Can adverse selection increase social welfare?

This talk will focus on the effects of bans on insurance risk classification on utilitarian social welfare. We consider two regimes: full risk classification, where insurers charge the actuarially fair premium for each risk; and pooling, where risk classification is banned and for institutional or regulatory reasons, insurers do not attempt to separate risk classes, but charge a common premium for all risks. For the case of iso-elastic insurance demand, we derive sufficient conditions on higher and lower risks' demand elasticities which ensure that utilitarian social welfare is higher under pooling than under full risk classification. Empirical evidence suggests that these conditions may be realistic for some insurance markets

Why Adverse Selection Need Not Be Adverse

Restrictions on insurance risk classification can lead to troublesome adverse selection. A simple version of the usual argument is as follows. If insurers cannot charge risk-differentiated premiums, more insurance is bought by higher risks and less insurance is bought by lower risks. This raises the equilibrium pooled price of insurance above a population-weighted average of true risk premiums. Also, since the number of higher risks is usually smaller than the number of lower risks, the total number of risks insured usually falls. This combination of a rise in price and fall in demand is usually portrayed as a bad outcome, both for insurers and for society. However, some restrictions on insurance risk classification are common in practice. For example, since 2012 insurers in the European Union has been barred from using gender in underwriting; and many countries have placed some limits on insurers' use of genetic test results. We can observe that policymakers often appear to perceive some merit in such restrictions. This observation motivates a careful re-examination of the usual adverse selection argument. In this talk, we study the implications of insurers not being allowed to use risk-differentiated premiums. We model the insurance purchasing behaviour of individuals based on their degrees of risk aversion and utility of wealth. We assume that an equilibrium has been reached, where insurers break even by charging the same `pooled' premium to both high and low risks. We characterise this equilibrium by two quantities: adverse selection, defined as the correlation of insurance coverage and losses; and `loss coverage', defined as the expected losses compensated by insurance. We find that adverse selection is always higher under pooling than under risk-differentiated premiums, as expected. However, loss coverage can be higher or lower under pooling than under risk-differentiated premiums. Loss coverage is higher under pooling if the shift in coverage towards higher risks more than compensates for the fall in number of risks insured. In other words, loss coverage is higher under pooling if adverse selection at the equilibrium is modest, but lower under pooling if adverse selection at the equilibrium is severe. Loss coverage represents the expected losses compensated by insurance for the whole population. We argue that this is a good metric for the social efficacy of insurance, and hence one which public policymakers may reasonably wish to maximise. If this argument is accepted, modest adverse selection under pooling can be a good thing, because it leads to higher loss coverage than risk-differentiated premiums

An Economic Capital study of the Pension Protection Fund and UK’s Defined Benefit Pension Sector

With the advent of formal regulatory requirements for rigorous risk-based, or economic, capital quantification for the financial risk management of banking and insurance sectors, regulators and policy-makers are turning their attention to the pension sector, the other integral player in the financial markets. In this paper, we analyse the impact of applying economic capital techniques to defined benefit pension schemes in the UK. We propose two alternative economic capital quantification approaches, firstly for individual defined benefit pension schemes on a stand-alone basis and then for the pension sector as a whole by quantifying economic capital of the UK’s Pension Protection Fund, which takes over eligible schemes with deficit, in the event of sponsor insolvency. We find that economic capital requirements for individual schemes are significantly high. However, we show that sharing risks through the Pension Protection Fund, reduces the aggregate economic capital requirement of the entire sector

Insurance Risk Classification: How much is socially optimal?

Restrictions on insurance risk classification can lead to troublesome adverse selection. A simple version of the usual argument is as follows. If insurers cannot charge risk-differentiated premiums, more insurance is bought by higher risks and less insurance is bought by lower risks. This raises the equilibrium pooled price of insurance above a population-weighted average of true risk premiums. Also, since the number of higher risks is usually smaller than the number of lower risks, the total number of risks insured usually falls. This combination of a rise in price and fall in demand is usually portrayed as a bad outcome, both for insurers and for society. However, some restrictions on insurance risk classification are common in practice. For example, since 2012 insurers in the European Union has been barred from using gender in underwriting; and many countries have placed some limits on insurers' use of genetic test results. We can observe that policy-makers often appear to perceive some merit in such restrictions. This observation motivates a careful re-examination of the usual adverse selection argument. In this talk, we study the implications of insurers not being allowed to use risk-differentiated premiums. First, we provide a micro-foundation in variations across individuals' utility of wealth to obtain an aggregate insurance demand function. Then, within this framework, we formulate the concept of loss coverage, defined as expected losses compensated by insurance, as a metric for evaluating different insurance risk classification schemes. Finally, we reconcile loss coverage to a utilitarian concept of social welfare, defined as the sum of individuals' expected utilities over the entire population. Specifically, we show that if insurance premiums are small relative to wealth, maximising loss coverage maximises social welfare. From a policy perspective, this may be a useful result because maximising loss coverage does not require knowledge of individuals' (unobservable) utility functions; loss coverage is based solely on observable quantities

Impact of the choice of risk assessment time horizons on defined benefit pension schemes

We examine the impact of asset allocation and contribution rates on the risk of defined benefit (DB) pension schemes, using both a run-off and a shorter 3-year time horizon. Using the 3-year horizon, which is typically preferred by regulators, a high bond allocation reduces the spread of the distribution of surplus. However, this result is reversed when examined on a run-off basis. Furthermore, under both the 3-year horizon and the run-off, the higher bond allocation reduces the median level of surplus. Pressure on the affordability of DB schemes has led to widespread implementation of the so-called de-risking strategies, such as moving away from predominantly equity investments to greater bond investments. If the incentives produced by shorter term risk assessments are contributing to this shift, they might be harming the long-term financial health of the schemes. Contribution rates have relatively lower impact on the risk

How can adverse selection increase social welfare?

This talk will focus on the effects of bans on insurance risk classification on utilitarian social welfare. We consider two regimes: full risk classification, where insurers charge the actuarially fair premium for each risk; and pooling, where risk classification is banned and for institutional or regulatory reasons, insurers do not attempt to separate risk classes, but charge a common premium for all risks. For the case of iso-elastic insurance demand, we derive sufficient conditions on higher and lower risks' demand elasticities which ensure that utilitarian social welfare is higher under pooling than under full risk classification. Empirical evidence suggests that these conditions may be realistic for some insurance markets

Insurance risk pooling, loss coverage and social welfare: When is adverse selection not adverse?

Restrictions on insurance risk classification may induce adverse selection, which is usually perceived as a bad outcome, both for insurers and for society. We suggest a counter-argument to this perception in circumstances where modest levels of adverse selection lead to an increase in `loss coverage’, defined as expected losses compensated by insurance for the whole population. This happens if the shift in coverage towards higher risks under adverse selection more than offsets the fall in number of individuals insured. We also reconcile the concept of loss coverage to a utilitarian concept of social welfare commonly found in economic literature. For iso-elastic insurance demand, ranking risk classification schemes by (observable) loss coverage always gives the same ordering as ranking by (unobservable) social welfare

Role of the Pension Protection Fund in financial risk management of UK defined benefit pension sector: a multi-period economic capital study

With the advent of formal regulatory requirements for rigorous risk-based, or economic, capital quantification for the financial risk management of banking and insurance sectors, regulators and policy-makers are turning their attention to the pension sector, the other integral player in the financial markets. In this paper, we analyse the impact of applying economic capital techniques to defined benefit pension schemes in the UK. We propose two alternative economic capital quantification approaches, firstly for individual defined benefit pension schemes on a stand-alone basis and then for the pension sector as a whole by quantifying economic capital of the UK's Pension Protection Fund, which takes over eligible schemes with deficit, in the event of sponsor insolvency. We find that economic capital requirements for individual schemes are significantly high. However, we show that sharing risks through the Pension Protection Fund reduces the aggregate economic capital requirement of the entire sector