. The downward slope of the demand

curve indicates that less insurance is demanded at higher prices. In other words, higher

premiums cause some buyers to drop out of the market or buy less insurance. The long

run market supply curve is represented by the flat line LS, which assumes that, in the

long run, insurers can provide increased insurance without increasing its price.

Figure 3
Supply and Demand

S
A
pc LS

D
O
Qc Quantity

25
 Under perfect competition, in the long run, the market price or rate will equal

average and marginal cost, pc, and the number of policies or amount of insurance sold

will equal Qc. In other words, the market price will be just sufficient to cover insurers’

costs, operating at an efficient level, and the quantity of insurance sold will equal the

quantity of insurance that consumers demand at that price. Total premiums will equal

total cost which is equal to the area OpcAQc and there will be no "economic profits."11

This means that consumers will receive any “surplus utility” reflected in the difference

between the price of insurance and what they would be willing to pay for it. The income

earned by insurers will be just sufficient to cover their costs, including their cost of

capital, and no more. Note, that in this model, we assume that insurers are “price takers”

and sell insurance at the price determined by the intersection of market demand and

market supply.

The impact of market competition is reflected in the market loss ratio. The loss

ratio is equal to total losses divided by total premiums which is equivalent to the average

loss, c, divided by the market price, pc. The loss ratio reflects the dollar amount of loss

protection policyholders receive for a dollar's worth of premiums. Under perfect

competition, the loss ratio will equal the ratio c/pc, i.e., the average loss divided by the

competitive market price.

It should be noted that if insurers’ claims costs or expense costs rise (e.g., due to

higher accident rates), this will push up the supply curve, LS, and result in a higher

market price and less insurance being purchased.

11
The term "economic profits" refers to profits in excess of insurers' cost of capital.

26
B. Theory of Competition

Perfect Competition

The characteristics of a competitive market provide a benchmark for comparing

alternative market structures and evaluating markets in the real world. Competition is

considered desirable from society's standpoint because it ensures that resources are being

used in the best way possible. An industry is considered perfectly competitive only when

the number of firms selling a homogeneous commodity is so large, and each firm's share

of the market is so small, that no firm is able to affect the price of the commodity by

varying its output. In addition, perfect competition requires that there be no barriers to the

entry and exit of firms and that resources be perfectly mobile in and out of the industry.

The long-run equilibrium outcome of a competitive market possess three desirable

properties:

1. The incremental or marginal cost of producing the last unit of output will be
equal to the price that consumers are willing to pay for it.

2. There will be no "excess" or "economic" profits. Investors will receive a

return just sufficient to induce them to maintain their investment at the level
required to produce the industry's equilibrium output efficiently.

3. Each firm will be producing at an output level where its average cost will be
at a minimum, i.e., maximum efficiency.

In essence, a large number of firms and the lack of barriers to entry and exit lead

to independent and competitive pricing which results in optimal market performance.12

12
This principle is taken to its logical limit under the theory of contestable markets, which argues that even
high concentration may not permit firms to maintain a price above the competitive price if entry and exit
are costless and can occur rapidly. However, the reality may be that very few markets, if any, have costless
entry and exit - empirical support for the theory of contestable markets has not been forthcoming. Still, we
would expect potential entry into a market would have some disciplinary effect on incumbent firms in that
market. For a discussion of the theory of contestable markets see Baumol, Panzar and Willig (1982).

27
Conversely, high market concentration and entry barriers will tend to constrain

competition and cause suboptimal performance.

Perfect competition also requires complete and perfect knowledge (Martin, 1988).

All firms should know the relevant technologies and buyers should be fully informed

about all aspects of the product they are buying and the market. Conditions with respect

to consumer information and consumer choice may be more relevant when other

conditions for perfect competition are violated. When entry is significantly constrained,

the fact that buyers lack information about prices and/or are forced by law to buy a

product, could result in higher prices or diminished product quality or services.

Workable Competition

The conditions for perfect competition are never satisfied in reality. Many

industries are characterized by a limited number of firms, considerable product diversity

among firms, entry and exit barriers, informational limitations, externalities, and other

structural impediments to competition. Hence, competition will always be something less

than perfect. For this reason, the concept of "workable competition" has been developed

as a practical standard to evaluate the structure and performance of industries (Scherer

and Ross, 1990). Arguably, workable competition exists when the structural

characteristics of a market reasonably approximate the conditions for perfect competition

and government intervention cannot improve the performance of the market. This view

appropriately focuses analysis on the question of whether regulation or other forms of

government intervention can make a market work better.

28
 The analysis of insurance markets requires the examination of market structure

and performance in a dynamic context. If a market is relatively unconcentrated, entry

barriers are low, profits appear to be in line with other industries of similar risk, and there

is no evidence of gross inefficiency, then it is unlikely that government intervention could

significantly improve performance. On the other hand, if a market is highly concentrated,

entry is restricted, and long-run profits substantially exceed those in other industries, then

some form of regulatory intervention may be beneficial. Workable competition does not

require that all firms in the market operate at maximum efficiency at all times or that no

sale is ever made at a price above the "competitive price" or insurers’ average cost. What

is relevant is whether the market, over the long run, rewards efficient firms and punishes

inefficient firms. When this occurs, then a market will be driven to greater efficiency over

time to the maximum benefit of consumers.

Alternative Market Structures

The main alternatives to a structurally competitive market are monopoly and

oligopoly. A monopoly occurs when there is only one seller of a commodity for which

there are no close substitutes. A monopolist possesses market power that allows it to

constrain the quantity of a good supplied to raise the market price. In other words, under

a monopoly, the quantity of a good sold and purchased is lower and the price paid is

higher than under perfect competition. The monopolist sets quantity and price to

maximize profits and consumer surplus is reduced to zero. Hence, consumers are

disadvantaged by a monopoly and social welfare is less than what would be achieved

under perfect competition. For this reason, governments seek to break up monopolies or

29
regulate them closely if they offer significant economies of scale or other advantages.

Monopolies rarely if ever occur naturally in insurance markets because the technology

required to underwrite insurance can be easily replicated by multiple firms. However,

governments sometime create an insurance monopolist by allowing only one firm (or

government agency) to sell insurance.

Oligopoly occurs when a few relatively large sellers and each possesses a share of

the market sufficient to cause them to recognize the interaction of their decisions in

determining the market price and output. This recognition creates a basis for cooperative

behavior and limits on competition, explicit or implicit, for the purpose of increasing

profits. Entry barriers further facilitate explicit and implicit cooperative behavior by

preventing new firms from entering the market and undermining existing price and output

agreements among firms already in the market. Entry also can be deterred if exit from the

market would be costly.

Oligopoly is more likely in insurance than monopoly, but cost conditions and the

lack of entry barriers typically prevent a small number of insurers from manipulating a

market. There are some insurance markets that are so small that they only allow a small

number of insurers to serve the market efficiently. This tends to be restricted to certain

specialty insurance markets. However, the threat of potential entry by other insurers can

deter oligopolistic behavior even in these specialty markets.

Monopolistic competition is another possible market structure that is relevant to

insurance. Under monopolistic competition, there are numerous firms, but they do not

sell a homogenous commodity. Their products are sufficiently differentiated so that each

firm effectively faces a separate demand curve for its product. At the same time, firms’

30
products are highly substitutable so that they must compete on price as well as the

features of their products. Because consumers will switch for a small difference in price

or quality in such a situation, firms are forced to compete and be efficient and charge

prices that just cover their costs, as is the case with perfect competition.

Because insurers vary their products and quality of service to some degree but

also compete aggressively on price, insurance markets might be best compared to

monopolistic competition. The above comments with respect to workable competition

also would apply to monopolistic competition. In other words, a monopolistically

competitive market also could be workably competitive.

Cyclical and Excessive Competition

There are circumstances where the structure of an insurance market may lead to

too much competition and negative profits for insurers. Unexpected increases in claim

costs and aggressive price competition can also adversely affect operating results. In the

standard competitive model, economists assume that firms will not price below variable

cost in the short run and average total cost in the long run. Economists also assume that

firms know what their costs are when they set prices. In reality, however, insurance rates

have to be set prospectively based on projected costs. Absent any regulatory constraints,

if insurers underestimate future costs, economic profits will be negative.

There are significant concerns about underpricing and cyclical pricing in long-tail

liability lines of insurance, i.e., lines of insurance where claims may not be reported and

paid for several or more years after a policy expires (Cummins, Harrington, and Klein,

1991). Economic losses are more likely if insurers systematically underestimate loss

31
costs, take excessive risks, or engage in underpricing strategies aimed at trading short-run

income losses for in market share that they expect will lead to higher profits in the long-

run. Indeed, the speculative and subjective nature of insurance pricing could serve to

facilitate deliberate or systematic underpricing if insurer managers are inclined to make

optimistic assumptions to support lower prices and increased short-term profits.

Several factors might contribute to systematic underestimation of costs and prices

by insurers. An increase in the rate of cost inflation is one factor. To the extent that

advisory organizations and insurers tend to project costs based on historical information,

they may not appropriately account for the effect of significant changes in the economic

environment or other cost drivers. For that matter, insurers' measurement of historical

costs may be understated, particularly in long-tail lines such as workers' compensation,

where ultimate liabilities may not be determined until several years after the close of the

policy period. Underreserving is a serious concern in many long-tail lines.

Underestimates of historical costs will contribute to underestimates of future costs.

Because the long-term adverse effects of underpricing may not be revealed for some

time, insurers are not forced to confront the implications of their pricing decisions until

after those decisions are made.

Since the market cannot sustain economic losses in the long-run, prices below

cost or the competitive price must eventually rise. This is a possible explanation for or at

least a contributor to the cyclical movement of prices observed in long-tail lines. Prices

eventually rise as insurers suffer excessive losses, which force them to reduce the amount

of insurance they supply. The long tail may delay the reconciliation of the market price

and loss costs but it cannot ultimately prevent it.

32
 Insurance buyers and regulators may be willing to tolerate some cyclicality in the

supply of insurance as a reasonable price to pay for the benefits obtained from aggressive

competition among insurers. However, severe underpricing may raise solvency concerns

for regulators and “hard” markets may increase pressure on regulators to restrict price

increases and take steps to expand the availability of insurance. Unfortunately,

experience indicates that it is difficult for regulators to control cyclicality in the supply of

insurance, and their actions can worsen market conditions. The most effective regulatory

approach may be to intervene against insurers who are engaging in severe underreserving

and underpricing.

V. Public Goods, Externalities, and Principal-Agent Conflicts

A. Public Goods
A public good is a good or service that has two characteristics: 1) no one can be

excluded from using or benefiting from it, and 2) it is non-rivalrous in that one person's

consumption of the good or service does reduce its availability to others. The non-

excludability aspect of a public good is important because it is only through the ability to

exclude some people from using it can its provider extract a fee or payment to help pay

for it. The non-rivalrous aspect of a public good is also important as the more people that

use or benefit, the greater will be the social welfare derived from it. There are number of

examples of public goods such as national security, flood control systems, and

lighthouses.

There may be some things that are viewed as public good in that they are non-

excludable but are not strictly non-rivalrous. Examples of such goods could include clean

water, clean air, and roads and highways. The more people use a water supply, the less

33
water that is available to others. The more people drive, the more congested public roads

and highways become. This may cause such goods to be under-produced, overused, or

degraded. Under-production, overuse, or degradation are associated with what is known

as the "free-rider" problem. Free-riding means that people or firms can use or access a

good without paying for it.

We can focus first on the problem of under-production. Given that it costs

something to produce a public good and may cost more to produce more of it (or enhance

its quality), to the extent that its supplier cannot recover all or part of the costs of

producing it, then the good will be under-produced or not at all. Consider the case of

certain flood-protection measures (e.g., levees, wetlands protections, etc). If everyone in

a community benefits from such measures and no one can be excluded from their

benefits, then the incentives for people and firms in that community to pay for these

measures will be diminished. It is possible that some may be still be willing to help pay

for such measures out of altruism or a sense of responsibility. Nonetheless, some people

will not elect to voluntarily pay for such measures. If this is the case, absent other funding

mechanisms, the likely result will be that less flood protection will be supplied than what

would be socially optimal.

For public goods for which this kind of problem exists, some other form of

funding will be needed to ensure that socially-optimal amounts of these goods are

produced. These alternative funding mechanisms can take various forms. One form

would be special fees or assessments that anyone benefiting from such a good would be

required to pay. These fees or assessments could be scaled in such a way so that people or

firms who receive more benefits pay more and those who receive fewer benefits pay less.

34
For example, K-12 education and other local services are largely financed through

property taxes. Alternatively, certain public goods could (and are) funded by income or

sales taxes. National defense is an example of a public good that is funded by income

taxes. Given that income tax rates tend to be progressive, funding public goods this way

effectively allocates costs in such a way that high-income earners should pay much more

than low-income earners.13 Funding a public good through sales taxes effectively allocate

its cost based on general consumption. The type of funding mechanism used and the

allocation of costs have efficiency and equity implications.

There are ways that providers of public goods have devised to exclude non-payers

from using or benefiting from these goods, i.e., they turn them into private goods. One

example of this is a toll road. Charging drivers to use an HOV lane is another example of

this. In the 1700s and early 1800s, fire protection was not provided as a public good per

se; each insurance company in a community would have its own fire brigade and owners

of a building would put a "fire mark" on the front of it. Each company would only

provide services to buildings that carried their fire mark. Another example of this kind of

practice would be communities that only provide a minimal amount of police protection

for everyone; those that want more protection are required to pay for additional security

out of their own pocket.

Turning to the problems of overuse and degradation, we face different challenges.

Here the "theory (or the tragedy) of commons" comes into play. When this concept was

first introduced, it was postulated in terms of a common resource. More specifically, this

common resource was a pasture that could be used by owners of cattle in a community.

13
When a tax system has many exemptions, deductions, credits, and other "loopholes," the qualifier
"should" can relevant.

35
Absent any restrictions on their use of this resource, cattle owners would have an

incentive to increase the number of their own cattle that they had and that would graze on

the pasture. Ultimately, this behavior would result in the overuse of the pasture to the

point where it would no longer be a sustainable resource. Current examples of resources

that have this characteristic include fisheries, water, air, forests, and anti-biotics (anti-

biotic resistance).

Solutions to this problem include those that would be considered social or non-

governmental and governmental. An example of a non-governmental solution to the

problem of anti-biotic resistance would be voluntary actions by physicians to restrict their

use of anti-biotics to cases where they only clearly needed. Governmental solutions for

this problem include privatization, regulation, and internalizing externalities (see

discussion below). An example of privatization would be placing more forest lands into

private hands. This could encourage more efficient use of such a resource. An example of

regulation applied to the problem of flood risk, would be restrictions on the ability of

developers to build in wetland protection areas or requiring developers to include proper

drainage in their projects.

B. Externalities

The economic theory underlying externalities has important implications for risk

management and insurance markets that are not typically discussed in introductory texts.

An externality occurs when individuals’ or firms’ choices and activities affect others but

these effects are not reflected in market transactions. Externalities can be positive or

negative. For example, Judy's neighbors may derive value from the painting of her house

36
but they do not help pay for the paint and her decision to paint the house is not influenced

by the value her neighbors derive from it. Alternatively, if Judy chooses to erect a

massive satellite dish in her yard, it may negatively affect the aesthetics of her

neighborhood, but the implicit cost to her neighbors is not something she reimburse them

for and may not concern her.

Externalities also can occur in risk and insurance. If Fred drives recklessly without

auto insurance, he externalizes risk to other drivers if he can escape paying the full cost

of any damages he causes. If Max adds dirt to his property that fills in a stream bed, this

could increase the risk of flooding to his neighbors. Conversely, if Sarah insures her

business, others may benefit from that insurance if it allows her to stay in operation when

she suffers a loss.

Externalities are important because they can result in an inefficient allocation of

resources. If it is possible for individuals and firms to externalize some risks to others,

then society may be burdened by more risk than what is optimal. For example, drivers

would be expected to drive more safely and cause fewer auto accidents if every driver

was forced to pay the full cost of any accidents they cause. However, externalities can be

internalized with mandatory insurance if insureds pay risk-based premiums. While risk-

based pricing is imperfect because of limited information, insurers can employ pricing

techniques that reward safe behavior and punish risk behavior. A good illustration of this

is experience rating in workers compensation insurance in which employers pay higher

rates if they have more claims than the average for their classification. This encourages

employers to improve the safety of their working conditions. As explained above, the

37
attempt to reduce externalities is reflected in compulsory insurance requirements,

although these requirements may not be fully effective.

C. Principal-Agent Conflicts
Principal-agent conflicts can occur when a “principal” has difficulty monitoring and

controlling the behavior of his “agent” and the agent’s interests differ from those of the

principal. There a numerous examples of principal-agent relationships including the

relationship between the owners (the principals) and the managers (the agents) of firm.

Another example is if you hire a contractor to replace the roof on your house; in this

instance you would be the principal and the contractor would be your agent. Your

interests and that of the contractors may not be perfectly aligned as you would want the

best possible workmanship performed whereas the contractor is concerned about his costs

and putting more time and effort into replacing your roof will reduce his profits.

Assuming that you are not an expert on building a new roof and it is not feasible for you

to supervise all of the work that is performed, you may get a new roof that is of lower

quality than what you would like. However, there are other ways in which your interests

and that of your contractor can be brought into closer alignment such as choosing a

contractor with a reputation for good workmanship and insisting that he give you a

warranty which requires him to fix any defects in his work that become apparent over

time.

Arguably, a principal agent relationship exists between an insurance company (the

agent) and its insureds (the principals) and conflicts may arise between the interests of

insureds and their insurance companies. Owners of insurance companies may have

diminished incentives to maintain a high level of safety to the extent that their personal

38
assets are not at risk for unfunded obligations to policyholders that would result from

insolvency.14 It is costly for consumers to properly assess an insurer’s financial strength

in relation to its prices and quality of service. Insurers also can increase their risk after

policyholders have purchased a policy and paid premiums. These incentive conflicts,

information asymmetries, and imperfect control mechanisms could cause some insurers

to incur greater financial risk than what would be optimal for policyholders and society.

This is one of the primary reasons why the government regulates insurer solvency to

mitigate such conflicts and limit the financial risk of insurers. Also, as with the example

of the roofing contractor, consumers can attempt to avoid future problems by choosing

insurance companies with good reputations and that receive good financial strength

ratings from rating agencies like A.M. Best and Standard and Poor's. Principal-agent

conflicts can be found in various aspects of insurance and help to explain some of

problems that develop as well as the devices that different parties employ to control them.

Synopsis of Key Points

1. Utility theory provides a framework for understanding individuals’ demand for
insurance. Risk averse people will be willing to pay a risk premium above the
expected payout on an insurance policy. This makes insurance feasible when the risk
premium consumers are willing to pay exceeds the loading for expenses that insurers
must add to expected loss costs in calculating an adequate premium.

2. Insurance serves an essential role in diversifying risk and reducing uncertainty by

pooling losses among a group of individuals and firms.

3. Social welfare is maximized when insurance markets function efficiently and the
costs of different activities are equal to their benefits.

14
This is the case with the corporate form of organization where the owners or stockholders of the
corporation are protected by limited liability, i.e., creditors of the corporation cannot go after the personal
assets of stockholders.

39
4. Equity can be defined in different ways but it is consistent with economic efficiency
when individuals pay insurance premiums commensurate with their relative risk of
loss.

5. Adverse selection arises when high-risk individuals are more likely and low-risk
individuals are less likely to buy insurance. Risk-based pricing, proper underwriting
selection, and policy design can diminish adverse selection.

6. Moral hazard arises when insureds stand to gain from causing a loss or have
diminished incentives to prevent losses. Insurers combat moral hazard by having
insureds bear a portion of their losses and declining to offer insurance in situations
where the insured would gain financially from having a loss.

7. Insurance contracts embody various concepts, including the principles of indemnity

and insurable interest. Under the principle of indemnity, in the event of a loss,
insureds should not gain financially from insurance and should be restored to no
better than their prior position. Under the principle of insurable interest, the insured
must suffer some harm or loss if the insured event occurs.

8. The supply of insurance is determined largely by the cost of providing coverage and
should be relatively price-elastic over the long run.

9. The demand for insurance is determined principally by consumers’ risk and degree of
risk aversion and will be somewhat less sensitive to price, particularly for essential or
mandatory insurance coverages.

10. The concepts of perfect and workable competition provide a benchmark for
evaluating the structure and performance of insurance markets. A competitive market
structure leads to competitive conduct and good market performance that maximizes
the value of insurance to consumers.

11. Many insurance markets may be characterized by a monopolistically competitive

structure where insurers compete on both price and product features. This structure
will generally be efficient, assuming that consumers value the product differentiation
provided by insurers.

12. There are instances where insurers may engage in excessive competition,
underpricing, and cyclical pricing. Underpricing should be a short-run phenomena but
may require regulatory intervention if it persists and threatens insurers’ solvency.

13. A public good is a good or service that is non-excludable and non-rivalrous. Problems
can arise with public goods that include their under-production, overuse, or
degradation. Various financing methods can be used to address the under-production
problem. Other methods such as privatization and regulation can be used to mitigate
overuse and degradation problems.

40
 14. An externality exists when individuals’ or firms’ choices and activities affect others
but these effects are not reflected in market transactions. Both positive and negative
externalities occur with respect to risk and insurance and in some cases may warrant
government intervention.

15. Principal-agent conflicts can occur when a “principal” has difficulty monitoring and
controlling the behavior of his “agent” and the agent’s interests differ from those of
the principal. This type of conflict can arise between insureds (the principals) and
their insurance companies (their agents) which could result in excessive risk taking by
insurers or other behavior that would be detrimental to the interests of their insureds.
As with externalities, government intervention may be warranted to deter insurance
companies from behaving in ways that are at odds with the interests of their insureds.

References

Baumol, William J., John C. Panzar, and Robert D. Willig, 1982, Contestable Markets
and the Theory of Industry Structure (New York: Harcourt Brace Jovanovich).

Cummins, J. David, Scott E. Harrington, and Robert W. Klein, eds., 1991, Cycles and
Crises in Property/Casualty Insurance: Causes and Implications for Public Policy
(Kansas City, Missouri: NAIC).

Gruber, Jonathan, 2015. Public Finance and Public Policy (New York: Worth
Publishers).

Martin, Stephen, 1988. Industrial Organization (New York: MacMillan).

Rejda, George E. and Michael J. McNamara, 2016. Principles of Risk Management and
Insurance, 13th ed. (Boston: Pearson).

Rothschild, Michael and Joseph E. Stiglitz, 1976. "Equilibrium in Competitive Insurance

Markets," Quarterly Journal of Economics, 90: 629-649.

Scherer, F. M. and David Ross, 1990, Industrial Market Structure and Economic
Performance, 3rd ed. (Chicago: Rand McNally).

Varian, Hal R., 1992, Microeconomic Analysis, 3rd ed. (New York: W.W. Norton & Co.).

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