Risk and the Choice of an Insurance Regime

All economic decisions embody some degree of risk. Risk can be defined as the associated probabilities of various outcomes, both positive and negative, that arise from any given decision. The more limited is the range of probabilities, the less the degree of risk, as in the comparisons of distributions A and B in comparison to distributions C and D above. Although most individuals and societies display risk averse behavior, how much they are willing to pay for more certain outcomes in comparison to less certain ones is a function of their underlying attitudes toward risk as well as the level and degree of instruments that are available to respond to a given degree of risk. As long as the distribution of risk is symmetric between buyers and sellers, it is possible for markets to devise relatively efficient choices to undertake decisions in the presence of risk.

One difficulty that most societies confront is that the distribution of risk may not be symmetric. When there is an asymmetric distribution of information, markets may not work well to allocate resources. Where asymmetric information is present, two kinds of market failure may arise. One is moral hazard, in which insured agents adopt riskier choices than they would in the presence of symmetric information, thus raising the potential losses to the insurer. Adverse selection is another example of potential market failure. In this case, those who purchase insurance tend to have higher loss probabilities than those estimated by the insuring agent. In both cases, losses tend to be higher than they would under a symmetric distribution of information.

Although moral hazard and adverse selection may generate market failure, it does not follow that government intervention can necessarily restore economic efficiency. Such was the case in the East Asian financial crisis of 1997, where implicit government guarantees themselves served to generate moral hazard and the general collapse of financial markets. What may be equally important is a set of transparent rules that provide symmetric cost access to the underlying degree of risk in any given decision. Universal accounting standards, prudential capital reserve ratios, and improved oversight are examples of the kinds of reforms that may reduce the prevailing degree of informational asymmetry.

   Profile of U.S. Social Insurance Programs

As with most societies, the United States has adopted a somewhat complex position with regard to risk. On the one hand, public sector decision-makers have developed policies to enable market institutions to better manage risk. Forward and futures markets are one such example, much as life, property, and casualty insurance cover contingent events in physical asset and labor markets. However, both financial and economic markets may not have contractual arrangements to cover all contingencies, in which case the public sector serves as an insurer of last resort. Such is the case with programs such as Old Age and Survivors Insurance, Disability Insurance, Unemployment Insurance, among others, and which are examined in the links for this internet site. Any choice involving the degree of public sector insurance ultimately must be weighed against the opportunity costs of public sector investments foregone, as well as the social welfare losses that may arise from reduced economic growth.

Governments acquire resources either through taxation or through borrowing, which eventually must be paid by taxation. In terms of spending, governments exercise two kinds of functions: first, they affect the composition of goods and services produced in terms of the level of public sector spending on various categories of goods, as illustrated by national defense, education, health, and infrastructure. Second, they affect the distribution of income through streams of transfer payments for which no particular good or service is produced at the time when public sector revenue is received. We concentrate to some extent here on public sector transfer programs, which at the U.S. federal government level are often classified as "social insurance." They are so called because they provide a serious of contingent payments to individuals based on the assumption that market institutions by themselves can not provide either an efficient or equitable allocation of resources.


  Economic Functions of the Public Sector   International Health Care
  The Measurement of Risk   Tobacco Economics
  US Futures and Options Markets   US Social Programs
  National Income Accounting   Evolution of US Social Programs
  US Budget Trends   U.S. Federal Benefits Profile
  US Budget and Trade Balances   U.S. Pension Assets
  Ownership of US Public Debt   FDIC Profile
  The Gini Inequality Model   Pension Systems
  US Poverty Rates   Fundamentals of Finance
  Education and Income   Economics of Excise Taxes
  The U.S. SSA Home Page   Risk and Insurance Bibliography
  Benefit-Cost Evaluation   Cost-Effectiveness Evaluation

Economic Efficiency Requires an Effective Navigation of Risk 

In the early fifteenth century, China developed seagoing ships with lengths up to four hundred feet and explored the Indian Ocean as far as the east coast of Africa. Such feats were not duplicated by Europeans until the arrival of Vasco da Gama in Calicut in 1498, with ships that had lenghts of far less than one hundred feet. European shipbuilding did not match Chinese standards until the construction of the Great Eastern in 1859. The message of Zheng He for today is clear: the act of discovery is an engagement with risk, and countries that adopt prudential policies for the management of risk can look forward to exceptional economic advance.

 Bibliography on Risk and Insurance

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Aaron, Henry J., editor. Behavioral Dimensions of Retirement Economics. (Washington, D.C.: Brookings Institution, 1998).

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Auerbach, Alan. J., Laurence J. Kotlikoff, and Willi Leibritz. Generational Accounting Around the World. (Chicago: U. Chicago Press and NBER, 2000).

Baker, Dean and Mark Weisbrot. Social Security: The Phony Crisis. (Chicago: U. Chicago Press, 2000).

Block, Stanley B. and Geoffrey A. Hirt. Foundations of Financial Management, 9th edition. (New York: Irwin/McGraw-Hill Publishers, 2000).

Bradford, David F. Taxation, Wealth, and Saving. (Cambridge, Mass.: MIT Press, 2000).

Brealey, Richard A. and Stewart C. Myers. Principles of Corporate Finance, 6th edition. (New York: Irwin/McGraw-Hill, 2000).

Buchanan, James M. and Richard. A. Musgrave. Public Finance and Public Choice: Two Contrasting Visions of the State. (Cambridge: MIT Press, 2000).

Cole, Gerald E, "An Explanation of Pension Plans" Employee Benefits Journal 24:2 (June 1999), pp. 3-13.

Corrado, Charles J. and Bradford D. Jordan. Fundamentals of Investments: Valuation and Management. (New York: Irwin/McGraw-Hill, 2000).

Gup, Benton E., editor. International Banking Crises: Large-Scale Failures, Massive Government Interventions. (New York: Quorum Books, 1995).

Helfert, Erich. Techniques of Financial Analysis, 10th edition. (New York: Irwin/McGraw-Hill, 2000).

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Jorion, Philippe. Financial Risk Management. (New York: Basil Blackwell, 1998).

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Malkiel, Burton. A Random Walk Down Wall Street, 6th edition. (New York: W.W. Norton & Company, 1996).

Mariger, Randall P., "Social Security Privatization: What Are the Issues?" National Tax Journal LII: 4, pp. 783-802.

Masuyama, Seiichi, editor. East Asia's Financial Systems: Evolution and Crisis. (Singapore: Institute of Southeast Asian Studies, 1999).

McInish, Thomas H. Capital Markets: A Global Perspective. (New York: Basil Blackwell Publishers, 1999).

Mishkin, Frederic and Stanley Eakins. Financial Markets and Institutions, third edition. (New York: Addison-Wesley Publishers, 2000).

Montes, Manuel F. and Vladimir V. Popov. The Asian Crisis Turns Global. (Singapore: Institute of Southeast Asian Studies, 1999).

Munnell, Alicia H. "Reforming Social Security: The Case Against Individual Accounts", National Tax Journal LII:4, pp. 803-817.

Neftci, Salih N. Introduction to the Mathematics of Financial Derivatives, second edition. (New York: Academic Press, 2000).

Neilsen, Lars Tyge. Pricing and Hedging of Derivative Securities. (New York: Oxford University Press, 1999).

Rose, Peter S. Money and Capital Markets, 7th edition. (New York: Irwin/McGraw-Hill, 2000).

Samwick, Andrew A. "Social Security Reform in the United States", National Tax Journal LII: 4, pp. 819:842

Saunders, Anthony. Financial Institutions Management, third edition. (New York: Irwin/McGraw-Hill, 2000).

Seidman, Laurence S. Funding Social Security: A Strategic Alternative. (New York: Cambridge U. Press, 1998).

Shleifer, Andrei. Inefficient Markets. (New York: Oxford University Press, 1999).

Stiglitz, Joseph E. Economics of the Public Sector, third edition. (New York: W.W. Norton & Co, 2000).

Valdès-Prieto, Salvador, editor. The Economics of Pensions: Principles, Policies, and International Experience. (New York: Cambridge U. Press, 2000).

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