Insurance, Risk and Resource Allocation

Abstract

Despite the considerably important role that insurance plays in the economic system, neither economic theorists nor insurance theorists have devoted much attention to this relationship. By bringing together economic theory and insurance theory and practice, this analysis discusses the restrictions on insurability of risks, as well as explains the reasons behind the limited risk-bearing ability of the economic system. In a capitalist economic system, institutions have evolved, such as insurance and the stock market, that allow business owners to shift a portion of the risk of uncertainty. The idea behind all forms of risk shifting is that risks are shifted to the party best able to bear them though its wealth and its ability to pool risks. This analysis argues that markets for risk-shifting enable risky productive activities that industrialists would not undertake in the absence of insurance. The analysis then presents a theoretical outline of an ideal insurance system, in which one could insure freely against any economically relevant event, and then contrasts it with the existing risk-shifting institutions. In the latter, the ideal risk-shifting method is prevented from being realized in practice for reasons such as the limits of the insurance as to scope and amount, the resort of the insurance to direct controls over the insured and, most importantly, the ‘moral hazard' i.e. the potential of the insurance policy to reduce the incentives for risky enterprises. As an optimal solution to the unwanted consequences of either a complete absence of risk-shifting, or of total risk-shifting, the analysis proposes partial risk-shifting, or, coinsurance, where the insurer pays some stated proportion of the loss.