Insurance – public and private

I went to a fascinating talk on insurance risk from a former Florida insurance actuary recently. He was talking about the public policy issues involved in insuring people against natural catastrophes.

Basically, insurance fulfils three main functions in the economy:

• transferring risk from the risk averse
• providing capital in the event of risky events
• (and this one is often forgotten)  analysing risk and providing price signals for risky behaviour.

The government can, at least in theory, provide all of these functions, or a combination of private and public provision can occur. There are pros and cons to government involvement – a government can compel insurance (handy if you want to get people with low risk to pay for people with high risk), and can compel changes in behaviour (for example changing building codes to force buildings to be sturdier, or stopping people from building entirely in risky areas). However, it is very difficult for a government insurance provision to provide accurate price signals – if they are very accurate, they will probably be politically problematic. For example, in an Australian context, accurate pricing for flood insurance in some places (if available) would be very expensive; but a government could not possibly charge those high prices for flood insurance.

Different countries have taken different approaches to how the government should intervene in insurance markets. In New Zealand, earthquake insurance is provided by the government, but floods are covered by insurers. In Australia, insurers refuse to provide flood cover to anyone, as very few people who were at risk would pay the premium required to cover the risk. In the US, prices are very strictly regulated, which can lead to insurers getting out of a particular area entirely if they don’t believe prices cover the risks.

Often people in the insurance industry believe that private insurance is always a better way of managing risks. But there are examples around the world of government provision also working well.

From observation from Australia, the Accident Compensation Corporation in New Zealand seems to give better overall outcomes. Everyone in New Zealand is entitled to seek help from ACC if they are injured in an accident – it doesn’t matter how old you are, if you are in the work force or not, or if you are at fault. In return, there is no right in NZ to sue anyone for personal injury. In Australia, we have a combination of workers compensation, third party motor cover, medical indemnity insurance and the option to sue councils and other deep pockets if you have an accident of some kind.  So if you can find someone who a court will decide was at fault for your injury, you can be compensated. If not, then bad luck.

So you get the impression from reading court judgements that case law tends to be expanded in terms of who might be at fault from a personal accident so that someone can pay compensation to the person who has been terribly injured (for examples councils being at fault for not signposting shallow water at beaches).

One of the things that government can do that an insurance company can’t do is change the rules; an insurance company couldn’t change the laws so that you can’t sue for personal injury. But a government would find it hard to send price signals about risky behaviour; I doubt in the NZ government has premiums that reflect the risk of accident for teenage male drivers (the Australian system has rules that stop these price signals too). On balance, the NZ system seems to work well, with little money spent on lawyers fees to prove negligence, and the boundary issues limited to whether there was an accident or an illness.

But there are other insurance markets (such as insurance against theft of house contents) where the private system will work much better in providing insurance, sending price signals about managing risk and managing the claims process so that replacing your belongings doesn’t involve using up your life savings.

So it’s horses for courses; there are some markets where the combination of public interest and complete lack of data does make it sensible for the government to be the insurer. But it is important to think about the signals insurance sends to those who want to indulge in risky behaviour. Fine to take risks; providing you aren’t expecting other people who don’t take risks to pay for them.

Updated to add: This post has been included in the David Maister’s hosted Carnival of the Capitalists. Thanks for the link, David!