Chapter 8:
Insurance.
Insurance?
Private v social
Decision under
Demand and supply of health insurance. uncertainty.
Demand for
Folland et al Chapter 8 insurance.
Supply.
Fair insurance
Chris Auld Moral hazard
Economics 317
February 9, 2011
Chapter 8:
What is insurance? Insurance.
Insurance?
Private v social
I From an individual’s perspective, insurance transfers Decision under
uncertainty.
wealth from good states of the world to bad states of Demand for
the world. insurance.
Supply.
I e.g. state of the world is one of: ”house burns down,”
Fair insurance
”house doesn’t burn down.” Buying fire insurance
Moral hazard
makes you better off in the bad state and worse off in
the good state.
I e.g. state of the world is: ”Require $X worth of dental
surgery.” Buying Blue Cross transfers wealth from good
states of the world ($X is small) to bad states of the
world ($X is large).
Chapter 8:
Private versus social insurance Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
I Private insurance is provided on markets. Social insurance.
insurance refers to government programs. Supply.
I Social insurance may be heavily subsidized, e.g., health Fair insurance
insurance premiums in Canada are either zero or Moral hazard
nowhere near outlays.
I Social insurance acts as both an insurance scheme to
reduce risk and often as a redistribution scheme.
Chapter 8:
Some terminology. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
I You pay a premium for your insurance which pays insurance.
coverage when some event occurs. Supply.
I When the bad event occurs, the fraction you pay is the Fair insurance
coinsurance rate, and the amount the insurer pays is Moral hazard
the copayment.
I You may have to pay up to $X out of pocket, and
thereafter insurance kicks in. Your deductible is $X .
Chapter 8:
Decision under uncertainty. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
insurance.
I How do people value uncertain outcomes, like a lottery Supply.
ticket or an insurance plan? Fair insurance
Moral hazard
I Need to extend theory of the consumer to allow for
uncertainty.
Chapter 8:
Expected value. Insurance.
Insurance?
Private v social
I The expected value of an uncertain outcome is the Decision under
uncertainty.
sum of the possible outcomes weighted by their
Demand for
probabilities. insurance.
I e.g. flip a fair coin. If it comes of heads, get two dollar, Supply.
tails, get nothing. The expected value of this uncertain Fair insurance
Moral hazard
outcome is
E (wealth) =Pr(heads)(outcome if heads)
+ Pr(tails)(outcome if tails)
=(0.5)(2) + (0.5)(0) = 1.00
Chapter 8:
Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I People are generally not willing to pay the expected Demand for
value of an uncertain event. insurance.
Supply.
I e.g. Consider this game: flip a fair coin over and over
Fair insurance
until tails comes up. If the coin comes up heads n times
Moral hazard
in a row, payoff is 2n .
I How much would you pay to play?
Chapter 8:
St. Petersburg Paradox Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
insurance.
Supply.
E (wealth) = [(1/2)20 + (1/2)2 21 + (1/2)3 22 + .... Fair insurance
= 1/2 + 1/2 + 1/2 + 1/2 + .... Moral hazard
→∞
But people actually willing to pay a few bucks.
Chapter 8:
Risk aversion. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I People are generally not willing to pay the expected Demand for
insurance.
value of an uncertain event. They are willing to pay
Supply.
extra to avoid risk.
Fair insurance
I Basic idea: utility of uncertain outcome < utility of Moral hazard
expected value of outcome.
I e.g., you are probably not willing to pay $5 to play a
game in which you have equal chance of getting $10 or
nothing.
Chapter 8:
Simple example Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
insurance.
Supply.
I Flip a coin. Get $4 if heads, nothing if tails. Fair insurance
√
I utility function: u(w ) = w . Moral hazard
Chapter 8:
simple example cont. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
I average payout: EV = (0.5)0 + (0.5)4 = 2. insurance.
√ √ Supply.
I utility under risk: EU = 0.5 p + 0.5 4 = 1
Fair insurance
I utility from certainly
√ getting average payout: Moral hazard
U(EV ) = U(2) = 2.
I certainty equivalent of risky outcome:
U(W CE ) = EU = U(1) → W CE = 1.
Chapter 8:
Insurance.
Insurance?
Private v social
I Risk aversion implies that an insurance industry may Decision under
uncertainty.
work. Demand for
insurance.
I Consider a population in which each person owns a
Supply.
house worth $90,000. Each house burns down with Fair insurance
(exogenously set) probability 1%. A burned house is Moral hazard
worth $10,000.
I Each person’s utility function is U(w ) = w 1/2 .
I Houses are people’s only assets.
Chapter 8:
Insurance.
I In the absence of insurance, the utility each person gets
is Insurance?
Private v social
EU = 0.01[U(10, 000)] + 0.99[U(90, 000)] Decision under
uncertainty.
= 0.01[100] + 0.99[300] = 298.
Demand for
insurance.
Supply.
I The expected value of the house is Fair insurance
Moral hazard
0.01(100)+0.99(90,000) = 89,200.
I If the consumer faced no risk and owned the expected
√
value of the asset, her utility would be 89, 200 =
298.66. Risk lowers utility by 0.66 units.
I The certainty equivalent of owning a house which might
burn down is 2982 =88,804.
I The consumer is better off if fully insured for any
premium less than 90,000-88,804=1,196.
Chapter 8:
Insurance.
Insurance?
I An insurance firm which offers to fully insure a Private v social
Decision under
homeowner pays zero when a house doesn’t burn down uncertainty.
and $80,000 when a house does burn down. Demand for
insurance.
I The expected payout from such a contract is then Supply.
0.01[80,000] = $800. Fair insurance
I But the consumer is willing to pay up to $1,196. Moral hazard
I Any price between $800 and $1,196 potentially makes
both the firm and the consumer better off.
I The firm sells a very large number of contracts and
does not bear (much) risk itself.
Chapter 8:
More on choice under uncertainty. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I If the utility function u(w ) is linear, the uncertain
Demand for
outcome is worth the outcome’s expected value to the insurance.
agent. Supply.
Fair insurance
I If the utility function is strictly concave, the agent is
Moral hazard
risk averse, she is willing to pay less than the expected
value.
I If the utility function is strictly convex, the agent is risk
loving, she is willing to pay more than the expected
value.
Chapter 8:
Demand for insurance Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I Consider a slightly richer model in which the consumer Demand for
insurance.
with wealth W can buy $q worth of insurance
Supply.
(insurance which pays off q in the bad state).
Fair insurance
I The loss in the bad state is L. Moral hazard
I The premium per dollar of coverage is a. E.g., if a
policy which pays $1,000 in the bad state has a
premium of $100, then a = 100/1000 = 0.10.
I The consumer’s expenditure to get q coverage is aq.
Chapter 8:
Demand cont. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
insurance.
I Utility in the good state is then U(W − aq). Supply.
I Utility in the bad state is U(W − L − aq + q). Fair insurance
I Expected utility is the utility in the good state times the Moral hazard
probability the good state occurs plus utility in the bad
state times the probability the bad state occurs.
Chapter 8:
The supply of insurance Insurance.
Insurance?
Private v social
Decision under
I We have seen that consumers are willing to pay to uncertainty.
Demand for
avoid risk. insurance.
I Firms can sell many contracts so that, by a law of large Supply.
numbers, they face little or no risk. Fair insurance
Moral hazard
I Consider a large population of people who face a
probability p of incurring q damages.
I Assume it costs the firm t to process the sale of an
insurance policy (“loading costs”).
I A policy costs $aq, where a is the premium.
Chapter 8:
Insurance.
The expected profit per claim is Insurance?
Private v social
E (profit) = P(loss)(profit if loss) + P(no loss)(profit if no loss) Decision under
uncertainty.
= p(aq − q − t) + (1 − p)(aq − t)
Demand for
= aq − pq − t. insurance.
Supply.
Fair insurance
Moral hazard
In a zero profit equilibrium, expected profits are zero, so
aq = pq − t
t
a=p+ .
q
Chapter 8:
Actuarially fair insurance Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I Actuarially fair prices for insurance mean that the the
Demand for
expected value of the insurance is zero, that is, its price insurance.
is the expected loss. Supply.
Fair insurance
I e.g., there is a 1% chance your house will be destroyed
Moral hazard
in an earthquake. The house is valued at 100,000. The
actuarially fair fair price to fully insure your house is
$1,000.
I Letting t go to zero above, we see that a = p defines
actuarially fair insurance in this simple environment.
Chapter 8:
Actuarially fair insurance cont. Insurance.
Insurance?
Private v social
I A consumer who buys q coverage has expected wealth: Decision under
uncertainty.
Demand for
EW = p[W − L − aq + q] + (1 − p)[W − aq] (1) insurance.
Supply.
I Increasing q by one unit then changes expected wealth Fair insurance
by Moral hazard
∆EW = p(−a + 1) + (1 − p)(−a) = p − a (2)
If insurance is not fair (a > p), expected wealth
decreases with q. If insurance is fair, expected wealth
does not vary with q.
Chapter 8:
Numerical example. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
Demand for
insurance.
I Suppose q = 100, 000, p = 0.10. Supply.
I The expected payout is pq=10,000. Fair insurance
Moral hazard
I The fair premium is therefore 10,000. Writing the
premium as per dollar of coverage: aq = 10000, or
a = 0.10.
Chapter 8:
Example cont. Insurance.
Insurance?
I The consumer’s expected wealth is
Private v social
E (wealth) = p[W − L − aq + q] + (1 − p)[W − aq] Decision under
uncertainty.
= W − pL − aq + pq Demand for
insurance.
= W − pL − (a − p)q Supply.
Fair insurance
Moral hazard
So if a = p (insurance is fair), expected wealth is
W − pL regardless of how much insurance is purchased.
I If a > p (insurance is unfair), every dollar of coverage
reduces expected wealth by (a − p).
I e.g. if t = 1, 000 and markets are competitive,
a = 0.01 + 1000/100000 = 0.02. Then
(a − p) = 0.02 − 0.01 = 0.01, and an extra dollar of
coverage reduces expected wealth by one cent.
Chapter 8:
Fair insurance cont. Insurance.
Insurance?
Private v social
I How much insurance would a risk–averse person who Decision under
uncertainty.
faces fair insurance rates buy? Demand for
insurance.
I We know that with fair insurance, expected wealth does
Supply.
not change with q, and also that risk decreases with q
Fair insurance
until the consumer is fully insured (q = L).
Moral hazard
I Therefore, a risk–averse person facing fair insurance will
fully insure and have the same wealth in all states of the
world.
I A risk–averse facing unfair insurance will less than fully
insure and have less wealth in the bad state of the
world.
Chapter 8:
Insurance so far Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I Risk-averse people are willing to pay to reduce Demand for
insurance.
uncertainty.
Supply.
I Insurers can spread risk over many people. Fair insurance
I Fair insurance—insurance with zero expected Moral hazard
value—implies risk-averse people will fully insure.
I When the cost of providing insurance (“loading cost”)
is positive (t > 0), insurance will not be fair and people
will not fully insure.
Chapter 8:
Moral hazard Insurance.
Insurance?
I Generally, moral hazard refers to a change in behavior Private v social
induced by the presence of insurance. Decision under
uncertainty.
I e.g., buy a crappy bike lock if you have good bike theft Demand for
insurance.
insurance.
Supply.
I In the context of health care, insurance often changes Fair insurance
the price paid out of pocket for care. Moral hazard
I When the price the consumer faces decreases, she may
choose to consume more care. This is called moral
hazard.
I e.g. Blue Cross pays 50% of a dental procedure. A
given person with Blue Cross will be more likely to
choose the procedure than if he does not have Blue
Cross.
Chapter 8:
Moral hazard and demand for care Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I How much extra care people consume when insured Demand for
insurance.
depends on the elasticity of demand.
Supply.
I (graphs) Fair insurance
I Insurance implies extra resource costs: the insurer must Moral hazard
charge a premium that covers the risk and the extra
care that an insured person will demand.
I A market might not even form for insurance if moral
hazard is a severe enough problem.
Chapter 8:
Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I We might then predict:
Demand for
1. We should be more likely to see insurance markets insurance.
against risks with little possibility of moral hazard (e.g., Supply.
you can buy life insurance but not employment Fair insurance
insurance). Moral hazard
2. More complete insurance against risks with little
possibility of moral hazard.
Chapter 8:
Moral hazard may lead to overuse of health care Insurance.
Insurance?
Private v social
Decision under
I Suppose we imagine we live in a world in which the uncertainty.
demand curve is the same as the social marginal Demand for
insurance.
benefits world.
Supply.
I In this world, the competitive equilibrium is efficient. Fair insurance
I A coinsurance rate of less than 1.0 induces consumers Moral hazard
to purchase more care than they would if they faced the
full price.
I Under these assumptions, too much care is consumed
and market prices are too high.
I (graph).
Chapter 8:
Moral hazard cont. Insurance.
Insurance?
Private v social
Decision under
uncertainty.
I Insurance then involves a tradeoff: decreasing the
Demand for
amount consumers pay out of pocket: insurance.
1. increases welfare because it reduces uncertainty Supply.
2. decreases welfare because people do not face the correct Fair insurance
incentives to economize on care Moral hazard
I Theory suggests an optimal fraction of the price to be
paid out of pocket.
I In Canada, for “necessary” care the actual fraction is
zero!