Social Insurance Arises, In Part, Because of Asymmetric Information

Social Insurance Arises, In Part, Because

of Asymmetric Information

„ Assume there are 2 groups, each with 100 people. The first group has 5% chance of getting injured, and the second group has a 0.5% chance. „ The payout is $30,000 when injured.

„

„ Table 2Table 2shows how information affects the insurance market in this context.

„ It illustrates the principle of adverse selectionin the presence

of asymmetric information.

„ The insured individuals know more about their risk level

than does the insurer.

Table 2 Premium per: -$135,000 $165,000 $30,000 (0 x $1,500 + 200 x $150) $150 $1,500 Separate Asymmetric

Insurance pricing with separate groups of consumers Net profits to insurers Total benefits paid out Total premiums paid Careful (100 people) Careless (100 people) Pricing approach Information 0 $165,000 $165,000 (100 x $1,500 + 100 x $150) $150 $1,500 Separate Full -$67,500 $150,000 $82,500 (100 x $825 + 0 x $825) $825 $825 Average Asymmetric

With full information, the insurance company can tell the high risks from

the low risks.

It therefore charges separate prices to each group; competition forces it to charge an actuarially fair price.

The premium to the accident prone is therefore 5% x $30,000. For the careful, it is 0.5% x $30,000.

The insurance company collects $1500 x 100 from the accident prone, and $150 x 100 from the careful. Total premiums of $165,000 equal expected costs. Now imagine the insurance

company cannot tell people apart. This is a case with asymmetric

information.

It could continue to charge separate premiums to the different groups, taking the person’s word that they are either careful or accident prone.

The accident prone have no incentiveto tell the company, however; they pay 10 times as much if they reveal truthfully about

their status.

The insurance company collects $150 x 100 from the accident prone,

and $150 x 100 from the careful. Total premiums of $30,000 are $135,000 less than expected costs.

In this case, the company loses money, so it will notoffer insurance.

Thus, the market fails; individuals will not be able to obtain the optimal

amount of insurance. Another potential alternative is that

the insurance company understands it cannot tell consumers apart. Thus, it charges a uniform premium

for all customers.

The average cost for the population as a whole would be $165,000 in claims divided by 200 people, or

$825 per person.

With this price structure, none of the careful people buy the policy. The

company collects $825 x 100 people, but pays $1,500 x 100

people in benefits. Again, the company loses money, so it will notoffer insurance. Thus, the market fails again with a pooling

equilibrium.

Does Asymmetric Information Necessarily Lead to Market Failure?

„ Will adverse selection alwayslead to market failure? Not if:

„ Most individuals are fairly risk averse, such that they will

buy an actuarially unfair policy.

„When risk averse people purchase insurance that is not

actuarially fair, we say that the policy entails a risk premium:the amount that risk-averse individuals will pay for insurance above and beyond the actuarially fair price.

„This leads to a pooling equilibrium, which is a market

equilibrium in which all types buy full insurance even though it is not fairly priced to all individuals.

Does Asymmetric Information Necessarily Lead to Market Failure? Separating Equilibrium… „ In addition, the insurance company might offer separate

products at separate prices that, in some cases, would cause consumers to reveal their true types (careless or careful).

„ This leads to a separating equilibrium, which is a market

equilibrium in which different types buy different kinds of insurance products.

„The separating equilibrium still represents a market failure.

„ Insurers can force the low risks to make a choice between full

insurance at a high price, or partial insurance at a lower price.

„ Although insurance is offered to both groups in this case, the low risk group does not get full insurance, which is

How Does The Government Address

Adverse Selection?

„

The government can help correct this kind of

market failure. It could:

„ Impose an individual mandate that everyone buy insurance at $825 per policy from the private company, forcing all to pool their risks.

„ It could offer the insurance directly, which would have similar effects.

„

Both policies would lead to low-risk types

subsidizing the high-risk types.

OTHER REASONS FOR

GOVERNMENT INTERVENTION IN

INSURANCE MARKETS

„ Although adverse selection is an important motivation for government intervention in

insurance markets, there are also motivations related to:

„ Externalities (early, preventive health coverage). „ Administrative costs (economies of scale). „ Redistribution (fairness – is it right to charge people

differently because of accidents at birth?)

„ Paternalism (society deems that people should behave in

particular ways).

„“Samaritan’s Dilemma”

Institutional Features of Unemployment

Insurance

„ Unemployment Insurance (UI)is a federally mandated, state-run program. Payroll taxes are used to pay benefits to workers laid off by companies for economic reasons.

„ This payroll tax averages 2.5%.

„ Although UI is federally-mandated, each state sets its own parameters on the program.

„ This creates a great deal of variation across states, which many

economists use as a “laboratory” for empirical work.

„ UI is partially experience-rated.

„ The tax that finances the UI program rises as firms have more

layoffs, but not on a one-for-one basis.

Institutional Features of Unemployment

Insurance

„ There are eligibility requirements for UI:

„ First, individuals must have earned a minimum annual amount. „ Second, the unemployment spell must be a result of a layoff,

rather than from quitting or getting fired.

„ Third, the individual must be actively seeking work and willing to

accept a job comparable to the one lost.

„ These eligibility requirements mean that not all of the unemployed collect benefits (44% of unemployed collect). „ Even among eligibles, participation is not full.

„ Roughly 66% of eligibles take up the UI benefit.

Non-participation (among eligibles) results from lack of information about eligibility, stigma from collecting a government handout, or from transaction costs.

Unemployment Benefits in Michigan $0 $50 $100 $150 $200 $250 $300 $350 $400 $0 $50 $100 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600 $650 $700 $750 W ee kly W a ge in Highe st Qua rte r of Pa st Yea r

W e e k ly B e ne fi t Figure 1 Benefits in Michigan initially rise, and are then

capped at a maximum.

The unemployment benefit schedule in Michigan

_{Institutional Features of Unemployment}

Insurance

„ The replacement rateis the amount of previous earnings that is replaced by the UI system.

„ Replacement rates vary from 35% to 55% of earnings, and UI is treated as taxable income.

„ In addition to benefits, the duration of UI can vary. In general, an individual can collect UI for 26 weeks. This varies:

„ For those with sporadic work, for a state that has a “supplemental”

UI program, or if there is a federal extension, as in 2003.

„ The time pattern of benefits must balance the trade-off between three considerations:

„ Consumption smoothing implies rising benefits „ Work disincentives from moral hazard „ Targeting

Net Replacement Rates Over a Five-Year Period

For a One-Earner Couple With Two Children

0 4 8 12 16 20 24 28 32 36 40 44 48 52 56 60 40 60 80 100 20

Length of Unemployment (months)

Net replac ement rat e (% ) Sweden Belgium USA Hungary Spain Figure 2

Other countries tend to have higher replacement

rates than the U.S.

Especially for extended spells of unemployment.

Institutional Features of Disability

Insurance

„ Disability Insurance (DI)is a federal program in which a portion of the Social Security payroll tax is used to pay benefits to workers who have suffered a medical impairment that leaves them unable to work.

„ Current expenditures are roughly $71 billion per year.

„ Benefits are federally uniform, but the initial decision on qualification is made at the state level.

Institutional Features of Disability

Insurance

„ Unlike many other programs, there is a waiting period of 5 months before an individual can collect DI.

„ The initial acceptance rate for DI is roughly 33%; after appeals to higher levels, the acceptance rate is roughly 50%. „ The benefits equal the primary insurance amount from Social

Security, computed as if the applicant were age 65. „ The applicant qualifies for Medicare after two years on DI. „ Detecting “true” disability is challenging.

„ Parsons (1991) reported on a study in which a set of disability

claims was initially reviewed by a state panel, and then one year later resubmitted as anonymous new claims.

„22% of those who had initially qualified were rejected, and 22% of

those initially rejected were qualified!

Institutional Features of Workers’

Compensation

„ Workers’ Compensation (WC)is state-mandated insurance, which firms generally buy from private insurers, that pays for medical costs and lost wages associated with an on-the-jobinjury.

„ The cash payment from WC is designed to replace two-thirds of workers’ wages. Unlike UI, these payments are untaxed, leading to a considerably higher replacement that can approach 90%. „ As with UI, there is substantial state variation in the

program parameters.

„ Unlike UI, however, the insurance premiums are more tightly experience rated.

Table 1 WC across states for permanentand temporaryinjuries in 2003

Type of permanent impairment

6,380 78,200 147,420 8,500 92,365 154,440 New Jersey 6,493 52,719 70,405 15,305 59,521 78,908 Missouri 5,880 50,500 74,500 10,400 62,500 86,500 Indiana 10,044 155,684 276,213 40,176 190,838 301,323 Illinois 5,800 118,900 167,040 26,800 141,520 180,960 Hawaii 6,530 105,786 140,395 24,814 140,395 175,657 Michigan

Maximum Indemnity Benefits Paid to Selected Types of Work Injuries, 2003

18,400 $4,440 Index finger 97,600 $64,056 Hand 124,800 $108,445 Arm New York California State 82,000 $49,256 Foot 4,000 $6,020 Temporary Injury (10 weeks) 115,200 $118,795 Leg Workers’ compensation payments are larger for permanent injuries. Yet there are dramatic differences in generosity

across states.

Institutional Features of Workers’

Compensation

„ A key feature of WC is that it provides no-fault insurance.

„ No-fault insurance–when there is a qualifying injury, the

WC benefits paid out by the insurer regardless of whether the injury was the worker’s or the firm’s fault.

„ In the early 20thcentury, workers could sue their employers, but the system was viewed as unfair because low-income workers may not have had the resources to bring suit against firms.

CONSUMPTION-SMOOTHING BENEFITS

OF SOCIAL INSURANCE PROGRAMS

support:

„ Households save less „ Spouses are less likely to work

„ Recent empirical work finds for UI that:

„ It mitigates the negative effects on consumption from

unemployment.

„ Every $1 of UI reduces the drop in consumption by 30¢.

„ There is no parallel evidence on consumption smoothing for Disability Insurance or Workers’ Compensation, however.

„ DI and WC probably play a stronger consumption smoothing role

than UI: disability is usually unexpected and permanent, so individuals are less able to use their own savings to smooth consumption.

1 5 10 15 20 26

Weeks Out of Work

E x it Rat e from Unempl o y ment 0.165 0.035 0.050 0.100 Figure 3

The exits from unemployment are fairly steady for most of the benefits period.

But towards the end of benefits eligibility, the hazard rate spikes upward.

Moral hazard in UI: are unemployment exits slower when UI benefits are higher?

Moral Hazard Effects of

Unemployment Insurance

„ In the 26thweek of unemployment, precisely the time when benefits run out, the exit rate from unemployment jumps up. „ Empirical work suggests a benefit elasticity of +0.8–each

10% rise in unemployment benefits leads to an 8% rise in unemployment durations.

„ Is this moral hazard good or bad?

„ If the unemployed individual is simply using the benefits to

subsidize leisure consumption (e.g., watching television, etc.), then the increase in duration is inefficient.

„ If the individual finds a better job match, society as a whole may

gain. Job match qualityis the marginal product associated with the match of a particular worker with a particular job.

„There is little evidence (using wages) that UI improves match quality.

Moral Hazard in Disability Insurance

higher DI application rates and lower labor supply. „ If an applicant was “truly disabled,” then use of the DI

program and work behavior should be unaffected by the benefit levels.

„ International evidence (where there is cross-sectional and

over-time variation in DI generosity) suggests the implied elasticity of labor supply with respect to DI benefits is -0.3.

„ In the U.S., applications for DI rise during recessions, even

though it is unlikely that true disability changes. Applicants find it a less costly “gamble” to go through the process when their labor market opportunities are smaller.

Moral Hazard in Workers’

Compensation

„ Moral hazard in WC is thought to manifest itself in reported injuries, injury durations, and types of injuries reported.

„ Krueger (1990) finds that for every 10% in benefits generosity, the rateof reported injury rises by 7%.

„ He finds that for every 10% in benefits generosity, the durationof

injury rises by 17%.

„ Moral hazard will be worse for injuries that are hard to observe or

verify, such as sprains or strains, and less of a problem for other types, such as lacerations or broken or missing limbs. He found larger elasticities for difficult-to-verify injuries.

„ Finally, there appears to be a “Monday effect” to WC claims.

„By examining claims by day of the week, there is a large rise in sprains and

strains relative to lacerations on Mondays.

„This suggests some weekend injuriesunrelated to the job are being passed on to

the employer.

The payroll tax is at first very steep, then flattens out completely.

5.4

Figure 7

10% means that UI benefits equal 10% of a firm’s payroll over the past 4 years The 45 degree line

would be a fully experience-rated

schedule. When the schedule

is above the 45 degree line, firms

pay morethan employees get out.

When the schedule is below the 45 degree line, firms

pay lessthan employees get out.

The benefit ratio is total UI benefits divided by payroll.

Partial experience rating in UI

The Effects of Partial Experience Rating

in UI on Layoffs

„ Relative to a full system of experience rating, partial experience rating subsidizes firms with high layoff rates.

„ How is this a “subsidy”?

„ Firms and workers may make a joint decision whether to

place the worker on temporary layoff, with a promise of being hired back later.

„ UI system acts to make such behavior a partially paid

vacation.

„ With partial experience rating, the cost to the firm of

doing this is less than the benefits to the workers.

The “Benefits” of Partial Experience

Rating

„ Why is partial experience rating so common in UI programs if it leads to more layoffs? The benefit that offset this moral hazard cost is consumption smoothing.

„ Fully experience rated UI would “hit firms while they are down.” Yet, by having a partially experience rated system, it sustains inefficient firms that perhaps should be driven out of business.

„ Empirical studies have examined state systems with different degrees of experience rating.

„ They find that partial experience rating increases the rate of

temporary layoffs.

„ Partial experience rating alone can account for as much as one-third

Workers’ Compensation and Firms

experience rated, firms and workers can get together to increase “injuries” and thus the payouts from insurance. „ Moreover, firms have less incentive to invest in safety,

because the insurance is no-fault.

„ Krueger (1991) examined injury durations at firms that

self-insureand at firms that buy insurance in the partially experience rated market.

„ By definition, self-insurance is full experience rating. The injury durations were shorter at these firms, and less sensitive to benefit increases.

TAX-BENEFITS LINKAGES AND THE

FINANCING OF SOCIAL INSURANCE

PROGRAMS

„ Tax-benefit linkagesare direct ties between taxes paid and benefits received.

„ Summers (1989) shows that such linkages can affect the equity

and efficiency of a tax. The link between payroll taxes and social insurance benefits can lead the incidence to fall more fully on workers than might be presumed.

„ The key point of Summers’ analysis is that with taxes alone, only

the labor demand curve shifts, but with tax-benefit linkages, the labor supply curve shifts as well.

„That is, workers are willing to work the same amount of hours at a lower

wage, because they get some other benefit as well, such as workers’ compensation or health insurance.

Labor (L) Wage (W) L2 L1 W1 W2 S1 D1 D2 A C B Labor (L) Wage (W) L2 L1 W1 W2 S1 D1 D2 A B S2 L3 W3 D E F Figure 10 Mandated benefits also shift the supply curve. Creating smaller DWL. Tax-Benefit Linkages

Wages adjust by more with the tax-benefit linkage, employment falls by less, and deadweight loss is smaller than with a pure tax.

Tax-benefits linkages and the financing of

social insurance programs: The model

onto workers in the form of lower wages, and there is no deadweight loss or employment reduction.

„ This raises some issues with tax-benefit linkages, especially with respect to employer mandates.

„ If there is no inefficiency, why doesn’t the employer simply provide

the benefit without government intervention?

„Market failures, such as adverse selection, may be present. The employer that

provides a benefit such as workers’ compensation or health insurance may end up with high risks.

„ When are there tax-benefit linkages?

„ They are strongest when the taxes paid are linked directly to a