PowerPoint Slidesfor Professors

Spring 2010 Version

This file as well as all other PowerPoint files for the book, “Risk Management and Insurance: Perspectives in a Global Economy” authored

by Skipper and Kwon and published by Blackwell (2007), has been created solely for classes where the book is used as a text. Use or

reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors.

Visit the following site for updates:http://facpub.stjohns.edu/~kwonw/Blackwell.html.

To change the slide design/background,[View] [Slide Master]

W. Jean Kwon, Ph.D., CPCUSchool of Risk Management, St. John’s University

101 Murray StreetNew York, NY 10007, USAPhone: +1 (212) 277-5196

E-mail: Kwonw@stjohns.edu

Risk Management and Insurance: Perspectives in a Global Economy

9. Public-Sector Economic Security

Click Here to Add Professor and Course Information

3

Study Points

Why private markets fail to provide some financial services

Selected public-based economic security services

The future of social insurance

4

Market Failure

Market failure stemming from• Financial intermediaries refusing to offer an otherwise demanded

service• Prices being so high that no or only a modest market evolves

Causes of the failure• Financial intermediaries cannot adequately address the information

problems.• Positive externalities accompany the purchase.• Buyers have insufficient income.• Risk aversion is insufficient to motivate individuals to pay high

loadings.

5

Cause – Information Problems

Financial markets characterized by• Adverse selection problems and• Moral hazard problems

Where the usual techniques for dealing with these information problems do not work well or at all, the private sector offers no solutions or offers them only at very high prices.

Also discussed in Chapters 2, 8 and 19.

6

Cause – Fails to Capture Positive Externalities

If society receives positive spillovers from some members having acquired additional security, the price becomes too high because• It reflects only private producers’ marginal costs of production and• It fails to credit against those costs the marginal societal benefits.

Individuals then consume too little (in society’s view) if they must pay the full private cost.

Examples• The market for terrorism insurance (figure 9.1)• Social insurance (figure 9.2)

7

Market for Terrorism Insurance (Figure 9.1)

8

Social Insurance (Figure 9.2)

9

Cause – Insufficient Buyer Income

Many individuals have income that are insufficient to pay for life’s necessities (immediate utility) and for financial security services (future utility).• The interest rate necessary to induce a poor person to forego

current consumption for future consumption is exceptionally high, maybe even infinite.

In the absence of positive externalities, insufficient income provides no economic justification for government becoming a provider of financial security services. But,• Some economic security services do carry positive externalities.• Societies often choose to provide security services for non-economic

reasons (e.g., concerns about fairness).

10

Cause – Insufficient Buyer Risk Aversion

Intermediaries incur expense and other cost loadings, which may be viewed high for several reasons

Illustration using insurance• Low-severity or high-frequency exposures• Correlated exposures• Exposure ambiguity

11

Public-based Economic Security Services

Social insurance• The most important government-provided economic security

services in most countries

Mandatory savings programs

Economic-needs-tested programs

The remaining part of the chapter discusses mainly social insurance.

The other two discussed in page 228.

12

Social Insurance

13

Fundamentals

Social insurance provides income security for individuals It is also an important public policy instrument

Government-sponsored economic security programs possesses three characteristics:1. Economic security is provided for well-defined loss exposures.2. Participation is compulsory for the target population.3. Contributions usually are not adjusted for probability of loss.

14

Social Security Programs Worldwide (Table 9.1)

15

Comparison of Programs by Region (Table 9.2)

16

Funding Social Insurance Programs

Three main sources• Taxes paid by participant workers• Taxes paid by employers• Government contributions

• Required contributions are closely related to worker earnings.• The government’s contribution may be derived from general

revenues or, less frequently, from special earmarked or excise taxes

Social insurance programs are often financed in a manner that redistributes income from one generation to another or from one income group to another or both.

Table 9.3

17

Funding Social Insurance Programs

Fully funded approach• Most private pension systems are fully funded.

Pay-as-you-go (paygo) approach• Benefits for current recipients paid from the contributions by the

currently working population• Politically, the easier of the two funding approaches to implement

• Most OECD states have paygo retirement income security plans.• • If the worker-retiree distribution remains roughly constant, the paygo

system does not necessarily result in a transfer of income between generations.

• If otherwise, the system may result in intergenerational transfers.

18

Public Pension Liabilities – NPV (Figure 9.3)

19

Social Insurance Benefits

1. Retirement income

2. Survivor benefits

3. Health insurance

4. Unemployment insurance

20

1. Social Insurance – Retirement

Support for the elderly is a prime focus of social insurance.

Logical assumptions• Individuals may not have the information needed to prepare

adequately for retirement.• There are economies of scale in funding retirement benefits.• The elderly’s consumption is likely to have external benefits to

society.

21

1. Social Insurance – Retirement

Originally for government (and military) employees in many countries

Gradually extended first to private-sector workers in urban areas and then to virtually all wage earners and salaried employees• Initially excluded were (1) agricultural workers and the self-employed

due mainly to administrative difficulty as well as (2) family workers, domestics and day workers

• The trend is to cover these groups under separate funds or to bring them under the general system.

• Even the non-employed may now be covered.

22

1. Social Insurance – Retirement

Plan design and reform objectives• Provide economic security against destitution in old age• Smooth the distribution of consumption spending over a lifetime• Provide for life’s requirements for those with exceptional longevity

Three distinct tiers• The first tier – provides poverty relief, normally in a public system

funded on a paygo basis participation with mandatory• The second tier – provides for consumption smoothing over each

person’s lifetime• The third tier – private, funded and voluntary

23

1. Social Insurance – Retirement

IMF’s proposals for plan design and reform

• All pension systems require strong and effective government.

• The choice between government paygo and (private or public) funded schemes is of secondary importance

• To the government’s ability to manage the economy effectively• To promote adequate output growth, and• To sustain a stable foundation for whatever pension system is adopted.

• Within the limits of national economic and government capacity, countries have a wide range of choice over pension design. No one approach will prove superior.

24

1. Social Insurance – Retirement

Benefit qualification – eligibility requirement• Attainment of a specified age and• Completion of a specified period of contributions or covered

employment• Many programs have the same pensionable age for women as for

men.

Nature of benefits• Benefits are commonly wage-related and based also on formulas.

For example,• A basic rate (e.g., 30%) of average earnings, plus an increment

of 2% of earnings for each year of service in excess of a minimum number of years for qualification

25

2. Social Insurance – Survivor Benefits

Most social insurance programs provide for some type of payment to dependents• Spouse and dependent children under a certain age• Patterned closely after their counterpart retirement income benefit

programs

Funding for survivor benefits ordinarily follows that for retirement income benefits.

Eligibility• The deceased worker was a pensioner at death or have completed a

minimum period of covered employment or contribution.• Again, certain additional conditions apply (e.g., age requirement)

26

2. Social Insurance – Survivor Benefits

Periodic benefits are provided under most systems, although a few pay lump-sum benefits only.

Survivor benefits are paid to some categories of widows under nearly all programs.

The age limits for children’s benefits are often the same as for children’s allowances through retirement income or disability income benefit programs.

Benefits are payable under a number of programs to certain widowers of insured workers or pensioners.

27

3. Social Insurance – Health Benefits

The healthcare delivery and financing systems reflect the cultural, economic and political character of the nation.

• Most industrialized countries place great value on equal access to healthcare across individuals, and provide basic universal coverage to all.

• It is not the case in the U.S., which does not have a national healthcare program.

• The culture in the U.S. places relatively less value on social equity and relatively greater value on private-market solutions to financing healthcare.

• Several attempts to introduce universal healthcaremade, including the Obama plan

28

Healthcare Expenditures (Figure 9.4)

29

Economics of Healthcare – Market Imperfections

Difficulty in measuring marginal benefit of additional medical service on health• Buyers cannot purchase health per se but consume medical

services to improve or maintain health.

Presence of information asymmetries, including adverse selection• Information asymmetry exists between buyers and sellers.• Information asymmetries exist with respect to the price of medical

services.• Information asymmetries exist between insureds and insurers.

30

Economics of Healthcare – Market Imperfections

Problems of moral hazard• Third-party payment for healthcare services not only reduces

incentives for consumers to seek price information, but also increases the potential for moral hazard.

• Consumer behavior may change since insureds do not bear the full cost of medical care.

Demand for services induced by suppliers• The provider of medical services not only supplies medical services

to consumers, but also advises them on what to demand.

Barriers to market entry• Healthcare markets have barriers to entry.

31

Economics of Healthcare – Market Imperfections

Other considerations

• Cultural beliefs

• Growth of medical technology

• Medical malpractice costs

32

Healthcare Systems

Trends• Developed countries have modern healthcare services available to

most of the population. Developing countries tend to provide a higher

• level of medical service to urban residents.

Delivery systems (Figure 9.5)• Direct, voluntary out-of-pocket payment• Compulsory public insurance

• General revenue tax model• Social insurance model

• Voluntary private insurance

33

Healthcare Systems (Figure 9.5)

34

Healthcare System Reform Initiatives

Increased use of the public contractual model

Greater use of third-party payers

Greater independence of hospital management

Enhanced use of managed care and cost sharing

35

Healthcare Spending and Health Outcomes

The prime determinant of differences in national spending for healthcare is national per capita income.

• The variation in general health of populations is also explained primarily by differences in income level.

• Nations with higher per capita incomes have longer life expectancy and lower infant mortality rates. Exceptions exist.

36

3.1 Social Insurance – Disability Benefits

In most programs, participants in the retirement income plan also participate in the disability income plan.• Funding ordinarily follows that of retirement income benefit funding.

Benefit eligibility requirements• Loss of productive capacity and• Fulfillment of a minimum period of work or contributions

37

3.1 Social Insurance – Disability Benefits

Additional features

• The qualifying period usually shorter than for an old age, retirement income benefit.

• Provisions for persons who are permanently disabled due to non-occupational causes are similar to those for retirement.

• A relatively short waiting period (e.g., 2~7 days) is imposed.• For example, workers ordinarily may receive short-term benefits

for up to 26 weeks.

38

3.2 Social Insurance – Occupational Injury Benefits

Workers’ (workmen’s) compensation programs are the oldest and most widespread type of social insurance.

Program structures• Social insurance systems utilizing a public fund• Various forms of private or semiprivate arrangements required by

law

Most countries maintain the programs that do not share a direct link with other social security programs.• In some other countries, the benefits are available under special

provisions of the country’s social security programs.

39

3.2 Social Insurance – Occupational Injury Benefits

Medical benefits: two variations• All “necessary” medical services – unless specifically excluded in the

law• A list of covered medical services

Income replacement benefits• A percentage of the (average) wage prior to disability, a stated

monetary ceiling, or both• Most programs not offer full indemnification• Compensation varies according to the degree of disability:

• Temporary disability• Permanent total disability• Permanent partial disability Table 9.6

40

3.2 Social Insurance – Occupational Injury Benefits

Survivor benefits• Customarily payable to a widow, regardless of her age, until her

death or remarriage; to a disabled widower; and to dependent children below specified ages

Industrialization and occupational injury• Employment shifted from the manufacturing to the service sector

• Claims associated with industrial injury and illness decreased

• Growth in the number of recognized occupational diseases due to a greater understanding of the origins of certain diseases

41

4. Social Insurance – Unemployment Benefits

Objectives• Provide periodic cash income to workers during temporary periods of

involuntary unemployment• Help stabilize the economy during recessionary periods• Encourage employers to stabilize employment• Help the unemployed find jobs

The programs exist mainly in industrialized countries.• About one-half of the compulsory unemployment programs cover the

majority of employed persons, regardless of industry.

Table 9.7

42

4. Social Insurance – Unemployment Benefits

Program structuring• Most are compulsory and fairly broad in scope.

• Some countries with voluntary programs with no government mandate.

• Some unemployment programs economic-needs tested.• Some offer scheduled payments of benefits, and others provide

lump-sum grants.

• Contribution solely by employers is the typical method governments use to finance unemployment insurance.

• The contribution usually as a fixed percentage of the covered payroll

43

4. Social Insurance – Unemployment Benefits

Benefit eligibility• Completion of a minimum period of service in a covered employment• Involuntary unemployment

• Nearly all unemployment insurance programs require that applicants be capable of and available for work.

Benefits• A percentage of the average wage during a recent period• Payable only after a waiting period

• Several countries maintain unemployment assistance or similar means-tested programs supplementing regular unemployment insurance.

44

Mandatory Savings ProgramsEconomic-needs-tested Programs

45

Mandatory Savings Programs

Also known as provident funds

Features• Employees’ contribution toward their own personal retirement

savings programs• Substitute for or complement paygo types of social insurance

systems• The account holder often may purchase separate disability and

survivors’ insurance coverages.

Little or no income redistribution among participants• These programs do not meet our definition of social insurance.

Table 9.8

46

Economic-needs-tested Programs Benchmarks each applicant’s resources to formula-based

standards for subsistence need estimation and offers benefits only to applicants who satisfy the test

Different countries have different tests, but they commonly take into consideration• The net wealth and current income of the applicant and the family• Health condition and age of the breadwinner• Family size• Place of living

If the program does not require contributions by the beneficiary, it is a social assistance (welfare) program intended to alleviate poverty.• It is not insurance.

47

The Future of Social Insurance

Selected factors affecting the insurance• Rising healthcare costs• Low birth rates• Increasing life expectancy• Paygo public pension systems preservation of economic security

through equitable financing approaches• Social and political environments• Macroeconomic performance

Transition into fully funded programs

Privatization of social insurance programs• Chile• Japan

48

Discussion Questions

49

Discussion Question 1

Does flood insurance qualify as a social insurance program? Justify your answer.

50

Discussion Question 2

In the section on “Low-Severity or High-Frequency Exposures,” the authors discussed several types of loss exposures for which private insurance is unsuitable. What are the characteristics of exposures that insurers are willing to cover?• You may refer to Chapter 19 for a related discussion.

51

Discussion Question 3

Provide a rationale for instituting a paygo social insurance program.

52

Discussion Question 4

Discuss the implications of a successful social insurance program on a country’s finances.

53

Discussion Question 5

Compare public and private programs for providing retirement income. Who benefits under each type of program?