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Social Insurance (Optimal Insurance (Perfect insurance market is one where…
Social Insurance
Optimal Insurance
Perfect insurance market is one where risk is observable and premium is actuarially fair.
- Actuarially fair: Perfect competition in the insurance market; insurers don't make any profits on insurance coverage.
Even with heterogeneity in risks, result holds as long as risks are observable.
- In this case, individuals will pay different actuarially fair premiums.
Market breakdown:
- Due to asymmetric information, risks are not observable
- Insurers thus have to offer insurance coverage at the average price
- This leads to adverse selection: at a given premium, the ones most likely to buy insurance are those with the worst risks
In the long run,
- Low-risk individuals will not pay for the insurance coverage
- Average risk level of the insured increases, and thus the insurer has to increase the price of insurance
- More low-risk individuals drop out...
- Leads to market unravelling
A solution is partial insurance and screening.
- Insurers provide different insurance contracts e.g. a partial insurance contract with lower price, and a full insurance contract with higher price
- Price differentiation will induce self-revelation
- However, while we are better than before, this is still socially inefficient; social optimum is full insurance coverage!
Background
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4 main types: Unemployment insurance, disability insurance, health insurance and social security
Problems
Crowding out
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Availability of private insurance determines extent of crowding out and thus value of social insurance.
Moral hazard
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Adverse responses to social insurance creates negative externalities:
- Insurance programme becomes more expensive, leading to higher premium/taxes for all insured individuals
- An insurance claim (e.g. UI/DI) is associated with lower labour supply, which reduces tax revenue for other productive uses
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Value
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Utility of expected consumption is greater than the expected utility of consumption
- In other words, the expected return of a lottery is better than the lottery itself.
- Individuals desire consumption smoothing over uncertain outcomes.
Government intervention
Government faces the same problem as private insurers, but unlike private insurers, government can compel individuals to participate
- This is done via mandates or taxes
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