Insurance Project Workshop

June 10, 2009
Kenneth Froot and Howard Kunreuther, Organizers

Liran Einav, Stanford University and NBER; Amy Finkelstein, MIT and NBER; and Mark R. Cullen, Yale University School of Medicine
Estimating welfare in insurance markets using variation in prices

Einav, Finkelstein, and Cullen show how standard consumer and producer theory can be used to quantify the welfare loss associated with mispricing in insurance markets with selection. They further show how this welfare loss can be estimated using variation in the price of insurance. Such variation allows them to trace the demand curve and, at the same time, to estimate how the insurer' costs vary as market participants endogenously respond to s price. They illustrate their approach by applying it to employee health insurance choices at Alcoa, Inc. They detect adverse selection in this setting, but estimate that the quantitative welfare implications associated with mispricing are small, and not obviously remediable by standard public policy tools.

Darius Lakdawalla, RAND Corporation and NBER; and Neeraj Sood, RAND Corporattion and NBER
Health Insurance as a Two-Part Pricing Contract

Monopolies appear throughout health care, because of patents, limits to the extent of the market, or the presence of unique inputs and skills. Health insurance, often implemented as an ex ante premium coupled with an ex post co-payment per unit consumed, effectively operates as a two-part pricing contract that allows monopolists to extract profits from consumers without inefficiently constraining quantity. The efficiency of this downstream nonlinear pricing arrangement alters the welfare analysis of monopoly in the context of health care. At the limit, frictionless and competitive health insurance markets, even under incomplete or asymmetric information, perfectly eliminate deadweight losses from upstream monopoly in health care. Frictions limiting downstream "premium-discrimination" restore some of these upstream monopoly losses, which then will manifest as uninsurance for the healthy (or poor), rather than direct restriction of health care quantity. Lakdawalla and Sood's empirical analysis of pharmaceutical patent expiration is consistent with the prediction that heavily insured health care markets experience little to no efficiency loss under monopoly, while less insured markets exhibit behavior more consistent with standard theories of monopoly and its associated deadweight loss.

Thomas Baker, University of Pennsylvania; and Peter Siegelman, University of Connecticut
Enticing Low Risks into the Health Insurance Pool: Tontines for the Invincibles and Other Ideas from Insurance History and Behavioral Economics

Over one third of the uninsured adults in the United States below retirement age are between 19 and 29 years of age. Young adults, especially men, often go without insurance, even when buying it is mandatory and sometimes even when it is a low cost employment benefit. Baker and Siegelman propose a new form of health insurance targeted at this group - the "Young Invincibles" - those who (wrongly) believe that they don't need health insurance because they won't get sick. Their proposal offers a cash bonus to those who turn out to be right in their belief that they did not really need health insurance. The concept comes from the "tontine life insurance" that fueled the rise of the U.S. insurance industry in the late nineteenth century. A largely forgotten casualty of the 1906 pacification of the life insurance industry, the tontine idea holds great promise for making health insurance attractive to the invincibles today. The tontine feature frames the health insurance purchase as a smart investment, rather than a way to spend money for something the customer does not think he needs. Tontines make insurance more attractive to the uninsured, without wasting funds by subsidizing those who are already covered. The authors identify a particular class of individuals (the invincibles), show how a specific cognitive bias accounts for their irrational behavior, and design an insurance mechanism (tontines or deferred dividends) to overcome the effects of this bias. The final sections of the paper offer an empirically calibrated pricing demonstration for a tontine health policy and an analysis of the legality of tontines in this context.

David Moss, Harvard University
An Ounce of Prevention:The Power of Public Risk. Management in Stabilizing the Financial System

The magnitude of the current financial crisis reflects the failure of an economic and regulatory philosophy that had proved increasingly influential in policy circles over the past three decades. Moss suggests: 1) that contrary to the prevailing wisdom, New Deal policies (including federal deposit insurance and bank supervision) worked to stabilize the financial system; 2) that the financial catastrophe of 2007-9 was not an accident, but rather a mistake, driven by a deregulatory mindset that took 50 years of post-New Deal financial stability for granted; and 3) that the dramatic federal response to the current financial crisis has created a new reality, in which virtually all systemically significant financial institutions now enjoy an implicit guarantee from the federal government that will continue to exist (and continue to generate moral hazard) long after the immediate crisis passes. Based on this analysis, one major step that is necessary now to help ensure financial stability in the future is to identify and regulate "systemically significant" institutions on an ongoing basis, rather than simply in the heat of a crisis. To guard against moral hazard (in the face of large implicit guarantees) and to ensure the safety of the broader financial system, these institutions must face significant prudential regulation, they should be required to pay premiums for the federal insurance they already enjoy, and they should be subject to an FDIC-style receivership process in the event of failure.

Erwann Michel-Kerjan, University of Pennsylvania; Paul Raschky, University of Innsbruck; and Howard Kunreuther, University of Pennsylvania and NBER
Corporate Demand for Insurance: An Empirical Analysis of the U.S. Market for Catastrophe and Non-Catastrophe Risks

Michel-Kerjan, Raschky, and Kunreuther test some existing theories developed over the past 25 years on corporate demand for insurance. Using a unique dataset of 1,809 large U.S. corporations tihey provide the first empirical analysis that compares corporate demand for standard property insurance and for catastrophe coverage (here, terrorism). They find that larger companies are more likely to have some catastrophe coverage. Corporate demand for catastrophe insurance is more price inelastic than insurance for non-catastrophe risks. This result differs from the findings on individual demand for insurance. The terrorism insurance premium per dollar of coverage is twice as high in the New York metropolitan area than in the rest of the United States. Yet the price elasticity of the demand for terrorism insurance in this area is half what it is in the rest of the country.

Alex Boulatov, University of Houston; and Stephan Dieckmann, University of Pennsylvania
Disaster Relief Funds: Policy Implications for Catastrophe Insurance

Boulatov and Dieckmann study the policy implications that arise from introducing a disaster relief fund to an insurance monopoly. Such a form of government intervention can promote higher demand and lower prices in the market for catastrophe insurance. Their model predicts buyers to increase their demand by 15 percent and the seller to lower prices by 30 percent. The optimal design of the fund contains two components. On average, the authors find that 20 percent of the fund serves as complementary insurance while 80 percent effectively serves as catastrophe reinsurance. The model also predicts a positive correlation between the size of the disaster relief fund and the fraction that serves as complementary insurance. The downside of the design is that the seller may be overhedged, and it thus becomes more costly for a potential new firm to enter the market.

Stuart Miller, AIR Worldwide; and Paul Freeman, University of Denver
The Evolution of Catastrophe Risk Management in Mexico

Miller and Freeman explain that as catastrophe risk management has become increasingly important for the private sector, sovereigns also are devoting more attention to their catastrophe risk exposure. As governments examine ways to manage their catastrophe risk, Mexico has established itself as a leader in the field. In 2006, Mexico issued a catastrophe bond, CAT-Mex, to provide post-disaster funding in the event of a large earthquake. Based upon the CAT-Mex example, other sovereigns are exploring different options to secure post-disaster funding. Although the issuance of CAT-Mex has rightly established Mexico as a pioneer in this area, CAT-Mex has its roots in more than a decade of disaster planning. Prior to CAT-Mex, the Mexican government devoted resources and planning to address the country's catastrophe risk exposure. In the 1990s, Mexico established a Fund for Natural Disasters (FONDEN) that was the first natural disaster fund in a developing economy. Its government has been active in examining alternative tools to cope with its natural hazard risk. Since 1998, the World Bank and other international financial institutions have worked diligently with Mexico to explore alternatives to cope with the costs of natural disasters. The work in Mexico is often the model for explore options in other developing countries.

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