03 September 2008

What's wrong with Cheap Insurance?

In continuation of 2 posts prior, Securities Trading: The Wild West.

I suggest that there is a problem with cheap insurance, in addition to the problems caused by lack of regulation in securities markets.

The problem with cheaper insurance is that people will buy more insurance, and thus our economy will suffer more from the 2 market failures caused by insurance: Moral Hazard and Adverse Selection.

Moral Hazard is the change in behavior caused by insuring. If I have health insurance, I will go to the doctor more often and incur higher health expenses for my insurance provider than I would have had if I were directly responsible for my own health expenses. If I have car insurance, I will be more likely to take a few more risks on the road. Or, if I am a company and am insured under higher costs, then I will take less effort to ensure lower future costs.

Due to private information, information unavailable to the insurance provider, individuals and corporations act slightly less responsible when they are insured. Unfortunate, but true.

Adverse Selection is the tendency for a disproportionate amount of those in need of insurance to buy insurance. Those who are unhealthy or have indications that they will be sick buy more health insurance. Health insurance providers try to control for this fact by analyzing your families medical history and charging you a higher premium if there is indication that you will suffer illness and cause them higher costs. Corporations that have inside information that their profitability will decrease are more likely to insure themselves by selling securities.

Again, due to private information, information advantage of the individual or corporation, insurance providers are at a disadvantage.

The moral of the story is that while it is good that companies have found cheaper means of insuring against risk through the securities markets, the proliferation of insurance does carry a non-negligible cost. More insurance means more moral hazard behavior (less rigorous investment in the future by corporations) and more adverse selection (more junk bonds/ more securities that wind up being worthless).

Identifying moral hazard and adverse-selection behavior econometrically has long been a daunting task. It requires estimation of a system of stochastic simultaneous equations. Progress has been made however, and as can be seen in my Public Finance project on Health Care (http://mastroresearch.googlepages.com/ , (private info in health care, on the right side)), is now identifiable.

Using similar techniques adapted to the securities markets, I believe that it can be shown that corporations trading a higher volume of securities experience lower stock returns. Similarly, in the field of International Finance, I purport that countries trading a higher volume of securities experience lower growth.

Overall, cheap insurance is good, but more intricate contract terms (like HMOs have implemented in the health insurance market) or regulations are needed in the securities markets to prevent our economy from taking two-steps forward and one-step back.

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