Economic Insecurity, Individual Behavior and Social Policy

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1 Economic Inscurity, Individual Bhavior and Social Policy By Indrmit S. Gill and Nadm Ilahi Th World Bank Washington, DC First Draft: March 27, 2000 Papr writtn for th Rgional Study Daling with Economic Inscurity in Latin Amrica and th Caribban, Offic of th Chif Economist, Latin Amrica and Caribban Rgion, Th World Bank. W ar gratful to Francisco Frrira, Robrt Holzmann, Saqib Jafary, Stn Jorgnsn, Bill Malony, Ghazala Mansuri, Truman Packard, Guillrmo Prry and Luis Srvn for hlpful discussions. Naturally, w alon ar rsponsibl for th viws xprssd hr.

2 Abstract This papr is an attmpt to rturn th discussion on social insuranc and protction to its conomic foundations. W us a framwork proposd by Ehrlich and Bckr (1972) in th conomics of insuranc litratur to first clarify th concpts and thn tak a comprhnsiv approach to insuranc and protction. Our approach starts with th choic problm of a rprsntativ individual facing risk, who chooss optimal lvls of markt insuranc, slf-insuranc and slf-protction. Markt insuranc and slfinsuranc transfr incoms btwn good stats and bad (without changing th probabilitis) whil slf-protction lowrs th probability of th bad stat (without affcting any transfrs across stats). Prics and costs ar crucial in dtrmining th optimal allocation. W illustrat th usfulnss of th framwork by considring th xampl of unmploymnt insuranc (as markt insuranc), prcautionary saving (as slfinsuranc) and invstmnts in human capital (as slf-protction). Govrnmnt action is warrantd from an fficincy point of viw only if markts for som instrumnts ar missing, or if thr ar distortions that prvnt individuals from achiving thir optimal insuranc and protction lvls. Th framwork yilds som novl insights and can xplain rlationships btwn trnds in conomic inscurity and th dmand for mor insuranc in dvloping countris. Whil not addrssing rdistribution concrns, w bliv that th simplicity and comprhnsivnss of this framwork could hlp prioritiz govrnmnt actions and thus assist in th dsign of bttr country-spcific social insuranc and social protction stratgis. 1

3 1. Motivation Rgional conomic criss in th 1990s hav lft in thir wak a world worrid about conomic inscurity, and govrnmnts puzzld about how bst to hlp popl manag th risks thy confront. Holzmann and Jorgnsn (1999) classify ths concrns rgarding risk managmnt as social protction policis. But attmpts to b all-ncompassing in th absnc of thortical guardrails hav rsultd in confusion about th natur of this problm and th rol of govrnmnt policy. Th approach has yildd chcklists of potntially hlpful policy masurs but littl guidanc on whn and whr ths policis will improv outcoms. Idally, for tackling a problm as complx as this, policymakrs should hav unambiguous dfinitions of th main concpts, a tight framwork that links thm, and clar ruls for idntifying th rol for and appropriat dsign of public policy. Evn a casual obsrvr would point out that th stat of thinking on ths mattrs in dvloping country govrnmnts and in dvlopmnt institutions such as th World Bank is far from idal. This papr maks an attmpt to start rmdying this. A systmatic approach to social policy formulation would bgin by undrstanding how individuals or familis bhav whn confrontd with risk. Fundamntally, thr ar two actions that an individual or family can tak: insur, viz., transfr incoms from good to bad stats, and slf-protct, viz., lowr th liklihood that th bad stat occurs. Nithr is costlss. A comprhnsiv framwork would allow for all typs of insuranc and slfprotction dcisions. Any constraints to individuals taking ths actions ffctivly would b of social policy intrst, and th problm thn bcoms on of dciding whthr and how govrnmnts can hlp rmov ths constraints. Thr ar svral advantags of an organizd and comprhnsiv approach to this problm. First, th analysis would hav strong micro-foundations, i.., us tstd principls of wlfar maximization undr constraints. Scond, th analysis would plac 1

4 individuals and housholds, not govrnmnt, at th cor of th problm. Third; th rational for govrnmnt action would not b ad hoc but would b basd on th absnc of wll-functioning markts. Fourth, th rlationships btwn instrumnts to dal with risk would not b arbitrary but would dpnd on budgts and prics. Finally, th analysis would yild not just a mnu of policis but also som ruls to prioritiz among thm. In applying such an approach to th problm of social protction, w hav rsistd th tmptation to b original. W instad draw on th sminal work by Ehrlich and Bckr (1972), which provids an lgant tratmnt of an individual s optimal insuranc dcisions whn facd with th options of markt insuranc, slf-insuranc and slf protction (s sction 2 for dfinitions). W illustrat how a thory of individual insuranc and slf-protction can b xtndd to idntify markt-augmnting rols of govrnmnt (i.., ovr- and undr-involvmnt of govrnmnt, in th sns of Olson, 2000). Undr on rathr strict intrprtation, th public policy analogs of th individual s insuranc and slf-protction problm ar social insuranc (govrnmnt actions to augmnt markt insuranc) and social protction (govrnmnt actions to augmnt slfprotction). Of cours, thr can b othr intrprtations. But w bliv that a disciplind approach that builds th cas for social policy from individual dcisionmaking can lad to mor maningful concpts and tightr dfinitions. Th framwork usd hr allows us to addrss problms that proccupy policymakrs around th world, viz., changs in th dmand for insuranc du to globalization, conomic growth, or incrasd uncrtainty, and th likly ffcts of social safty nts installd in rspons to ths changs. Th approach is vrsatil nough to distinguish btwn th policy implications of conomy-wid and idiosyncratic shocks, btwn catastrophic (larg and rar) and noncatastrophic (small and frqunt) losss, and btwn good and bad instrumnts for insuranc against ths shocks. Th approach yilds insights that can with som additional work lad to rigorous stratgy formulation at th country lvl. 2

5 At th outst, w should warn radrs that this papr dals only with risk-rlatd dcisions for th individual and thir possibl policy implications. Our viw is that th thortical insights in th xisting conomics litratur on risk and insuranc hav bn insufficintly xploitd by policy rlatd work on th subjct of social insuranc. W attmpt to rmdy this. But our proccupation hr is solly on risk, and th rational for policy ar solly fficincy-rlatd. Thr is littl or no discussion of issus rlatd purly to rdistribution or structural povrty; w bliv th analysis can b xtndd to addrss ths problms, but at considrabl cost in trms of practicality and simplicity. Th practicality of th analytical framwork is illustratd by moving from a largly thortical summary of th modl in th nxt sction, to its us in idntifying th rlativ advantags of xisting social programs in countris such as Argntina, Brazil, and Mxico in th concluding sction. In btwn, th concpts formalizd by Ehrlich and Bckr (1972) ar usd to undrstand individual choic and social policy in a world with unmploymnt insuranc, imprfct savings and financial markts, and human capital accumulation undr ral-world constraints in sction 3. 3

6 2. Th Thory In addition to clarifying basic concpts, a good thortical framwork for risk managmnt would hav thr attributs: First, it should b comprhnsiv, in that it should covr all th major instrumnts for managing risk and b snsitiv to th rlationships btwn ths instrumnts (substitution and complmntarity). Scond, it should us wll-stablishd microconomic foundations to structur th approach to addrss th problm of risk. Gnrally this mans that th problm of th individual not th govrnmnt taks cntr-stag. Th problm of govrnmnt has its roots in individual xpctd utility maximization: only th absnc or failur of markts for insuranc and protction against risk provids caus for govrnmnts to intrvn. Third, it should afford clar insights that hlp th dsign of policy rgarding social insuranc and social protction. That is, working through th structurd framwork should formaliz xisting thinking about th subjct of risk but vn mor important yild insights additional to thos that w bgan with. W propos hr that th framwork dvlopd by Ehrlich and Bckr in thir sminal 1972 articl in th Journal of Political Economy has all of ths attributs.. 1 Thr is littl, thrfor, that is novl in this papr. Th innovation lis largly in xtnding Ehrlich and Bckr s insights to social policy though, vn in doing this, w found many hlpful hints in thir papr. Our contribution may thus li simply in rturning th discussion on social insuranc and protction to its conomic foundations. 2a. Th Ehrlich-Bckr Framwork Ehrlich and Bckr (1972) stat th comprhnsiv insuranc problm of th individual as on of dtrmining th lvls of xpnditur on markt insuranc, slf-insuranc and 1 Whil Ehrlich and Bckr (1972) has influncd th subsqunt work on insuranc, much of what has followd has bn on th subjct of moral hazard, s,.g., Marshall (1976), Hirschlifr and Rily (1979) and Coat (1995). Thir contribution of th concpt of comprhnsiv insuranc consisting of markt insuranc, slf-insuranc and slf-protction which lnds itslf naturally to th analysis of social policy has, to our knowldg, rmaind largly unxploitd. 4

7 slf-protction. Th prmis is that individuals can ithr insur against loss, or lowr th probability of th loss. Both involv xpnditurs. Markt insuranc can b purchasd at pricπ, if availabl. Slf-insuranc diffrs from markt insuranc in that thr is no markt for it and thrfor no xplicit pric; howvr, a shadow pric can b imputd from th costs incurrd by th individual in slf-insuring. A critical diffrnc btwn markt insuranc and slf-insuranc is that th formr uss pooling to sprad risk across individuals, whil th lattr dos not. Both markt and slf-insuranc, it bars rptition, srv only to transfr incom from th good to th bad stat of th world and do not rduc th liklihood that ths transfrs will b rquird. Slf-protction, on th othr hand, only rducs th probability of th bad stat of th world, doing nothing to th siz of th loss in cas it occurs anyway. In this simplifid world, th rprsntativ agnt smooths consumption ovr th good and bad stats of th world. 2 Missing markts ar asily accommodatd in th modl: th absnc of markt insuranc rsults in th individual smoothing consumption using only slf-insuranc and slf-protction. And whn this markt is introducd, th ffcts on slf-insuranc (it will fall) and slf-protction (it may or may not fall, dpnding on th natur of markt insuranc) ar transparnt immdiatly. In a world whr both markt insuranc and slf-insuranc opportunitis ar prsnt, th individual ss thm as substituts. Th provision of markt insuranc at or nar actuarially fair prics would rduc slf-insuranc. But Ehrlich and Bckr also find that contrary to popular argumnts involving moral hazard markt insuranc dos not always crowd out slf-protction. In othr words, it may not always b th cas that individuals rduc thir xpnditurs on slf-protction in rspons to gratr insuranc covrag through th markt. Thy argu this is bcaus in on aspct markt insuranc and slf-protction ar complmnts incrasd slf-protction incrass th marginal product of markt insuranc. That is, if slf-protction or a lowrd probability of th 2 It is worth clarifying th concpt of stat hr. Stat is x ant and th stats of th world ar mutually xclusiv thus in our two stat world, ithr th good stat occurs, or th bad, but not both. Th analysis can b gnralizd to mor than two stats of th world. Not also that any tratmnt of rdistribution or povrty would not b possibl with only on typ (or rprsntativ) agnt. 5

8 bad stat is rwardd by markt insuranc, markt insuranc and slf-protction can indd bcom complmnts, and moral hazard is liminatd. 3 2b. Optimality Conditions: Th Rol of Prics To kp mattrs simpl, thr ar only two stats of th world bad (stat 0) and good (stat 1). Th bad stat occurs with probability p, and so th good stat with probability 1-p. Th ndowd incoms of th individual in th two stats ar, rspctivly, I 0 and I 1. Th individual incurs xpnditurs on markt insuranc (s), slf-insuranc (c) and/or slf-protction (r) to smooth incom ovr stats. Markt insuranc is availabl at markt pric π. Each dollar spnt on slf-insuranc rducs th loss in th bad stat according to a loss function L (..). Each dollar allocatd to slf-protction lowrs th probability of th bad stat according to th function p(r). Just as a lowr π allows th individual to buy mor markt insuranc with a givn budgt, incrasd marginal productivity of slfinsuranc and slf-protction allows th individual to gt mor at a givn cost. Tabl 1: Main Symbols and Dfinitions Symbol Dfinition Main Proprtis U(..) Utility function U > 0; U <0 p (p, r) Probability of bad stat Expnditurs on slf-protction lowr th probability of bad stat, i.. p (r)<0 1-p Probability of good stat p Endowd probability of bad stat Changs in p ar xognous I 0 Endowd incom in th bad stat I 1 Endowd incom in good stat L Endowd loss =I 1 - I 0 s Expnditurs on markt insuranc Dcision variabl if markt xists c Expnditurs on slf-insuranc Dcision variabl r Expnditurs on slf-protction Dcision variabl π Markt pric of (markt) insuranc Actuarially fair if = p/(1-p) πs Expnditur on markt insuranc L(L,c) Loss function associatd with slfinsuranc Expnditurs on slf-insuranc (c) lowr th loss in th bad stat, i.. L (c) 0 λ Loading factor for insuranc λ (p)>0 in cas of markt insuranc, λ (p)<0 in cas of slf-insuranc 3 As an xampl, th installation of lightning rods in th hous rducs th probability of damag from a lightning strik and thrfor lowrs th pric of markt insuranc for th individual. 6

9 Tabl 1 provids th dfinitions of all th variabls us in th modl, strictly following th trminology adoptd by Ehrlich and Bckr (1972). In th modl with comprhnsiv insuranc i.., whn markt insuranc, slfinsuranc and slf-protction ar all availabl th individual chooss s, c, and r to maximiz th xpctd utility function bfor th stat of th world is rvald (i.., th framwork is x ant) 4 : U [ p( p, r) ] U[ I c s r] + p( p, r) U[ I c + s L( L, c r] = 1 1 π 0 ) (1) In th absnc of markt insuranc, s is constraind to zro, and th individual s choic is rstrictd to c and r. Th utility function thn bcoms: U [ p( p, r) ] U[ I c r] + p( p, r) U[ I c L( L, c r] = ) (1b) Analogously, th modl can accommodat situations whr slf-insuranc or slfprotction ar not possibl, that is, c=0 or r=0 rspctivly. Th optimal lvls of insuranc and slf-protction in (1) ar chosn by diffrntiating th utility in th full modl with rspct to ach of th choic variabl (s, c and r). Th individual chooss th lvl of markt insuranc (s*) to th point whr π = pu 0 ( c*, s*, r*) (1 p) U ( c*, s*, r*) 1 (2) or th pric at which incom can b transfrrd from good stat to bad through markt insuranc (π) quals th probability wightd marginal rat of substitution (or th slop 4 Coping bhavior, rfrrd to in Aldrman and Paxson (1992), Holzmann and Jorgnsn (1999) and othrs, is an x post phnomna, and is not a dcision variabl hr. Whr anticipatd, coping options ar intrnalizd in th x ant dcisions in an insuranc framwork. 7

10 of th indiffrnc curv in Figur 1, which natly illustrats th tradoffs btwn markt and slf insuranc at diffring markt prics). Similarly, th individual chooss th lvl of slf-insuranc (c*) so that th shadow pric of slf-insuranc (th lft-hand sid in quation 3 blow) quals th probability-wightd slop of th indiffrnc curv (right-hand sid). 5 1 pu 0 ( c*, s*, r*) = L ( c*) + 1 (1 p) U ( c*, s*, r*) 1 (3) Th xpnditurs on slf-protction rduc th probability of th bad stat. Ths xpnditurs ar optimizd at lvl r* whr th marginal gain from rducing th probability of loss (th lft-hand sid in quation 4 blow) quals th marginal loss in utility from having to pay r* for it in ach priod (th right hand sid). p ( r*) [ U ( c*, s*, r*) U ( c*, s*, r*) ] 1 0 = [1 p( r*)] U ( c*, s*, r*) + 1 p( r*) U 0 ( c*, s*, r*) (4) Thr ar thr main rsults of this charactrization of th individual s risk managmnt dcisions within a comprhnsiv insuranc modl, which would b absnt in tratmnts that ithr tak a picmal approach (.g., xamin only markt insuranc) or nglct to includ prics. First, markt insuranc and slf-insuranc ar substituts; i.., an incras in th pric of markt insuranc would lowr th dmand for it and incras that for slf-insuranc. This is illustratd in Figur 1 as a chang from π to π, rsulting in a dclin in markt insuranc from P to Q and an incras in slf-insuranc from M 1 to M 2. Scond, th individual is mor likly to prfr markt insuranc ovr slf-insuranc for insuring rar losss. This is bcaus th shadow pric of slf- 5 Both slf-insuranc and slf-protction xpnditurs (c* and r* rspctivly) ar incurrd in both stats of th world. On way to concptualiz this is to think of ths xpnditurs bing mad prior to th rvlation of th stat of th world. Thus, for xampl, a farmr who invsts in a grain storag facility (a form of slf-insuranc against crop failur) has to pay for it bfor th stat of th world is rvald. H thus pays for it in both stats. 8

11 insuranc dos not fall as th probability of loss dcrass, whil th pric of markt insuranc dos. So as th probability of loss falls (that is, th loss bcoms rarr) thr is an incntiv to insur through th markt rathr than us slf-insuranc. Third, contrary to convntional wisdom, markt insuranc dos not always caus moral hazard, viz., rducs xpnditurs on slf-protction. This is bcaus of two countrvailing ffcts. On th on hand, markt insuranc rducs th prospctiv loss and thrfor crats a tndncy toward lowr slf-protction and moral hazard. But on th othr, by rducing th probability of th bad stat, slf-protction maks markt insuranc chapr and hnc incrass th tndncy to us th markt for insuranc. Illustrating th potntial complmntarity btwn markt insuranc and slf-protction is a ky contribution of Ehrlich and Bckr (1972). Bfor w conclud this sction, it is important to point out that an individual njoys highr wlfar whn all thr instrumnts (markt insuranc, slf-insuranc and slfprotction) ar availabl than whn on is missing. This may b bst xplaind at a huristic lvl by two xampls. First, considr th cas whr only markt insuranc and slf-protction ar availabl, i.., no slf-insuranc is possibl. Th individual would b wors off in this cas compard to th cas whr all thr ar availabl bcaus, for losss that ar not rar, th individual would still hav to us markt insuranc. W know from th framwork that markt insuranc is a lss-prfrrd instrumnt of insuranc than is slf-insuranc for losss that occur frquntly. 6 Scond, considr th cas whr only markt insuranc and slf-insuranc ar availabl, and that it is not possibl to invst in slf-protction. Individuals who ar rlativly fficint at slf-protction would b wors off in this cas bcaus thy ar dnid th possibility of rducing th prmium thy pay for markt insuranc by rducing thir p through xpnditurs on slf-protction. 7 6 Considr a ral-lif xampl th cas of auto insuranc. If slf-insuranc (prcautionary savings) wr not availabl thn vn frquntly occurring small dnts (from minor accidnts) hav to b fixd through markt insuranc. Th individual would b wors off in this cas bcaus th prmium h/sh would nd up paying for markt insuranc would b highr than th shadow pric of slf-insuranc (sinc th prmium paid for markt insuranc riss with th occurrnc of small accidnts but th shadow pric of slfinsuranc would not). 7 Continu with th ral lif xampl of auto insuranc. Considr th cas whr saf drivrs ar not rwardd by lowr prmia for markt insuranc. Obviously, thos who ar fficint at rducing th probability of accidnts would now b wors off. 9

12 Figur 1: Substitution Btwn Markt Insuranc and Slf-Insuranc I 1 T M 1 M 2 Q P Slop: π = p/(1-p) Slop: π > p/(1-p) N I 0 An xognous and actuarially unfair incras in th pric of markt insuranc (π) rducs markt insuranc (P to Q) and incrass slf insuranc (M 1 to M 2 ). 10

13 2c. Comparativ Statics: Gaining Insights into Ral World Changs In this sction, w illustrat th mchanics of th modl through comparativ static xrciss, viz., by xamining how th individuals chang s*, c* and r* in rspons to changs in th paramtrs p, I 1, and I 0, and combinations throf. π is an xognous variabl as wll, but it is viwd as linkd to p whn insuranc is assumd to b availabl at actuarially fair prics. Ths changs may hav parallls with ral or prcivd dvlopmnts in th ral world. Tabl 2 summarizs th ffcts on optimal markt insuranc, slf-insuranc and slf-protction of th rprsntativ agnt. Not that vn by starting with a simpl framwork lads quickly to difficulty in pointing out how changs in paramtrs will affct s*, c* and r*. But, th xrciss conductd blow yild som nw, vn surprising, insights. Tabl 2: Changs in Markt Insuranc, Slf-insuranc and Slf-protction Whn All ar Availabl Paramtric Chang Markt Insuranc (s*) Slf-insuranc (c*) Slf-protction (r*) Incras in p, no chang in π + Incras in p, incras in π +? Incras in Incras in Incras in p and I 1 +? + I 0? I 1??? Incras in L +? + Hightnd conomic inscurity Incrass in p Considr first th cas whr only th probability of th individual bing in th bad stat p gos up. This may b on way to charactriz th rcnt changs in Latin Amrica and East Asia, whr it is blivd that thr is now gratr conomic inscurity. Th ffct of an incras in p rsults in a dclin in s*, an incras in c* and no chang in r*. Th rasoning is as follows: assum for th sak of simplicity that markt insuranc is initially availabl at an actuarially fair pric, i.., π=p/(1-p). An incras in p without a chang in π would rsult in markt insuranc now bing availabl at bttr-than-fair 11

14 prics (or a ngativ loading factor), rsulting in xcss dmand for insuranc. This maks markt insuranc lss xpnsiv rlativ to slf-insuranc, so th individual lowrs slf-insuranc. With actuarially fair insuranc, th amount of slf-protction dpnds only on th siz of th ndowd loss I 1 - I 0 and not on th probability of loss p. So r* dos not chang with an incras in p. If a dlinking of π from p rsults in th possibl complmntarity btwn markt insuranc and slf-protction bing waknd, it is likly that slf-protction falls as wll, crating a moral hazard for markt insurrs. Suppos that th markt pric incrass to rflct th highr odds ratio. Now w ar in th classic Ehrlich-Bckr world. Whil th dmand for insuranc ovrall incrass, slf-insuranc whos shadow pric dos not dpnd on p is now chapr rlativ to markt insuranc. This rsults in an incras in c*, and a dcras in s* (vn though xpnditurs on markt insuranc may incras bcaus of th highr π). Th ffct on slf-protction xpnditurs is uncrtain. Th xrcis shows th importanc of prics. What happns to th dmand for markt insuranc and slf-insuranc in this cas clarly dpnds on whthr th markt pric of insuranc π adjusts to th incras in probability. If it dos, thn th optimal lvl of markt insuranc would b lowr and slf-insuranc highr 8 But if th pric of markt insuranc dos not incras to rflct incrass in p thn thr would b an xcss dmand for markt insuranc, and th dmand for slf-insuranc will ncssarily dclin. Undr prics of markt insuranc that rmain actuarially fair aftr an incras in p, thr may b littl chang in slf-protction xpnditurs. 9 Globalization Incrass in I 1 and p Considr first th cas whr thr ar highr incoms in th good stat without ithr th incrasd probability of th bad stat or th lowr incom in th bad stat. In othr words 8 W assum hr that th xognous chang in th ndowd probability (p ) dos not altr th marginal product of slf-protction xpnditurs i.. p (r*) rmains unchangd. 9 This is bcaus undr actuarially fair prics, optimal slf-protction xpnditurs satisfy th condition p (r*)( I 0 - I 0 ) = 1. Thr is no ffct sinc p (r*) dos not dpndnt on p. 12

15 good tims ar bttr and bad tims rmain unchangd, both in probability and in outcom. An xognous incras in I 1, with I 0 rmaining unchangd, incrass th siz of th ndowd loss L (viz., th loss bcoms mor catastrophic ). For th sak of simplicity, assum that markt insuranc can b purchasd at actuarially fair prics. Th individual thn has a gratr tndncy to us th markt to insur against th loss, so th dmand for markt insuranc incrass. Incrass in I 1 also incras xpnditurs on slf-protction bcaus incrass in xpnditurs on slf-protction mak ach dollar of spnding on markt insuranc mor productiv. 10 It is unclar what happns to slfinsuranc in this cas bcaus whil on th on hand th incras in th ndowd loss incrass th ovrall dmand for insuranc, on th othr incrass in markt insuranc substitut for slf-insuranc. Now considr th cas of what w trm globalization whn prospctiv incom in th good stat incrass (viz., viwd somwhat pssimistically, losss bcom mor catastrophic), but so dos th probability of th bad stat (viz., losss bcom lss rar), that is, both I 1 and p incras. Undr th assumption that th pric of insuranc adjusts to changs in prospctiv probabilitis, th outcom for markt insuranc would b ambiguous. This is bcaus incrass in prospctiv probabilitis lowr th tndncy for markt insuranc (losss ar mor frqunt), but incrass in incom in good tims incras it. Th ffct on slf-protction would b ambiguous, but probably positiv. This xampl illustrats th difficulty of prdicting how complx phnomna such as globalization affct th dmand for insuranc. Safty Nts Incrass in Only I 0 Suppos that th xpctd incom in th bad stat incrass,.g., bcaus of a guarant by th govrnmnt or charitabl organizations that vryon will gt a minimum incom in th bad stat which is highr than I 0. According to th Ehrlich-Bckr framwork, 10 This is du to th optimality condition undr actuarially fair prics p (r*)( I 1 - I 0 ) = 1. 13

16 this rducs th dmand for markt insuranc bcaus th prospctiv loss dcrass. Its ffct on slf-insuranc is indtrminat bcaus th fall du to th ovrall rducd tndncy to insur is offst du to th substitutability btwn markt insuranc and slfinsuranc. Expnditurs on slf-protction fall. 11 This xampl illustrats that it is not ncssarily th cas that individuals will rduc slfinsuranc whn such a safty nt is availabl, but it is quit likly that thy will rduc slf-protction. 12 Thus, for xampl, following th xampls laboratd in th nxt sction, th provision of a public works program will not ncssarily rduc prcautionary saving by individuals but would lowr th ffort to rduc th probability of bing in th bad stat (.g., by rducing invstmnts in halth and work skills). Economic Growth Proportional Incrass in Both I 0 and Economic growth and rducd povrty is simplistically charactrizd hr by th cas whr both I 1 and I 0 incras in th sam proportion, so th siz of th prospctiv loss also incrass by that proportion. As a rsult, markt insuranc and slf-protction will incras (s abov). I 1 This xampl illustrats that, somwhat countr-intuitivly, a stat-nutral improvmnt in conomic status (or walth 13 ) whr incoms in both stats go up proportionally will rsult in an incras in th dmand for insuranc. Th rason is that th absolut siz of th prospctiv loss bcoms largr. Bttr incom prospcts in th good stat will hav th sam ffct. Evn with th nvironmnt not bcoming riskir, conomic growth an unmistakably good dvlopmnt should b xpctd to rsult in an incrasd dmand for insuranc oftn associatd with mattrs bcoming wors. 11 This again is du to th condition p (r*)( I 1 - I 0 ) = 1. So if I 0 falls, r* must ris for th rlationship to hold. 12 This finding is somwhat contradictory to th rsults of Cox, Esr, and Jimnz (1998) who find that public social scurity transfrs crowd-out privat transfrs (slf-insuranc). But not that our framwork uss only a risk lns, and incorporats only fficincy concrns. 13 Walth in this framwork is masurd by W = I 1 + π I 0. 14

17 3. Rational for Social Policy Following th modl prsntd abov, th rational for govrnmnt ariss from th inability of individuals to attain optimal lvls of markt insuranc (s*), slf-insuranc (c*), and slf-protction (r*). This could b du to two rasons. First, on or mor of th instrumnts ar not availabl to th individual. W know from th discussion in th prcding sction that th absnc of any on of th instrumnts maks an individual wors off than whn all thr ar availabl. Scond, all thr instrumnts may b availabl but markt infficincis may prvnt individuals from mploying thm fully. Th rol for social policy thrfor ariss by complicating th modl, which w do by introducing changs that w bliv charactriz th ral world: (a) Markt insuranc for som risks (such as th risk of bcoming unmployd) dos not xist. Th govrnmnt could stp in by providing such insuranc. (b) Privat agnts may slf-insur using bad instrumnts (.g., using cattl or land as a mdium of prcautionary saving) bcaus good instrumnts (such as divrsifid financial assts) ar not availabl. Th govrnmnt could stp in to fostr th dvlopmnt of such markts,.g., through prudntial rgulation of capital markts. (c) Slf-protction may bst b don by invsting in som typ of asst (such as human capital that lowrs th probability of bcoming unmployd) but which forms poor collatral (viz., th individual cannot borrow against his stock of skills in cas h/sh dos bcom unmployd anyway). Individuals may ract by tilting thir asst-profil away from human capital and towards mor asily collatralizd (viz., nonhuman) capital. Th govrnmnt could stp in by subsidizing th acquisition of human capital. W do not xpct hr to b xhaustiv or dfinitiv about th rol of social policy in th prsnc of risk. 14 Our aim is simply to show how principls dvlopd by conomists on th subjct of insuranc can provid usful insights for social policy. W pick on 14 Not also that th rol of social policy hr ariss solly du to fficincy rasons. Thr may b rdistributiv or quity rasons for govrnmnt actions w do not addrss such concrns hr. 15

18 commonly usd instrumnt in ach of th thr catgoris markt insuranc, slfinsuranc and slf-protction for xpositional purposs, though it is asy to catgoriz all othr instrumnts into on or mor catgoris. W considr th xampls of unmploymnt insuranc as markt insuranc, prcautionary saving as slf-insuranc and human capital accumulation as slf-protction. It bars rptition that w rcogniz that all ths instrumnts do mor than just protct from risk. But our objctiv hr is to look solly at thir risk rduction or insuranc charactristics to provid insights using th conomic framwork. For instanc, whil w rcogniz that human capital can incras incoms in both good stats and bad, w concntrat only on its ability to lowr th probability of occurrnc of th bad stat. 15 It should b mphasizd that w focus hr on risk-rlatd rational for individual and govrnmnt action. For xampl, thr ar obviously othr rasons to sav and accumulat human capital. W ar not dnying thos, but by focussing on th risk-saving and risk-human capital linkags, w hop to clarify ky social policy qustions such as th importanc of financial sctor dvlopmnt policis in a comprhnsiv social insuranc stting, and why human capital has to b a cntral componnt of social protction policy. 3a. Augmnting Markt Insuranc: Providing Unmploymnt Bnfits Unmploymnt in many countris can b rgardd as a rar vnt. Following Ehrlich and Bckr (1972), individuals would look mor to th markt than slf-insuranc to protct against rlativly rar losss. Th markt insuranc prmium for a rar loss is low (ssntially bcaus p is low), but th cost of slf-insuranc is th sam for rar as for frqunt losss. 16 But th risk of bcoming unmployd is gnrally not considrd 15 Thus, th mpirical finding that is ky hr is that unmploymnt rats ar gnrally lowr for halthir and/or mor ducatd workrs, and not that rats of rturn to ducation xcd th social cost of capital. 16 Bcaus slf-insuranc rquirs a cost in ach priod, it ssntially has a highr loading factor for rar losss. Furthr as p falls (th loss bcoms rarr) th shadow pric of slf-insuranc dos not fall lik it dos for markt insuranc. Thus individuals ar mor likly to sk markt insuranc for rar losss (such as unmploymnt) than us slf-insuranc (such as prcautionary saving). 16

19 insurabl by privat agnts, and workr guilds or govrnmnts somtims stp in to provid unmploymnt insuranc. 17 Th problm with govrnmnt-sponsord unmploymnt bnfit schms is that thy rarly charg prmia according to individual risk factors or idiosyncratic probabilitis of bing unmployd. Sinc th prmium in unmploymnt insuranc is collctd through taxs, it is gnrally st at th sam rat for vryon prsumably at th actuarially fair rat for th mdian individual. Th bluntnss of this instrumnt mans that thr will b an advrs slction problm for individuals whos risk of unmploymnt is lowr than that of th mdian prson. If highr human capital ndowmnts imply lowr probabilitis of unmploymnt, this mans that thos with high lvls of human capital hav an incntiv to xit th insuranc markt i.., go informal. 18 Ths individuals ar likly to slf-insur by rlying on privat prcautionary saving. In our trminology, thy will hav low s*, and high c* and r*. At th othr nd, th blunt prmium is bttr-than-fair for thos whos risk of unmploymnt is highr than that of th mdian prson. In this group ar individuals who will hav xcssivly high dmand for markt insuranc (bcaus to thm markt insuranc is too chap) and thrfor thy will typically hav low lvls of slf-insuranc (c*). It is also likly that thir incntivs to invst in slf-protction (r*, including human capital invstmnts and work ffort) is also lowr, i.., thr is likly to b a moral hazard. This is bcaus in this cas, an additional dollar spnt on slf-protction dos not lowr th prmium in th markt. 19 Thus high markt insuranc lowrs th prospctiv loss and thrfor rducs th incntivs to slf-protct. 17 Govrnmnt provision of unmploymnt insuranc dos not disqualify it from bing catgorizd as markt insuranc. Rcall that th critical assumption rgarding markt insuranc is that it rquirs a prmium in th good stat and triggrs a payoff in th bad stat. Govrnmnt provision would also provid pooling, a critical rquirmnt for markt insuranc. 18 This would b consistnt with Malony (1999), whr it is rasond that thos in informal activitis ar htrognous in both obsrvabl charactristics and in thir rasons for not bing formal. 19 Rcall that in th modl, markt insuranc and slf protction could b complmnts if incrasing invstmnts in th lattr ar rwardd by lowr prmia for th lattr. In th cas of publicly providd social insuranc, th bluntnss of dsign oftn mans that it is not tailord to individual risk factors and thrfor th link btwn slf-protction and markt insuranc that maks thm complmnts is brokn. 17

20 To wakn or vn rvrs th problm of moral hazard, govrnmnts could us mployr xprinc rating (as in th US) and/or individual unmploymnt historis in stting unmploymnt insuranc prmia. 3b. Augmnting Slf-insuranc: Facilitating Prcautionary Savings Prhaps th most important form of slf-insuranc is prcautionary saving. In a world without risk, individuals sav or postpon consumption up to th point whr th marginal rat of tim prfrnc quals th rat of intrst. Whn risk is addd, individuals incras saving byond this point. 20 This has costs for th individual rgardlss of th stat of th world bcaus th rat of tim prfrnc xcds th intrst rat. Sinc ths costs ar infrrd and not obsrvd, thy imply a shadow pric, akin to that drivd from th loss function L(L,c) in th modl. Th slf-insuranc natur of prcautionary saving implis that it srvs as a substitut for markt insuranc in sttings whr markt insuranc is not availabl, or is undrsupplid. 21 Individuals choos th bst instrumnts for prcautionary saving that ar availabl. Th assts that provid th bst hdg against loss ar thos whos valu riss or dos not fall much in th bad stat. If such assts ar not availabl, howvr, individuals will us bad instrumnts for prcautionary saving. Govrnmnts can augmnt slf-insuranc through prcautionary savings by improving th quality of slf-insuranc options availabl to individuals. This could b don by,.g., intrvning to provid prudntial rgulation of banking, dposit insuranc, rgulating non-bank financial intrmdiaris, or by fostring th markt for long-trm public bonds. 20 S Daton (1990). Carroll, Dynan, and Kran (1999) also find vidnc of prcautionary saving in th prsnc of unmploymnt risk. 21 S for instanc, Engn and Grubr (1995). 18

21 3c. Augmnting Slf-Protction: Subsidizing Human Capital On important instrumnt for slf-protcting against risk, or lowring th probability of an conomic loss is th accumulation of human capital. Halthir prsons ar lss likly to b unabl to work, for xampl, and mor ducatd or bttr-traind workrs may b lss likly to suffr long-trm unmploymnt. Individuals could b xpctd to dmand invstmnts in human capital as an important risk managmnt dvic. Th rol for social policy ariss from th spcial natur of human capital: long gstation lags, irrvrsibilitis, and littl collatral valu. Typically human capital taks tim to build, and rquirs sustaind ffort by familis. Evn brif intrruptions in this procss may rsult in larg prmannt ffcts, a phnomnon known as hystrsis in conomics. If th bad stat rsults in individuals or familis falling blow a thrshold lvl of walth (.g., som povrty lin), thy may lowr thir invstmnts in human capital. 22 Last, a portfolio loadd with human capital can b a poor asst to hold if th bad stat occurs anyway, sinc it is impossibl to offr human capital as collatral for borrowing. This can, among othr things, rduc thir incntivs to slfprotct in th futur. Th rol of social policy may b to augmnt slf-protction fforts by individuals and familis. If govrnmnt fforts to augmnt slf-protction form th cor of social protction, thn public human dvlopmnt initiativs will b an important componnt of social protction. 22 For instanc Durya (1998) finds childrn s ducational attainmnt in Brazil suffrs whn thr is a transitory shock to houshold incom. 19

22 4. Discussion Th prcding sctions hav st out th framwork for analyzing an individual s bhavior whn facd with risk and possibl rational for social policy. This sction points out som of th advantags of adopting this framwork for dsigning social policy whn risk is prsnt. 4a. A Simplr Approach In contrast to unstructurd thinking on th subjct of social insuranc and social protction, this approach offrs a simpl yt disciplind framwork for undrstanding individual/family bhavior and dvising minimalistic but ffctiv social policy. Th basic framwork is comprhnsiv and simpl Individuals hav thr options markt or slf-insuranc and slf-protction. Whn facd with th prospct of a loss in incom, th individual has two basic options: transfr incom from good stat(s) to bad, i.., insur, or rduc th probability of occurrnc of th bad stat, i.., slf-protct. Thr ar two avnus for insuranc: markt or slf. Whil thr ar thr basic options, th individual may hav multipl instrumnts within ach catgory at his or hr disposal. All insuranc and protction masurs hav costs. Th cost of markt insuranc is obsrvabl as th prmium for transfrring on dollar across stats. Th cost of slfinsuranc can b infrrd as a shadow pric of moving incom across stats. Th cost of slf-protction is similarly infrrd from th ffort of th individual to rduc th liklihood of loss. Rarr or mor catastrophic losss ar bttr insurd through th markt. Th prics of markt insuranc and slf-insuranc diffr in anothr important rspct. Whil th pric of markt insuranc (.g., th prmium for lif insuranc) is lowr if th probability of loss is lowr and vic vrsa, th shadow pric of slf-insuranc (.g., th cost of 20

23 prcautionary saving) dos not vary with th liklihood of loss. This rsults in markt insuranc bing rlativly suprior for insuring against som risks (largr and/or rarr losss) than slf-insuranc. Prics play th cntral rol in allocating rsourcs for risk managmnt Whil th discussion of prics or costs of instrumnts of risk managmnt is largly absnt in currnt discussions, th framwork usd hr by virtu of bing basd on microconomic principls puts prics cntr-stag. Substitutability dpnds on rlativ prics. Changs in th rlativ pric of diffrnt insuranc instrumnts prompt changs in allocation of rsourcs. An incras in risk that is rflctd in th pric of markt insuranc would lad to a substitution away from markt to slf-insuranc (th pric of which is invariant to risk). Altrnativly, if infficincis in markts rsult in prics not adjusting to accuratly rflct changs in risk, xcss dmand or supply would aris. Possibl complmntarity dpnds on prics accuratly rflcting risk. Prics of insuranc instrumnts should diffrntiat by risk factors. Whn thy do so, fforts to slf-protct would not ncssarily b rducd whn markt insuranc is mad availabl i.., moral hazard would b absnt. Whil this is a somwhat obvious charactristic of privatly providd insuranc, social insuranc schms could, but gnrally do not, mimic this charactristic. Th rational for social policy ariss out of markt failurs With an approach that is individual-cntrd, th nd for govrnmnt ariss only whr markts fail. Social policy formulation is basd on minimalistic and not ad hoc principls. Th only rol of govrnmnt hr drivn by fficincy concrns is to augmnt markts. Social insuranc as policis to augmnt markt insuranc. Failur of markts to fficintly insur,.g., bcaus som risks ar uninsurabl or cannot b divrsifid, lads 21

24 to th rational for social insuranc policis. Following this lin of rasoning, govrnmnt actions that hlp individuals and familis dal with risk by facilitating transfrs from good stats to bad through risk-pooling would b classifid as social insuranc. This would includ unmploymnt bnfits and disability insuranc. Prcautionary saving as policis to augmnt slf-insuranc. Th failur of markts to provid good instrumnts for slf-insuranc is th rational for govrnmnts to intrvn. Th fatur that distinguishs ths policis from social insuranc is th lack of pooling. This catgory would includ financial sctor strngthning, mandatory saving schms such as mploy providnt funds in Singapor and Malaysia, and individual svranc funds in countris such as Brazil and Colombia. Social protction as policis to augmnt slf-protction. Th failur of markts to facilitat slf-protction by individuals or familis that is optimal provids th rational for govrnmnts to intrvn. Th fatur that distinguishs ths intrvntions from th abov two sts of policis is that th aim of social protction policis would b to rduc th probability of occurrnc of th loss and not simply insur against it. Following this lin of rasoning, policis to facilitat th acquisition of human capital (bttr halth and ducation and training) may wll constitut th cor of social protction. 4b. Additional Insights Wlfar is highr whn mor options ar availabl to individuals. Mor instrumnts ar bttr than lss. As discussd abov, th availability of all thr insuranc instrumnts (markt insuranc, slf-insuranc and slf-protction) will improv wlfar ovr a situation whr on or mor instrumnt is not availabl,.g., making unmploymnt insuranc availabl is likly to b wlfar improving vn whn fficincy losss ar involvd (though ths losss ar not invitabl s nxt point). Making markt insuranc availabl is xpctd to lowr slf-insuranc, but would still rsult in wlfar improvmnts.g., introducing unmploymnt insuranc would rais wlfar vn if it lowrs prcautionary saving, an important form of slf-insuranc. 22

25 Moral hazard is not invitabl. Th introduction of markt insuranc is usually thought to lowr slf-protction and rais th probability of occurrnc of th bad stat ( moral hazard ) but our framwork and common sns indicats that this can b avoidd. Unmploymnt insuranc that somhow discriminats btwn workrs by thir risk factors (.g., prmia diffring across occupations) can lowr or vn rvrs this ngativ rlationship btwn markt insuranc and slf-protction. Thrfor, th appropriat policy qustion is not whthr to provid unmploymnt insuranc or not, but how to bst dsign it and to figur out how govrnmnts can dvlop th capacity to implmnt it. Dmand for social insuranc can incras vn whn th world is bttr In a comprhnsiv insuranc stting, thr is no contradiction btwn gratr dmand for insuranc and th world bing a bttr plac to liv in, ithr in trms of lvls or prdictability of incom. An incrasd clamor for social insuranc is not ncssarily an indication of worsning conomic circumstancs. Positiv dvlopmnts could mak popl dmand mor insuranc. Argumnts that prcivd or ral incrass in conomic inscurity or risk hav ld to a gratr dmand for insuranc ar commonplac. Th rasoning is that th nvironmnt, in which individuals work and liv, has bcom mor unprdictabl an obviously bad dvlopmnt if no othr chang has takn plac. W do not dismiss such concrns. But th prcding analysis shows that vn changs that ar clarly good can lad to a gratr dmand for insuranc. W provid two xampls: first, whr conomic growth lads to highr ndowd incoms in both good and bad stats of th world and, scond, whr th probability of occurrnc of th bad stat falls. Scnario on: highr incom in both good and bad stats. Suppos that conomic growth lads to incoms in both good and bad stats incrasing by th sam proportion. For xampl, th incom in th good stat incrass from $1000 to $1100, and that in th bad stat incrass from $100 to $ With this 10% incras in incoms in th two 23 Not that this should not b intrprtd as incrasd inquality bcaus th comparison is btwn two stats of th world (for ach rprsntativ agnt) and not btwn a rich and a poor individual. 23

26 stats of th world, th ndowd loss or gap btwn good and bad stats also incrass by 10%. This incras would lad to a highr dmand for markt insuranc (and if th markt dos not xist, for social insuranc) and a rducd dmand for slf-insuranc, bcaus th loss has bcom somwhat mor catastrophic. But nobody could rasonably claim that gratr social insuranc is bing dmandd bcaus mattrs hav takn a turn for th wors. Scnario two: lowr liklihood of bad stat. Tak anothr xampl. Suppos that improvd macroconomic managmnt lads to a fall in th probability of th bad stat ( crisis ) occurring, again unambiguously improving th stat of affairs. For xampl, th probability of businss failur falls from 10% to 1% prcnt. Our framwork implis that sinc losss hav bcom rarr, this incras would lad to a highr dmand for markt insuranc (or, if th markt dos not xist, for social insuranc) and a rducd dmand for slf-insuranc. But social insuranc is not bing dmandd bcaus th stat of affairs is wors. Financial markt strngthning should b a cntral componnt of social policy If on xplicitly taks th approach that th nd for social policy or govrnmnt action ariss out of markt failurs that prvnt individuals/familis from pursuing ffctiv and fficint markt insuranc, slf-insuranc, and slf-protction dcisions, financial sctor strngthning coms out as on of th most important and surprisingly undrmphasizd policis for balancd, markt-augmnting social risk managmnt. Financial markt rform can augmnt slf-insuranc. Most important, slf-insuranc involvs prcautionary saving. Without a strong financial sctor, th poor nd up doing so through "bad" instrumnts such as cattl and land, whos prics may fall if th bad stat of th world ( crisis ) occurs. Financial sctor strngthning can lad to "good" instrumnts bcoming availabl; this is spcially crucial whr social insuranc mchanisms such as unmploymnt bnfits ar difficult to st up. Financial markt rform can augmnt slf-protction. Scond, financial sctor strngthning could rsult in lowr probabilitis of th crisis occurring, thus augmnting 24

27 slf-protction fforts by individuals/familis. In th countris of East Asia whr th financial sctor waknsss wr a primary caus of th criss in th 1990s, this slfprotction augmnting rol of financial sctor strngthning is spcially important. Caballro (2000) proposs a gnral framwork with an application to Latin Amrican countris whr th combination of wak intrlinkags with intrnational capital markts and lack of dpth in domstic capital markts is idntifid as a primary caus of conomic criss (in our framwork, of highr probability of th bad stat, p). Financial markt rform can augmnt markt insuranc Third, financial sctor strngthning will hlp crat (mor fficint) markts for insuranc against catastrophic losss such as du to poor halth or natural disastrs. Thus privat financial markts can provid lif insuranc, disability insuranc instrumnts, insuranc against natural disastrs and vn insuranc against macroconomic criss in small countris. 4c. Hlp in Dvising a Stratgy Th idas prsntd in this papr can with som additional work hlp countris dvis ffctiv stratgis. It provids a strong framwork that maks th linkags btwn social insuranc, human dvlopmnt, financial sctor and macroconomic policis xplicit, which if augmntd by institutional capacity assssmnts can hlp in prioritizing and squncing actions. Rcognizing what prvnts individuals from optimal insuranc. Policymakrs should idntify what constrains individuals in using all thr basic instrumnts of insuranc and protction to thir advantag and, if all thr ar availabl, thn whthr thr ar any infficincis that prvnt optimal allocation across th thr. Ar all thr availabl? In conditions whr a country has good capacity, all thr instrumnts of insuranc and protction ought to b availabl for achiving highst wlfar. For instanc, if options that offr markt insuranc ar absnt, individuals would 25

28 b constraind thy would only hav slf-insuranc and slf-protction. This would yild a non-optimal lvl of insuranc and protction. Govrnmnt s rol thn would b to nsur non of th instrumnts ar missing. Do individuals optimally allocat all thr? Evn in countis whr all thr ar availabl, thr may b infficincis that do no allow individuals to avail of thm optimally. Poorly dsignd social insuranc that augmnts markt insuranc may not allow vryon to us this instrumnt optimally (s our xampl of unmploymnt insuranc abov). Similarly, individual agnts may not hav th bst slf-insuranc options at thir disposal (s our xampl of financial vrsus non- financial prcautionary saving abov). Th rol for govrnmnts thn would b to nsur fficint mchanisms for markt- and slf-insuranc and slf-protction ar availabl to individuals. Illustration: Stratgy aftr financial sctor rlatd conomic criss. To bttr apprciat th usfulnss of th framwork proposd hr, th study of East Asian countris afflictd by th rcnt crisis may b usful. Bfor th crisis, th insuranc dcisions of individuals in ths countris could b charactrizd as bing intnsiv in slf-insuranc and slf-protction, viz., with low s* (social insuranc was not widsprad) but high c* (high saving rats) and r* (high invstmnts in human capital and wag flxibility that both lowr p). Th quality of slf-insuranc mchanisms such as prcautionary savings dtrioratd du to financial sctor waknsss, which also causd risk lvls to ris (thus both lowring c and raising p), laving slf-protction as th only rmaining instrumnt. This diagnosis suggsts a stratgy for socioconomic rcovry. Govrnmnt actions, in ordr of priority, thn would b: first, giv back slf-insuranc instrumnts to individuals through financial sctor strngthning; scond, nsur that slf-protction mchanisms ar not waknd by maintaining public programs to augmnt human dvlopmnt and by kping wags flxibl; third, ovr th longr trm, augmnt markt insuranc to giv individuals a third instrumnt for daling with conomic uncrtainty. Th last instrumnt, which has bn missing, should not b an immdiat priority bcaus govrnmnts nd to build th capacity for ffctiv provision of social insuranc. 26

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