Handbook of Insurance

The paper reviews the evolution in insurance economics over the past 25 years, by first recalling the situation in 1973, then presenting the developments and new approaches which flourished since then. The paper argues that these developments were only possible because steady advances were made in the economics of risk and uncertainty and in financial theory. Insurance economics has grown in importance to become a central theme in modern economics, providing not only practical examples to illustrate new theories, but also inspiring new ideas of relevance for the general economy.

This chapter uses the technique of “generalized expected utility analysis” to explore the robustness of some of the basic results in classical insurance theory to departures from the expected utility hypothesis on agents’ risk preferences. The areas explored include individual demand for coinsurance and deductible insurance, the structure of Pareto-efficient bilateral insurance contracts, the structure of Pareto-efficient multi­lateral risk sharing agreements, and self-insurance vs. self-protection. Most, though not all, of the basic results in this area are found to be quite robust to dropping the expected utility hypothesis.

This paper provides a survey on optimal insurance when insurers and policyholders have symmetric information about the distribution of potential damages. When transaction costs are proportional to transfers, it is shown that 1) there is at least one state of the world where no indemnity is paid, 2) the indemnity schedule is deterministic, implying in particular that umbrella policies are optimal, and 3) the optimal contract contains a straight deductible. This is proven without assuming expected utility. The use of expected utility generates additional results, e.g., in the case of nonlinear transaction costs.

We examine an important class of decision problems under uncertainty that entails the standard portfolio problem and the demand for coinsurance. The agent faces a controllable risk—his demand for a risky asset for example—and a background risk. We determine how a change in the distribution in one of these two risks affects the optimal exposure to the controllable risk. Restrictions on first order and second order stochastic dominance orders are in general necessary to yield an unambiguous comparative statics property. We also review another line of research in which restrictions are made on preferences rather than on stochastic dominance orders.

This chapter presents the basic theoretical models of insurance demand in a one-period expected-utility setting. Models of coinsurance and of deductible insurance are examined along with their comparative statics with respect to changes in wealth, prices and attitudes towards risk. The similarities and difference between market insurance, self-insurance and self-protection are also presented. The basic models are then extended to account for default risk and for background risk.

This chapter surveys the theory of optimal insurance contracts under moral hazard, revisiting the topic in light of developments in contract theory over the past twenty-five years. Moral hazard leads to less than full insurance, so that the insured retains some incentive to reduce accident costs. What form does the partial insurance contract take: a deductible, co-insurance or a ceiling on coverage? Posed in the most general form, the problem is identical to the hidden-action principal-agent problem. The insurance context provides some structure that allows more specific predictions. Optimal insurance contracts vary, for example, depending on whether effort affects the probability of an accident or its severity. The chapter characterizes the optimal insurance contract and integrates developments in contract renegotiation, contract dynamics and other extensions.

In this survey we present some of the more significant results in the literature on adverse selection in insurance markets. Sections 7.1 and 7.2 introduce the subject and section 7.3 discusses the monopoly model developed by Stiglitz (1977) for the case of single-period contracts and extended by many authors to the multi-period case. The introduction of multi-period contracts raises many issues that are discussed in detail: time horizon, discounting, commitment of the parties, contract renegotiation and accidents underreporting. Section 7.4 covers the literature on competitive contracts. The analysis becomes more complicated since insurance companies must take into account competitive pressures when they set incentives contracts. As pointed out by Rothschild and Stiglitz (1976), there is not necessarily a Cournot-Nash equilibrium in presence of adverse selection. However, market equilibrium can be sustained when principals anticipate competitive reactions to their behaviour or when they adopt strategies that differ from the pure Nash strategy. Multi-period contracting is discussed. We show that different predictions on the evolution of insurer profits over time can be obtained from different assumptions concerning the sharing of information between insurers about individual’s choice of contracts and accidents experience. The roles of commitment and renegotiation between the parties to the contract are important. Section 7.5 introduces models that consider moral hazard and adverse selection simultane-ously and section 7.6 treats adverse selection when people can choose their risk status. Section 7.7 discusses many extensions to the basic models such as risk categorization, different risk aversion, symmetric imperfect information, multiple risks, principals more informed than agents and uberrima fides.

Risk Classification is the avenue through which insurance companies compete in order to reduce the cost of providing insurance contracts. While the underwriting incentives leading insurers to categorize customers according to risk status are straightforward, the social value of such activities is less clear. This chapter reviews the literature on risk classification, and demonstrates that the efficiency of permitting categorical discrimination in insurance contracting depends on the informational structure of the environment, and on whether insurance applicants become informed by the classification signal.

Emphasizing general liability insurance, we describe basic relationships between legal liability law, liability insurance, and loss control, including the practical limitations of liability rules and insurance markets as mechanisms for promoting efficient deterrence and risk-spreading. After a brief introduction to the role of liability rules in providing incentives for loss control, we consider the implications of limited wealth and limited liability for the demand for liability insurance and accident deterrence. We then discuss the effects of correlated risk on liability insurance markets, the nature and causes of liability insurance contract disputes, causes of the U.S. tort liability/liability insurance crisis in the mid 1980s, and efficiency of the U.S. tort liability/liability insurance system.

We survey recent developments in the economic analysis of insurance fraud. The paper first sets out the two main approaches to insurance fraud that have been developed in the literature, namely the costly state verification and the costly state falsification. Under costly state verification, the insurer can verify claims at some cost. Claims’ verification may be deterministic or random. Under costly state falsification, the policyholder expends resources for the building-up of his or her claim not to be detected. We also consider the effects of adverse selection, in a context where insurers cannot distinguish honest policyholders from potential defrauders, as well as the consequences of credibility constraints on anti-fraud policies. Finally, we focus attention on the risk of collusion between policyholders and agents in charge of marketing insurance contracts.

The paper surveys recent empirical studies that test for or evaluate the importance of asymmetric information in insurance relationships. I first discus the main conclusions reached by insurance theory in both a static and a dynamic framework. A particular emphasis is put on the testable consequences that can be derived from existing models. I review several studies exploiting these theoretical insights in a static context. Then I briefly consider the dynamic aspects.

We discuss the difficult question of measuring the effects of asymmetric information problems on resource allocation. Two of them are retained: moral hazard and adverse selection. One theoretical conclusion, shared by many authors, is that information problems may introduce significant distortions into the economy. However, we can verify, in different markets, that efficient mechanisms have been introduced in order to reduce these distortions and even eliminate, at the margin, some residual information problems. This conclusion is stronger for adverse selection. One explanation is that adverse selection is related to exogenous characteristics while moral hazard is due to endogenous actions that may change at any point in time.

This survey covers extensively the theoretical and the empirical work that was done on the incentive effects related to the existence of workers’ compensation (WC) in the North American context. It first analyzes the economic rationale for compulsory WC. Then it studies the impact of WC on behavior. Three types of effects can be distinguished: 1) WC may influence frequency, duration and nature of claims through a variety of incentive effects. Under asymmetrical information about accident prevention activities, WC may affect safety behavior of both employers and employees and the risk level in the market place. Under asymmetrical information about the true nature of workplace injuries, insured workers may attempt to report false or off-thejob accidents and to undertake activities in order to obtain higher WC benefits, especially in the case of hard-to-diagnose injuries. Moreover, substitution between WC and other insurance programs may be observed. The decision of reporting a workplace accident may also be affected by the generosity of WC benefits. 2) WC may induce changes in occupational wages rates and 3) WC may affect firms’ productivity. So far, the literature has focused mainly on the first type of effects. The main results show that increases in WC insurance are associated with an increase in the frequency of injuries (elasticities ranging from 0.4 to 1), and with an increase in the average duration of claims (elasticities ranging from 0.2 to 0.5). Furthermore, increases in WC are associated with more reporting of injuries that are hard-todiagnose and, in the same line, there are some evidence (at least in Canada) of substitution between unemployment insurance and WC insurance. Lastly, there are empirical results showing that the presence of WC insurance induces important reductions in wage rates, while an emerging literature suggests that changes in WC insurance may also have negative productivity effects.

This paper presents statistical models which lead to experience rating in insurance. Serial correlation for risk variables can receive endogeneous or exogeneous explanations. The paper recalls that the main interpretation for automobile insurance is exogeneous, since positive contagion is always observed for the number of claims reported and since true contagion should be negative. This positive contagion can be explained by the revelation throughout time of a hidden features in the risk distributions. These features are represented by heterogeneity components in a heterogeneous model. Prediction on longitudinal data can be performed through the heterogeneous model, and the paper provides consistent estimators for models related to number and cost of claims. Examples are given for count data models with a constant or time-varying heterogeneity components, one or several equations, and for a cost-number model on events. Empirical results are presented, which are drawn from the analysis of a French data base of automobile insurance contracts.

Recent financial innovation in managing catastrophe risk, such as catastrophe bonds and catastrophe options, may be seen as a specific response to the problem of insurance and reinsurance capacity. This view is bolstered by a clear upward revision of estimates of loss potential. An equally compelling case can be made that such innovation is a natural expression of a conceptual revolution, in which the nature of risk and its impact on firms, has been reworked. This so called revolution is known in financial circles simply as “risk management”.

The first prong of new risk management, why risk is costly to firms, arose from an apparent contradiction between the theory and practice of financial management. The second prong of risk management is that it is inclusive in nature. I will start with a summary of the results of recent literature on why risk is costly to firms and I will identify the generic pairs of strategies that are available to manage risk costs. The structure reveals how reinsurance, financial instruments, insurance policy design, leverage management and organizational form can be used jointly or selectively to manage insurer risk.

Although insurance contracts are regularly purchased by corporations and play an important role in the management of corporate risk, only recently has this role received much attention in the finance literature. This paper provides a formal analytic survey of recent theoretical developments in the corporate demand for insurance. Insurance contracts are characterized as simply another type of financial contract in the nexus of contracts that comprise the corporation. The model developed here focuses specifically on the efficiency gains that can be derived from using corporate insurance contracts to reduce bankruptcy costs, agency costs, and tax costs.

This chapter has two objectives. The first objective is to survey the finance literature on corporate hedging and financial risk management with an emphasis on how the general literature applies in insurance. We begin by reviewing the theoretical rationales for widely-held, risk-neutral, profit-maximizing firms to practice risk management and then go on to discuss the empirical literature on corporate hedging. The second objective is to develop a theoretical model to provide a new explanation for why widely-held insurers manage risk. Insurers are hypothesized to invest in multiple period, private assets where the payoffs are not fully realized if the assets have to be liquidated prior to their expiration. Avoiding adverse shocks to capital that would trigger a liquidation provides the motivation for risk management in our model.

The insurance industry has suffered very large losses in the past 10 years from natural disasters and has the potential for experiencing even greater losses in the future. This chapter examines the role that insurance coupled with cost-effective risk mitigation measures (RMMs) can play in managing the risks from natural disasters. Large insurers have incentives to provide premium reductions to encourage RMMs if the allowable premiums are sufficiently high that they can pass the savings in losses to the property owner or if they are required to continue providing their current policyholders with coverage. Small insurers also have incentives to encourage their policyholders to adopt mitigation measures through premium reductions so as to reduce their chances of insolvency from a large-scale disaster. They may also want to consider purchasing reinsurance to cover a portion of their excess losses. Well-enforced building codes can complement insurance by forcing the adoption of cost-effective RMMs. They may be needed because many property owners underestimate the risks from disasters. In addition, mitigation measures not only reduce losses to the property itself but may produce positive externalities by reducing other costs of a disaster. The chapter concludes by outlining the roles that financial institutions, real estate developers and municipalities can play in developing incentives for the adoption of cost-effective RMMs and suggesting directions for future research.

This chapter provides a comprehensive survey of the literature on the financial pricing of property-liability insurance and provides some extensions of the existing literature. Financial prices for insurance reflect equilibrium relationships between risk and return or, minimally, avoid the creation of arbitrage opportunities. We discuss insurance pricing models based on the capital asset pricing model, the intertemporal capital asset pricing model, arbitrage pricing theory, and option pricing theory. Discrete time discounted cash flow models based on the net present value and internal rate of return approaches are also discussed as well as pricing models insurance derivatives such as catastrophic risk call spreads and bonds. We provide a number of suggestions for future research.

This paper describes and illustrates the main ideas and findings of research on the volatility and cyclical behavior of insurance prices relative to those predicted by a perfectly competitive market in long-run equilibrium. After presenting evidence that insurance market prices indeed follow a second order autoregressive process, we examine several lines of research that have tried to explain the cyclical behavior of insurance prices. Particular emphasis is given to the theoretical developments of and empirical results supporting capital shock models, which primarily explain periods of high insurance prices. We then summarize the idea that moral hazard and/or winners curse effects can explain periods of low insurance prices. Finally, the potential effects of regulation on insurance price volatility are summarized.

Organizational forms within the insurance industry include stock companies, mutuals, reciprocals, and Lloyds. We focus on the association between the choice of organizational form and the firm’s contracting costs, arguing that different organizational forms reduce contracting costs in specific dimensions. This suggests that differing costs of controlling particular incentive conflicts among the parties of the insurance firm lead to the efficiency of alternative organizational forms across lines of insurance. We analyze the incentives of individuals performing the three major functions within the insurance firm—the executive function, the owner function, and the customer function. We review evidence from the insurance industry that directly examines the product-specialization hypothesis. We then examine evidence on corporate policy choices by the alternative organizational forms: executive compensation policy, board composition, distribution system choice, reinsurance purchases, and the use of participating policies. Finally, we review evidence of the relative efficiency of the alternative organizational forms.

This chapter details the use of different insurance distribution systems in practice, analyzes key issues in distribution system use based on economic theories of the organization of the firm, and discusses public policy and regulatory issues related to insurance distribution. The chapter focuses on what we believe to be the three major economic issues in insurance distribution: the choice of distribution system(s) by an insurer; the nature of insurer-agent relationships, including compensation structure and resale price maintenance; and regulatory oversight of insurance distribution activities, including regulation of entry and of information disclosure to consumers.

In the past, many developing countries have considered financial institutions locally incorporated or even State-owned monopolies, an essential element of their economic and political independence. At the same time, structural, financial and technical constraints such as the small size of the markets and the lack of sufficient experience have limited the retention capacity of these markets. Reliance on foreign reinsurance has remained an important policy issue. The purpose of this cross-sectional study of developing countries is to present some empirical tests of the relationship between insurance development and socio-economic characteristics of these countries.

Frontier efficiency and productivity methodologies have become the state-of-the-art for measuring the performance of firms and other organizations. Traditional theory assumes that all firms minimize costs and maximize profits and that firms that do not succeed in attaining these objectives do not survive. The frontier approach reflects the recognition that some firms will be less successful than others in minimizing costs or maximizing profits and that such firms may be able to survive for some period of time. Modern efficiency methodologies measure firm performance relative to “best practice” cost, revenue, or profit frontiers consisting of the dominant firms in the industry. This chapter explains modern frontier methodologies, discusses input and output measurement for insurers, and reviews the most significant studies utilizing frontier methodologies to analyze the insurance industry. These studies not only measure efficiency but also identify firm characteristics that are associated with efficiency and analyze classic industrial organization topics such as economies of scale and scope. Efficiency and productivity measurement is useful in testing economic hypotheses, informing regulators about firm performance, providing information to management, and comparing performance across countries. It is hoped that this chapter will encourage more economists to use these methodologies in testing hypotheses and measuring performance in insurance and other industries.

This chapter synthetizes and extends the treatment of the insurance business in the system of national accounts, with a focus on the measurement of the production activity. The framework begins with an overall discussion, at the macroeconomic level, on the past and current approaches on the measure of the insurance business production activity in the system of national accounts. But this macroeconomic approach of the insurance business turns out to be limited in many important respects. In extending the framework, I adopt a more disaggregated approach, making a strong case on the need to understand the behaviour and to measure the activities of the insurance business at the level of the line of business. This approach, overlooked by the existing economic literature, provides many insights in terms of the delineation of insurers’ lines of business, the measurement of their activities and their interaction within an integrated input-output framework. As a by product, the chapter also discusses issues related to the regional breakdown of insurers’ activities and the unduplicated measure of the insurance firm’s output.

In both developed and developing countries, many elderly depend on government and employment-based pensions. Yet the pension institution faces difficult challenges, even as a rapidly growing aging population turns to it for retirement support. One development is that defined contribution plans have become very popular, sometimes at the expense of defined benefit pensions. This changes the risks and rewards for plan sponsors and participants, as well as government regulators charged with pension oversight. Expenses associated with pension management have also come under scrutiny, imposing new performance pressures on trustees and other pension stakeholders. Finally, it is now becoming clear that far-reaching reforms will be required to restore government social security programs to solvency. As a result, pension plans will require the attention of insurance experts for the foreseeable future.

This survey reviews the micro-economic foundations of the analysis of life insurance markets. The first part outlines a simple theory of insurance needs based on the life-cycle hypothesis. The second part builds on contract theory to expose the main issues in life insurance design within a unified framework. We investigate how much flexibility is desirable. Flexibility is needed to accommodate changing tastes and objectives, but it also gives way to opportunistic behaviors from the part of the insurers and the insured. Many typical features of actual life insurance contracts can be considered the equilibrium outcome of this trade-off.

This contribution reviews two types of reasons for the existence and growth of social insurance, viz. possible enhancements of efficiency and public choice reasons related to the interests of governments and politicians. Empirical evidence suggests these latter reasons to be important in explaining the existing division of labor between private and social insurance. However, this division is being challenged in several ways; its modification may therefore result in improved efficiency. Viewing the several lines of private and social insurance as elements of a portfolio, one can indeed conclude that individuals in the United States and Germany at present are subject to excess asset variance. A few proposals for improving the interplay between private and social insurance are formulated, which tend to accord a more important role to the private component.