SOSIAL INSURANCE

Social Insurance: Reforming Contributory Social Security

Insurance offers the service of financial protection to its clients by reimbursing an individual for some or all of his financial losses that are linked to the occurrence of a risky event. The expression "risk" refers to the chance or likelihood that an event will cause damage or loss. In its simplest feature, insurance has two fundamental characteristics: risks are transferred from an individual to a group (RiskTransfer) and losses are shared on a predefined basis by all members of the group (Risk Sharing)⁵³.

Financial protection is accomplished through a pooling mechanism, which constitutes the basic underlying principle of insurance. The pooling mechanism comprises two elements:

1. People who face the same particular risk are joined together into a risk pool (Risk Pooling).

2. Each person pays a small amount of money (the premium or contribution) into the pool, which is then used to compensatethose individuals who do actually suffer a loss (Resource Pooling).

Insurance works by sharing the risk across a larger number of people. The larger the risk pool the more efficient risk pooling is.

Insurance reduces vulnerability by replacing the uncertain prospect of losses with the certainty of making small regular premium/contribution payments. Furthermore, it enables an individual to protect himself from financial losses that exceed his own income. Therefore, from a micro level perspective, insurance is more effective than savings or credit, because these instruments can only protect from losses, which do not go beyond the individual wealth.

People are exposed to a wide array of risks throughout their lives. With regard to social insurance, illness, old age, and unemployment are the most prominent risks. A risk can be classified according to the following three categories:

1. The type and degree of uncertainty caused by the risk

2. The relative size of the loss and

3. Whether the risk is idiosyncratic or covariate

The uncertainty may refer to the timing or the magnitude of the event. For example, health risks are particularly uncertain regarding timing: The severity of a certain illness might be known, but it might not be known if and when this illness might occur. The occurrence of a risk may lead to high or low costs. Health risks are very dissimilar in nature. They may vary from rather low costs (e.g. basic medicines) to very high costs (e.g. major surgeries). The distinction between idiosyncratic and covariate risks points at the number of people affected by the occurrence of a risk. It may affect an individual or many people at one time. In the first case, the risk is called "idiosyncratic", in the latter case it is called "covariate", which means that the risk is correlated between different people. For example, health risks can be idiosyncratic (e.g. illness) as well as covariate (e.g. epidemics).

Table 2 categorizes the three main risks of social insurance according to the above-mentioned categories.

In addition, the prospect of insurance or the state of being insured might alter individual behavior in different ways. These are the so-called "behavioral risks" associated with insurance, which impact negatively on the financial situation of an insurance provider. Adverse selection refers to the risk that only persons with a high-risk profile join an insurance program, whereas low-risk profile persons do not. Adverse selection induces high claim ratios, which can lead to a continued need for increasing premium/contribution levels. As a result, people with relatively low-risk profiles opt out of the insurance. If premiums/contributions levels are not increased, the financial condition of the insurance program deteriorates. In both cases, the insurance breaks down. Moral hazard on behalf of the clients occurs if the insurer is not able to monitor the behavior of the insured. Being insured introduces incentives for the insured to alter their behavior towards being less careful to avoid the risk (as they do expect financial compensation), which might not be easily detectible by the insurance provider. This is called ex ante moral hazard. In addition, if insurers cannot verify if a submitted claim did really occur, clients face an incentive to produce false claims. This problem is called ex posf moral hazard. Free rider behavior refers to the risk that people join an insurance program when in need and opt out after directly having received compensation. Another form of moral hazard might occur if a third party, i.e. besides the insurance and the insured, is involved and the insurance provider is not able to fully monitor or verify the actions of this party (third party moral hazard). This is the case with health insurance: it is not easy to verify if a certain treatment was necessary or appropriate. Thus, health providers face an incentive to exploit this fact and treat people more often or with higher cost care than is actually necessary.