A world without insurance

What would life be like if there was no insurance? This was the title of a short essay I set a little while ago. Here is one of the answers written by a 17 year old A level student - nicely judged and getting to the heart of some important issues.

Imagine living a world with no insurance: no health insurance, fire insurance, auto insurance, Social security and unemployment insurance. Discuss some of the economic consequences.

The extensive effects of the transition to a world without insurance are in part due to the exhaustive forms of insurance available today: this ranges from the ordinary automobile and life insurance to terrorist and volcano insurances that are currently available. Insurance is effectively a method of managing risk, in an attempt to hedge against loss or smoothen risk.

In this field, individuals are often classified into two distinct groups: those who are risk-averse and risk loving. The former refers to conservative individuals who tend to avoid risk unless adequately compensated whilst the latter are those who seek high risks for high returns. Arguably there may be a great impact on individuals that are risk loving, as they are no longer hedged against potential losses and therefore feel the full brunt of their actions. This may also result in a shift towards a dominant risk-averse mentality. However, it is often the case that those who are risk loving are not insured due to extra high premiums and redlining therefore minimising the resulting effect. In either case it is evident that variations in attitudes towards risk within a country will significantly shape the following consequences.

It can be argued that the moral hazard problem would be solved in a world without insurance. The idea of moral hazard, based primarily on the work of Kenneth Arrow suggests that insurance leads to a distortion of economic incentives. Insurance can change the behaviour of a person, perhaps causing them to act in a dangerous or reckless way as they are ‘insulated’ by their insurance policy, thus causing a difference between the private marginal cost and social cost of the same action. In terms of simple cost-benefit analysis, the benefit of an action is greater than the perceived cost or premium paid for insurance. For example, after purchasing mobile phone insurance, some tend to be less worried about losing their phone and there may in fact be an incentive to lose a phone, as the value of a new phone is greater than the cost incurred by the individual. These extra costs from fraud and individuals affected by the moral hazard problem are very large and would be eliminated in a world without insurance.

However, in this scenario the moral hazard problem has only been sub-optimally solved through the elimination of insurance. One can also question the extent to which moral hazard is a substantial problem or if it is in fact, just a myth. For example, in the case of health insurance, it can be argued that insurance changes an individual’s behaviour in a beneficial way as there may be an incentive to consume a merit good with positive externalities, thus moving towards a socially optimum equilibrium. Moreover, developments in insurance policy in recent years attempting to solve issues arising from imperfect information have been reasonably successful: deductibles and an improved screening process have readjusted the incentives of making an insurance claim, contributing to the view that moral hazard is not necessarily a serious issue.

The effect on entrepreneurship would be damaging to the global economy. Entrepreneurship by definition, the willingness to take risk, will be adversely affected by the removal of all forms of insurance. This will subsequently have a dampening effect on economic growth as a fall in entrepreneurship will lead to lower innovation, based on the principle that high risk comes high returns, an idea that is appealing to risk-loving individuals.

Without insurance, we may see a higher number of firms failing each year. In ‘Why Most Things Fail’ by Paul Ormerod, it is stated that over 10% of all companies fail every year. If firms had to bear the full costs of employee health care as well as be subject to the volatility of resource and commodity prices, it follows that we might see a much higher number of firms failing in the short run, due to the great increase in risk upon a single firm.

In a world with no insurance, there would be a significant fall in standards of living. This may already be apparent when one compares countries of varying development and insurance. Welfare benefits are in a way a form of insurance, in that they provide the same benefits of normal insurance, yet are provided by the state with taxes being the premium. This explains why Scandinavian countries, conventionally perceived to have strong welfare benefit systems, have the highest living standards in the world. In America, it is estimated that the death rate in any given year for someone without insurance is 25% higher than an individual with health insurance. Currently, over 45 million people in America do not have insurance. Were this figure to rise to 300 million, the effect on standards of living would truly be staggering. This would also have an adverse effect on the labour force as fewer people would be able to go to work and there would be fewer people available to work. It is therefore apparent that no insurance would have a great effect on a macroeconomic as well as microeconomic level.

As insurance essentially is a method of redistributing risk, the removal of insurance would have a profound effect on inequality in countries around the world. According to ‘The New Yorker’, the leading cause of personal bankruptcy in America is unpaid medical bills. Without insurance, only the rich would be able to pay for expensive medical treatment and other such premiums therefore accentuating inequality in standards of living and incomes. One must also consider the value of the insurance industry itself. It is estimated that in the UK alone, the insurance industry generated over $300 billion in 2005; were this industry not existent, there would be a substantial fall in aggregate demand and rise in unemployment.

Many people do live in a world without insurance, particularly in developing nations. Emerging markets account for over 85% of the world’s population yet generate only 10% of premiums. This raises an interesting, yet entirely different question: is there a relationship between development and levels of insurance?

Kartik Kumar