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On January 1, 2006 a new mandatory basic health insurance will be introduced in the Netherlands. One aspect of the new scheme is that the insured can choose to have a deductible. This option should increase the individual responsibility and reduce moral hazard. In the new scheme, a risk equalization system is aimed at avoiding preferred risk selection and insolvency of insurance companies with a relatively high-risk pool. A crucial issue with respect to a voluntary deductible in this type of social health insurance is whether the premium rebate should be community rated or risk rated. The Dutch government has chosen the former, which means that the premium rebate will be independent of health status and risk. Our analysis shows that, in a situation with "accurate" risk equalization, a community-rated premium rebate could lead to an adverse selection spiral. Over time, this spiral results in none of the insured taking a deductible and thus no reduction in moral hazard. INTRODUCTION On January 1, 2006 a new mandatory basic health insurance will be introduced in the Netherlands for the whole population. One aspect of the new scheme is that the insured can choose to have a deductible. (1) One of the issues related to the practical implementation of a voluntary deductible is whether the premium rebate should be community rated or risk rated. The Dutch government has chosen the former, implying that the premium rebate will be independent of health status and risk. In this article we analyze the consequences of a community-rated premium rebate in combination with the risk equalization system that will be functioning in new basic health insurance. Risk equalization is aimed at avoiding subtle forms of preferred risk selection and upward premium spirals for insurers with a relatively high-risk pool. The need for risk equalization comes from the ban on premium differentiation and the obligation for insurers to accept every new applicant. As part of risk equalization, the insurers receive a compensation for the relatively high-risk individuals in their insurance pool and pay a contribution for the relatively low risks. On the one hand risk equalization among insurers can reduce incentives for cream skimming. On the other hand it could be problematic with regard to the introduction of a voluntary deductible. Without risk equalization, the premium rebate for a deductible does not only reflect cost sharing, a reduction in moral hazard, and a reduction in administration costs, but also the effect of adverse selection by insured. Adverse selection is the phenomenon that within each risk group of insured who pay the same premium for full coverage, the relatively healthy will opt for a deductible whereas the relatively unhealthy opt for full insurance. Adverse selection thus results in market segmentation, which allows the insurer to ask different premiums from the two groups of insured. Competition will force the insurers to ask costs-based premiums. This implies that they increase the premium for the (relatively unhealthy) insured choosing full coverage and decrease the premium (i.e., further increase the premium rebate) for the insured taking the deductible. So, without a risk equalization system the difference in expected expenditures between the two groups of insured, which results from their different health status, can be reflected in the premium rebate for the deductible. However, with an accurate risk equalization system the insurer receives a compensation for the unhealthy insured and has to pay a contribution for the healthy insured. So the difference in expected expenditures between the two groups, which is the result of their different health status, is then fully reflected in these compensations and contributions. This holds true both in the case without a voluntary deductible and in the case with a voluntary deductible. So the differences in health status between the two groups cannot be reflected in the premium rebate for a deductible. …

True Odds: How Risk Affects Your Life, by James Walsh, 1996, Santa Monica, Calif.: Merritt Publishing. Reviewer: James Kallman, St. John's University, New York. Like a good novel writer, Walsh immediately engages the reader. The possibility of birth defects in his anticipated child provide a personal and gripping example of risk analysis. From this anecdote, with which the reader can easily sympathize, Walsh presents 16 case studies of risk analysis. Through these familiar episodes, Walsh is able to demonstrate the important and interesting elements of statistics, risk, and decision making. The stated objective of the book is to "explain the basic concepts of risk and how they influence your everyday life." Walsh's case-study analyses effectively accomplish this goal. Fortunately for academics, each of the 16 case studies is appropriate for a classroom discussion. For example, Chapter 11, "The Moral Hazard of Buying Insurance," presents a familiar argument with a refreshing perspective. The first four case studies examine the methodology of data collection. Each case study demonstrates a statistical procedure used in risk analysis. As is true for the birth defect story, the reader will find them readily familiar. They include contemporary topics such as AIDS research ("Who's Most Likely To Contract AIDS") and crime research ("New York City Is Safer Than Tallahassee, Florida"). Because these case studies are relevant to most college students (and professors), they provide an excellent means to engage the reader in understanding the process of collecting risk data. Walsh suggests that people get more information about risky events from the media than they do from more credible sources. In addition, Walsh acknowledges the importance of revealing assumptions and particular definitions in modeling. Thus, the biases of researchers are exposed and the structuring of risk problems is critically examined. The next four cases expose the difficulties in analyzing data. Walsh demonstrates how perceptions and misperceptions of data create sensationalism. In Chapter 6, "The Shortest Distance Between Two Points," he reveals how the press exaggerates the risk of airline travel while simultaneously almost ignoring the risk of automobile travel. The serious risks (driving and heart disease) are often ignored while we obsess over more trivial risks (pesticides and breast implants). Walsh refers to this as "statistical homicide," where the risks that scare people overshadow the risks that kill people. …

The authors present a version of Spier's (1992) dynamic model of litigation and use it to derive predictions about the duration of legal claims against motor insurers. Those predictions are tested against a unique set of case data collected from an English motor insurer. The main predictions are supported, with one exception. The authors' results suggest that information plays a key role in such cases and indicate that insurers may be able to speed cases by taking steps to collect information at early stages in a case. They also suggest that different forms of plaintiff finance (including insurance) can affect case duration. Finally, the results suggest a role for signaling models of litigation.

If individuals decide whether to file an insurance claim based in part on the expected value of the benefits they will receive, then changes in the probability that a claim will be denied by the insurer will influence the probability that a claim is filed. Increasing claim-denial rates to reduce claim rates and cut costs would be a questionable strategy for an insurance company that marketed policies to the individuals who will file claims. But in the workers compensation insurance market, insurers sell policies to employers, while it is workers who file claims that may be denied. This article examines evidence from a period in the state of Oregon during which workers whose employers were covered by different workers compensation carriers faced different claim-denial rates at the same point in time, and during which the state's largest carrier changed its claim-denial rate dramatically over time. Using this evidence, the author finds that higher denial rates were associated with lower rates of claim filing. F urthermore, this relationship was strong and significant for claims arising from back injuries but insignificant for claims arising from traumatic injuries. Possible reasons for this latter finding are explored. INTRODUCTION Insurance carriers do not accept all the claims made by those they insure. Some claims are denied, whether because the insurer believes that the insured party misunderstood the terms of the coverage, or because the insurer suspects exaggeration of losses or some other intentional fraud on the part of the insured. Standard economic reasoning suggests that in deciding whether to file a claim, the insured individual takes into account this possibility of denial, along with any costs in terms of time and trouble imposed on him or her by the screening process through which the insurer makes the denial decision. Thus, an increase in the probability that all or part of a claim will be denied, or in the delays and requirements imposed on the claimant while that decision is reached, lowers the number of claims filed, Of course, an insurance company competing in a private market would likely be wary of a strategy designed to reduce the number of claims filed by increasing denial rates and/or the rigorousness of claims- screening procedures, as such behavior would potentially lead to a loss of customers to other carriers. Designers and administrators of social insurance programs such as Unemployment Insurance or Social Security Disability Insurance are in a different position, as they do not need to solicit customers for their insurance in a competitive marketplace. When faced with rising costs or concerns with moral hazard on the part of potential recipients, they can raise denial rates by tightening eligibility requirements or enforcing eligibility requirements more stringently, subject only to political pressures from potential recipients and those who represent them. Such increases lower program costs directly by lowering the number of filed claims that are paid. But, as Parsons (1991) has pointed out, an increase in claim-denial rates also acts as a self-screening mechanism, discouraging some potential recipients from even attempting to file a claim. Parsons offers empirical evidence of the claim discouraging effect of rising denial rates in the Social Security Disability Insurance program, as do Helpern and Hausman (1986 ) and Gruber and Kubik (1997). Likewise, Blank and Card (1991) show that the proportion of eligible unemployed workers filing for Unemployment Insurance benefits is lower, other things equal, in states that disqualify a greater percentage of those who actually do file claims. This study looks at another social insurance program, workers compensation insurance, for evidence that claiming is discouraged by higher claim-denial rates. The author examines data on workers compensation claims from the state of Oregon, covering a period during which, because of changes in state law and policy changes by the state's largest workers compensation insurer, there was considerable variation in claim-denial rates experienced by claimants over time, and by different groups of claimants at the same point in time. …

This article analyzes farmers' choices of crop insurance contracts and offers empirical evidence of adverse selection in crop insurance markets. Farmers' risk characteristics, their level of income, and the cost of insurance significantly affect the choice of yield and revenue insurance products as well as the selection of alternative coverage levels. Empirical analysis indicates that high-risk farmers are more likely to select revenue insurance contracts and higher coverage levels. Results show that low-risk farmers are overcharged and high-risk farmers are undercharged for comparable insurance contracts, implying informational asymmetries in the crop insurance market.

Option models can provide not only the value of an insurance policy, but also more disaggregated information concerning those precise circumstances under which defaults occur and, hence, insurance payouts must be made. The value of the insurance policy serves as a summary statistic describing insurance payouts. However, given the rather highly irregular and skewed character of the entire distribution of insurance payouts, this single value will be a poor estimate of the typical payout. Thus it should be of considerable interest to mortgage insurance issuers to know not only the expected cost of insurance, but also the entire distribution of potential payouts as exhibited in this study. Insurers have not traditionally differentiated prices among different homeowners' mortgage insurance policies as much as rational pricing or even common sense would seem to demand. The option model pricing techniques presented in this study provide the means of assessing differential mortgage insurance values.

Given the increasing consolidation in the insurance industry, the authors' objective is to determine how the market revalues the acquirer, target, and rival insurance companies in response to merger announcements. The authors find that target and acquirer insurance companies experience favorable valuation effects at merger announcements. The authors also find positive and significant intra-industry effects in response to the announcements of insurance company mergers, which supports the signaling hypothesis. Furthermore, the authors find that the magnitude of the intra-industry effects is conditioned on the type, size, and location of the insurance companies. INTRODUCTION In recent years, the insurance industry has experienced substantial consolidation as mergers have been consummated to increase shareholder value. (1) The merger between two insurance companies may be value-enhancing for the following reasons. First, the merger may achieve economies of scale, as the combined company provides services at a lower average cost. The underlying factors that allow economies of scale include the application of technology to a larger customer base, a more efficient distribution system, and more efficient funding that reduces financing transaction costs. Second, the merging of two insurance companies may reduce redundant operations or branches, which would allow the remaining resources to work more efficiently. Third, the combination of two insurance companies that emphasize different services may allow for each entity to benefit from the expertise of the other entity. Fourth, to the extent that unsystematic risk is valued (see Harrington, 1983; Williams, 1983; and Venezian, 1984), the combination of two insurance companies may reduce the risk (see Cox and Griepentrog, 1988). Fifth, a merger may serve as a better alternative than potential insolvency for insurance companies that are experiencing financial problems (see BarNiv and Hathorn, 1997). Although there are valid value-enhancing motives for insurance company mergers, the ultimate test of the validity of mergers from a shareholder perspective is based on how shareholder wealth is affected. Many studies have measured the valuation effects of mergers. These studies have generally focused on industrial firms or commercial banks. Although virtually all related studies have found that the target firms experience positive significant valuation effects, the results for the acquiring firms are mixed. The authors' objective is to assess the valuation effects that result from large mergers between insurance companies. More specifically, the authors (1) measure the valuation effects of acquiring and target insurance companies whose stock was publicly traded, (2) measure the valuation effects of rival insurance companies (intra-industry effects) in response to announcements of mergers between insurance companies, and (3) attempt to explain the cross-sectional variation in intra-industry effects among rival insurance companies. The authors find positive and significant valuation effects for publicly traded acquirer and target insurance companies. Second, the authors find positive and significant intra-industry effects in response to the announcements of insurance company mergers, which supports the signaling hypothesis. Third, the authors find that the magnitude of the intra-industry effects is conditioned on the type of insurance company target. The authors also find that the intra-industry effects of insurance company mergers are more pronounced for insurance companies that have a similar size and are located in the same region as the target insurance company. The remainder of this article is organized as follows: the second section develops the hypotheses for intra-industry effects, the third section outlines the data and methodology, the fourth section presents the empirical results, and the final section provides conclusions and implications. …

The theory of optimal insurance with noninsurable background risk has previously been examined under the assumption that the background risk and insurable loss random variables are additively separable within the agent's utility function. In this study, these two variables are nonseparable because marginal insurable loss is positively dependent on the outcome of the background risk variable. This positive dependence implies that background risk has a smaller marginal impact on profits at higher levels of insurable loss. The optimal contract is shown to require coinsurance above a deductible minimum when the agent is prudent. This result is opposite Gollier's (1996) finding that a "disappearing deductible" is optimal when a higher level of insurable loss implies a more risky distribution of the background risk variable. With relatively weak restrictions on the various functions, the optimal indemnity schedule is a convex function of loss and the slope of this function is inversely related to certainty income.

The authors apply results on complementarities to theories of insurance companies' choices of ownership structure and executive compensation. They identify minimal restrictions on the interaction between firm policies and exogenous characteristics for theories to have testable implications for reduced-form regression coefficients. Obtaining testable implications for structural-equation regression coefficients requires additional identifying restrictions. The authors' analysis highlights a basic tradeoff between theory and statistical methods.

This article examines the implications of the positive correlation of mortality and disability for the benefits of combining an immediate income annuity with long-term care disability coverage at retirement ages. It also investigates the value of such a combined benefit to various subgroups of prospective purchasers and the implications of possible errors and moral hazard in the reporting of disability status and making claims. (The Journal of Risk and Insurance, 2001, Vol. 68, No. 2, 225-254)

The authors analyze a tax arbitrage opportunity that results from engaging in two seemingly counterintuitive transactions in the Canadian insurance market. Specifically, if an individual acquires a fixed immediate life annuity and then uses the periodic annuity income to fund a term-to-life insurance policy, these two transactions, which the authors refer to as a “mortality swap,” will generate a payoff pattern that is risk-free. In other words, a mortality swap replicates a risk-free security, albeit one with a stochastic liquidation date. The authors show theoretically that the rate of return on a mortality swap is equal to the risk-free rate on a before-tax basis, but exceeds it on an after-tax basis. This is confirmed by the results of the empirical test, which uses observed annuity and insurance quotes that already reflected adverse-selection and transaction costs. The authors also observe that the older an individual is and/or the higher his/her marginal tax rate is, the more he/she stands to gain from this tax arbitrage. This advantageous investment opportunity exists because of the arguably lenient method that Canadian authorities use to tax annuity income. The authors provide two major reasons that this method leads to an arbitrage opportunity. The authors then compare this method to that under the U.S. tax rules and show that the U.S. method renders tax arbitrage very unlikely. The demand for life insurance and annuities is usually attributed to risk aversion, consumption smoothing, and the desire for household protection. The authors’ findings provide an arbitrage-based reason for their demand. As a natural by-product, the authors’ research contains policy implications for the optimal taxation of annuities and insurance policies. Narat Charupat is assistant professor of finance at the DeGroote School of Business, McMaster University. Moshe Arye Milevsky is associate professor of finance at the Schulich School of Business, York University, and the Director of the Individual Finance and Insurance Decisions (IFID) Centre in Toronto, Canada. Financial support from the Life Underwriters Association of Canada (Charupat), the York University Research Authority, and the SSHRC (Milevsky) is gratefully acknowledged. The authors would like to thank Glenn Daily, Clarence Kwan, and the two anonymous referees for their helpful suggestions, as well as Lowell Aronoff (CANNEX), John Hitchcock (SunLife), Jon Archer (RBC), and Zale Newman (PanFinancial) for providing data on insurance and annuity quotes. Any errors are the authors’ responsibility.

One of the key problems facing annuity providers is mortality risk, the risk of underestimating mortality improvements. The authors argue that the government could help the issuers of annuities to hedge aggregate mortality risk by introducing a new type of bond, which the authors call a survivor bond. The future coupons on this bond depend on the percentage of the population of retirement age on the issue date who are still alive on the future coupon payment dates. The coupons on the bond therefore decline over time but continue in payment until the last members of this population cohort have died. The government would therefore be assuming a risk that has hitherto been borne by the private sector. However, governments now issue inflation-indexed bonds, and the authors would argue that inflation risk is a much greater risk than mortality risk in aggregate. Furthermore, governments directly contribute to mortality risk: for example, they promote public health campaigns that, if successful, lead to mortality improvements that are difficult to predict many years ahead. Survivor bonds enable pension provision to be a shared responsibility between the public and private sectors.

Experience rating is largely absent from medical malpractice insurance contracts. This article presents evidence that physician risk differences persist, and it develops an empirical model for experience rating with a semi-parametric estimator. Estimating the model using claims history data from Florida, the authors obtain improved prediction of individual claims over several years and provide a detailed picture of the incidence of surcharges under experience rating. This evidence suggests that an experience rating system would be feasible and would greatly reduce the subsidization across physician risk types that exists under most current medical malpractice insurance contracts.

Previous studies of life insurance demand mainly employ multivariate regression analysis to examine the social, economic and demographic effects on life insurance purchases. However, this causal modeling approach can not separate the age, period, and cohort effects completely. This study employs cohort analysis method as well as age standardization and decomposition to examine the life insurance purchase pattern in the U.S. from 1940 through 1996. It finds that, without the aging process, the purchase rate in 1990 and 1995 would have been even lower. It also finds that the baby boomers tend to purchase less life insurance than their earlier counterparts and that this phenomenon consequently led to the decline of recent life insurance purchases in the U.S. Men show a strong age effect and strong negative cohort effects while women have strong positive cohort effects.

The authors examine risk pooling arrangements with moral hazard. Because of the nature of the risk pooling arrangement, full nominal coverage is shown to be optimal, despite the presence of moral hazard, and positive loss-prevention effort levels are induced even at full nominal coverage. When marginal utility is convex and higher-order utility effects are sufficiently small, as the number of members in the pool increases, the effort levels of members decrease and, as the pool size approaches infinity, effort levels approach zero. The latter result suggests that moral hazard may define an optimal size for risk pooling arrangements.

The authors use risk-neutral option pricing theory to value the guaranteed minimum death benefit (GMDB) in variable annuities (VAs) and some recently introduced mutual funds. A variety of death benefits, such as return-of-premium, rising floors, and "ratches," are analyzed. Specifically, the authors compute the fair insurance risk fee, charged to assets, that funds the embedded option. The authors derive analytic option prices for a simplified exponential mortality model and robust numerical estimates in the case of a properly calibrated Gompertz model. The authors label this contingent claim a Titanic option because its payoff structure is in between European and American style but is triggered by death. The authors' main objective is to compare theoretical estimates against a cross-section of insurance risk charges, as reported by Morningstar, Inc. The authors' main conclusion is that a simple return-of-premium death benefit is worth between one and ten basis points, depending on gender, purchase age, and asset volatility. In contrast, the median Mortality and Expense risk charge for return-of-premium variable annuities is 115 basis points. Presumably, the remaining markup can be attributed to profits, model imperfections, or, more cynically, to an implicit payment for the tax-deferral privilege. INTRODUCTION In the United States, a variable annuity (VA) policy is a collection of investment subaccounts that are wrapped with a life insurance contract. The raison d'etre of the VA is the convenient deferral of all income and capital gains taxation until the funds are withdrawn or annuitized at retirement. The tax deferral on investment gains--of increasing long-term benefit--make VAs a popular alternative to fully taxable mutual funds, even though they involve higher management fees. In fact, despite the recent reduction in the long-term capital gains tax rate, sales of variable annuities amounted to $121 billion during 1999 and $100 billion during 1998. Interestingly, an estimated 55 percent of these variable annuity purchases were conducted within qualified, i.e., tax-sheltered, IRAs, 401(k)s, 403(b)s, and 457 retirement savings plans for which the tax deferral is redundant. [1] However, in addition to the tax deferral--and in contrast to most mutual funds--the variable annuity provides a unique death benefit, possibly justifying its sale within tax-sheltered plans. The variable annuity death benefit stipulates that at least the original investment will be returned to the estate or beneficiary of the policy, regardless of the performance of the underlying assets in the account. This guaranty will be in-the-money if the VA policyholder (annuitant) dies during a "bear" market and at the same time the investment is showing a paper loss. Recently, some innovative mutual funds have joined with insurance companies to offer a similar death benefit on their investments. Presumably, this innovation has been partially driven by an attempt to compete with the VA market and its implicit investment protection. Of course, the tax deferral can only be provided by VAs. The coincidence of death and market downturn, as unlikely as it may seem, is the impetus for this study. Specifically, the authors are interested in the economic value and fair cost of this death benefit. Before embarking on this endeavor, it is important to mention that not all VA contracts and death-protected mutual funds (DPMF) are created equal. Many innovative insurance companies sell VA products with death benefits that are more "generous" than others. By generous the authors mean that the guaranteed minimum death benefit is higher than a simple return of premium plus minimal interest. For example, some products guarantee a more lucrative death benefit that locks in accrued investment gains during the life of the contract. As such, the VA and death-protected mutual fund market is not homogenous, and one must be careful with any generalizations about these products. …

This article presents a valuation theory of futures contracts and derivatives on such contracts when the underlying delivery value follows a stochastic process containing jumps of random claim sizes at random time points of catastrophe occurrence. Applications of the theory are made on insurance futures and options, new instruments for risk management launched by the Chicago Board of Trade. Several closed pricing formulas are derived based on a partial, competitive equilibrium assumption both for futures contracts and for futures derivatives, such as caps, call options, and spreads, assuming constant relative risk aversion for the representative agent.

This article uses life insurance data to estimate the Pratt-Arrow coefficient of relative risk aversion for each of nearly 2,400 households. Attitudinal differences toward pure risk are then examined across demographic subgroups. Additionally, differences in speculative risk-taking are examined across demographic groups based on survey responses and compared with the results on pure risk aversion. INTRODUCTION In the mid-1960s, John Pratt and Kenneth Arrow introduced the now-familiar measure of relative risk aversion, along with the hypothesis that relative risk aversion increases with wealth. Since that time, numerous researchers have attempted to estimate the magnitude of relative risk aversion for subsets of the population using a variety of techniques, and others have conducted empirical tests of the increasing relative risk aversion (IRRA) hypothesis. Most recently, attention has turned to comparing risk aversion across different demographic subgroups, particularly men and women. [1] Remarkably, these efforts have been largely independent of one another. Some of those seeking to estimate risk aversion parameters, for example, assumed a utility function exhibiting constant relative risk aversion (CRRA), effectively precluding tests of the IRRA hypothesis. On the other hand, most studies examining the relationship between risk aversion and demographic or wealth variables infer differences in risk aversion parame ters rather than calculating the parameters explicitly. Many use either hypothetical questions or experimental gambling data, and most restrict attention to forms of risk in which both gains and losses are possible. In the present study, the authors integrate and extend these three strands of research. First, the authors derive a reduced form equation for the Pratt-Arrow measure of relative risk aversion without imposing prior assumptions on the shape of the utility function. The authors then estimate the risk aversion parameter empirically for individual households using survey data on life insurance purchases. This gives us more than 2,300 numerical measurements of the Pratt-Arrow coefficient. These measurements are then used to examine differences in relative risk aversion across demographic groups based on age, gender, education, nationality, race, marital and parental status, religion, health and behavioral indicators, and employment status, income, and wealth. The availability of wealth data also allows us to test the IRRA hypothesis. Finally, the authors examine attitudes toward a second type of risk, by studying survey responses to a hypothetical question regarding employment and income risk. The first section briefly reviews the prior research. The second and third sections present the authors' theoretical model and empirical results, respectively, pertaining to relative risk aversion in the context of mortality risk. The fourth section discusses results pertaining to speculative risk, and the article ends with a brief conclusion. PREVIOUS RESEARCH For a concave utility function U defined over wealth of W, Pratt (1964) and Arrow (1965) suggested the elasticity of marginal utility with respect to wealth, or R(W) = -WU"(W)/U'(w), as an appropriate measure of relative risk aversion. Arrow showed that this measure is directly related to one's insistence on favorable odds when putting some fraction of wealth at risk, and Pratt demonstrated that R(W) is proportional to the insurance premium one is willing to pay to avoid a given risk. Both Pratt and Arrow hypothesized that R(W) increases with W; the hypothesis implies that at higher levels of wealth, individuals become less willing to subject a given percentage of wealth to risk. Subsequent empirical research has addressed three central questions: the magnitude of R(W), the IRRA hypothesis, and the relationship between risk aversion and demographic variables. Among the earliest empirical estimates were those by Friend and Blume (1975), who studied the demand for risky assets and concluded that R(W) generally exceeds unity and is probably greater than 2. …

Defining propensity to self-protect as the maximum amount an individual is willing to pay for a one-unit reduction in the probability of loss, this article studies its basic behavior and its relationship to the individual's degree of risk aversion and the initial loss probability. It is shown that if the initial loss probability is below a threshold, a more risk-averse individual has a higher propensity to self-protect, and the threshold is controlled by individuals' aversion to general downside risk increases and aversion to overall riskiness measured in variance. INTRODUCTION Self-protection is defined as the expenditure on reducing the probability of suffering a loss. Despite its relevance to a wide range of economic issues, [1] self-protection--especially its relationship with an individual's attitude towards risk--has not been adequately understood. In their pioneering work, Ehrlich and Becker (1972) noted that self-protection may be attractive to both risk-averse people and risk lovers and that unlike self-insurance (the expenditure on reducing the severity of loss), self-protection and market insurance can be complements. More recently, Dionne and Eeckhoudt (1985) showed that a more risk-averse individual does not always purchase more self-protection. And Briys and Schlesinger (1990) explained this phenomenon by showing that self-protection in general does not reduce the riskiness of individuals' final wealth. Sweeney and Beard (1992a) went one step further in showing that for a general loss probability function of self-protection spending, it is impossible to characterize th e preferences of an individual who always chooses a higher level of self-protection. In their attempt to verify an interesting intuition that insurance is reducing small chances of bad outcomes and gambling is increasing small chances of good outcomes, McGuire, Pratt, and Zeckhauser (1991) came closest to identifying a relationship between an individual's degree of risk aversion and his or her choice of self-protection. They show that if a less risk-averse individual's optimal choice of self-protection is such that the resulting loss probability is less than a critical "switching" level, then a more risk-averse individual's optimal choice will be higher than the less risk-averse. [2] From these previous contributions, it is clear that the relationship of an individual's attitude towards risk with his or her propensity to purchase self-protection is not as straightforward as that with market insurance or self-insurance. What they do not imply, however, is that a more primitive and more precise characterization of the relationship between risk aversion and individuals' propensity to purchase self-protection is impossible insofar as one accepts the Expected Utility paradigm. Staying within the Expected Utility framework, one can look at the problem from a slightly different angle. Specifically, instead of investigating the optimal choice of self-protection given an assumed relationship between self-protection spending and the loss probability, one can explicitly consider an individual's willingness (or propensity) to purchase self-protection-the maximum an individual is willing to pay for a given reduction in the probability of loss. [3] So far only scant effort has been made in understanding the problem from this perspective. Under various restrictions, Eeckhoudt, Godfroid, and Gollier (1997) compared the effects of risk-aversion on the risk premium [defined in Pratt (1964)] and on the willingness to pay and conclude that some properties of the risk premium are not shared by the willingness to pay. Eeckhoudt and Godfroid (1998) showed in a quite different context with exponential utility functions that the lower the initial probability of accident, the greater the market value o f a reduction in the probability. The aim of this article is to provide a comprehensive study of individuals' propensities to purchase self-protection. …

In their seminal work, Rothschild and Stiglitz (1976) have shown that in competitive insurance markets, under asymmetric information, pooling contracts cannot exist in equilibrium, firms make zero profit, and, under some circumstances, equilibrium does not exist. In the present work, the model is extended by introducing unobservable wealth in addition to the differing risks. The study shows that if the differences in wealth are small, different wealth types are pooled while different risks are separated. For large wealth differences, partial risk pooling contracts, in which one type chooses different contracts in equilibrium, are feasible. Furthermore, equilibria with profit-making contracts can exist. Complete risk pooling contracts can occur only under very restrictive assumptions. The effect of the extra dimension of asymmetric information on the nonexistence problem is ambiguous. INTRODUCTION Since the seminal work by Rothschild and Stiglitz (1976), it has become clear that competitive insurance markets under asymmetric information display features not known from the conventional competitive analysis. Contracts specify both quantity and price, and it may happen that equilibrium does not exist. The nonexistence problem has led to a lengthy debate in the literature. Solutions proposed are other equilibrium concepts (Wilson, 1977; Miyazaki, 1977; Spence, 1978), extensions to multi-stage games (Grossman, 1979; Hellwig, 1987; Asheim and Nilssen, 1996), or the introduction of mixed strategies (Dasgupta and Maskin, 1986). Although the equilibrium nonexistence problem has been the main focus of research, some other results by Rothschild and Stiglitz deserve attention. First, they showed that in a competitive environment, pooling contracts cannot exist in equilibrium, and second (maybe less surprisingly), they demonstrated that firms make zero profits. In other equilibrium concepts, the existence of pooling contracts is possible; however, the no-profit result always holds. As was already argued by Spence (1978, p. 427), "not only may individuals differ in the expected cost they impose upon the insurer, they may also differ in their preferences with respect to insurance coverage." Following up on this remark, the author considers individuals who differ in risk aversion in addition to their risks. There are two dimensions of asymmetric information--the insurer observes neither the risk nor the degree of risk aversion of the individual. The author models the different degrees of risk aversion by assuming that individuals have decreasing absolute risk aversion and different wealth levels. Other studies on multidimensional adverse selection problems in the context of insurance markets include the ones by Fluet and Pannequin (1997) and Landsberger and Meilijson (1996). The first authors model two types of individuals with multiple risks. Their main result is that bundling insurance contracts can be efficiency enhancing. Landsberger and Meilijson analyze the case in which two types of individuals differ with respect to their distribution of losses. However, they are mainly concerned with the derivation of assumptions under which a first-best result can be achieved or approximated. In contrast to these studies, this article assumes that there are four different types of individuals: those with high or low risks with either high or low wealth. To the author's knowledge, this is the first study that analyzes the insurance market with four unobservable types. It derives the following new results. First, in the standard case, where the single crossing property holds in the relevant region of the contract space, different wealth types are pooled, while different risk types are separated. This pooling is the same as in the first-best situation, in which different risks obtain full insurance at their fair premium, which is independent of the wealth. …

To immunize an insurance company's surplus against interest-rate fluctuations, asset-liability managers commonly adopt the so-called classical immunization strategy to set the duration of the surplus equal to zero. Unfortunately, this strategy is derived on the basis of the flat-term structure. This article examines the immunization strategy with a stochastic process, which can generate a mean-reverting term structure. By means of the stochastic process, the authors provide a measurement for evaluating the assets and liabilities of the insurance company. The authors also show that the immunization strategy suggested in the article is a general model and includes the classical immunization strategy as a special case. Furthermore, if a firm's objective is to maximize its convexity of the surplus subject to zero surplus duration and its budget constraint, the authors demonstrate that linear programming can implement the optimal immunization strategy in this case. Moreover, the results of this simulation show that the cost of failing to recognize stochastic interest-rate changes can be extremely high.

This study introduces a flexible nonlinear semiparametric spline model, new to solvency studies, as a tool for managerial discretion and regulatory oversight. The model has a linear component and a nonlinear component that uses stochastic splines. The study focuses on the functional relationship between regressors and the probability of financial distress as an object for managerial action. Leverage plots are provided to analyze the potential effect of decisions to modify firm levels of financial variables. If the true relationship between regressors and the response is not linear, then managerial efforts to rectify deteriorating financial conditions can be misinformed by reliance on a linear solvency model. The leverage plots adjust to the firm's position within the industry and its specific levels of various financial variables. A five-regressor semiparametric spline model is shown to yield insights into the behavior of the risk of financial distress probabilities that linear parametric models suppress. The model also classifies and validates well in comparison with recent insolvency studies and as well as parametric logit and probit models on the same data.

Physicians handling workers compensation cases serve in a dual capacity not required of physicians treating non-workers compensation cases. Not only are they are asked to treat the workers' injuries and disability symptoms, but they are also frequently asked to evaluate the extent of economic damage done to a worker via the assignment of an impairment rating to certain types of injuries. Although physicians are trained to treat traumatic injuries as well as the symptoms of cumulative trauma processes, they generally receive no training in disability evaluation. The authors examine physicians' ability to carry out their latter, "lost earnings capacity" assessment, role. Their multivariate regressions indicate that physicians' impairment ratings are poor guides to subsequent wage loss; impairment ratings explain no more than one-half of 1 percent of subsequent wage loss.

Two competing approaches to setting risk-based capital (RBC) parameters are the traditional probability of ruin approach and the more recent expected policyholder deficit (EPD) ratio approach. The probability of ruin approach develops capital standards based on a fixed maximum probability of insolvency regardless of risk. The EPD ratio approach allows tradeoffs between the risk of insolvency and the average cost of insolvency so as to force the product of these two numbers, the EPD, to some fixed value. After an explanation of the underlying mathematics, the author develops risk-based capital parameters for private passenger auto liability reserve risk using both methods. The author shows that capital standards developed using the EPD approach increase the risk of insolvency for larger insurers that pose the greatest potential indirect costs to the insurance market through market disruptions in the wake of a major insolvency. These findings have important public policy implications because the EPD approach cu rrently forms the basis for both the Standard & Poor's capital adequacy model and the A.M. Best Company's Best's Capital Adequacy Ratio (BCAR), and it is also used by the American Academy of Actuaries' Risk-Based Capital Task Force as a basis for recommendations to the National Association of Insurance Commissioners (NAIC) on parameters in the regulatory RBC model. INTRODUCTION In response to concerns about the minimum capital standards applicable to insurance companies, the National Association of Insurance Commissioners (NAIC) adopted a regulatory risk-based capital (RBC) formula for property-liability insurers in 1994. The NAIC regulatory RBC formula computes a minimum capital requirement based on each insurer's risk profile. Most insurers, though, actually have much more than the minimum capital required by the NAIC formula. Many considerations affect the actual level of capital, including franchise value, taxes, reinsurance arrangements, and the level of risk aversion within the company. Insurers use internal RBC models to help develop optimal capital levels, and those optimal levels are almost always higher than the minimum standards under the NAIC RBC formula. In addition, private rating agencies such as A.M. Best and Standard & Poor's use their own internally developed RBC formulas to evaluate each insurer's capitalization as part of the quality rating process. Therefore, th e process of selecting appropriate RBC parameters, whether as part of a regulatory formula, a rating agency formula, or an internal management formula, affects virtually every insurer. Two of the competing approaches to assigning appropriate RBC parameters to the various risk elements in these RBC formulas are the traditional probability of ruin approach and the more recent expected policyholder deficit (EPD) approach (Bustic, 1994). This study will compare and contrast these two approaches. In recent years, the EPD methodology has been adopted as the basis for risk parameters in the capital adequacy models both A.M. Best and Standard & Poor's use. The American Academy of Actuaries' Risk-Based Capital Task Force has also used the EPD approach as the basis for recommendations on risk parameters in the NAIC's regulatory RBC formula (NAIC, 1993). Additionally, internal RBC models used by individual insurance companies may employ either of these approaches or yet another alternative approach. A firm grasp of the underlying mathematics of these approaches is necessary to evaluate the suitability of each approach in developing appropriate capital standards. This article is organized into four sections. The first section gives general background and descriptions of both the probability of ruin and the EPD approaches to setting capital standards. The second section compares the computation of risk parameters using different assumptions about the underlying risk of a particular insurer. …

This book considers the effectiveness of insurance coverage for low-probability, high-consequence events such as natural disasters--and how insurance programs can successfully be used with other policy tools, such as building codes and standards, to encourage effective loss reduction measures. The authors discuss the reasons for the dramatic increase in insured losses from natural disasters since 1989 and the concern that insurers have about their ability to provide coverage against more such events in the future. It addresses why there has been an increasing demand for hazards insurance, what types of coverage private insurers are willing to offer, and the role of reinsurance and private-/public-sector initiatives at the state and federal levels for providing protection to victims of natural disasters. Detailed case studies of the challenges facing Florida in the wake of Hurricane Andrew in 1992 and California following the Northridge earthquake in 1994 reveal the challenges facing the insurance industry as well as other concerned stakeholders. The National Flood Insurance Program illustrates how a public-/private-sector partnership can mitigate damages and provide financial protection to victims. The book identifies new initiatives for reducing future losses and providing funds for recovery through cooperation by the relevant parties.

This article develops an equilibrium pricing model examining the nature of health insurance contracts by considering the relationship between information about risk types and equilibrium prices. Both community-rated (pooling) and risk-rated (separating) premia may co-exist under certain conditions, given that the insurer can observe the real risk type of the insured by spending some fixed amount on information. The higher the costs of determining risk class, the more heterogeneous will be the risk types offered insurance at the same (or pooling) premium. Also, the higher the mean and variance of the risk type distribution for the population, the more relatively healthy insureds would prefer risk-rated contracts to community-rated contracts. INTRODUCTION The issue of equilibrium pricing under adverse selection has received much attention. Most studies show different equilibria of either community-rated (pooling) contracts or risk-rated (separating) contracts based on sorting of risk types (Akerlof, 1970; Rothschild and Stiglitz, 1976; Wilson, 1977; Miyazaki, 1977). An equilibrium pricing policy taking the form of community-rated contracting means that each member of the community pays the same premium independently of whether the individual is perceived to be a high health risk or a low health risk. Risk-rated contracts establish a premium appropriate for each insured's expected medical costs. In American voluntary health insurance markets, premium setting is risk-rated for individuals and groups on the basis of indicators such as age, sex, occupation, and previous health condition. [1] Also, the risk-rated structure differs in terms of individual, small group, and large group plans (Light, 1992; Gauthier et al., 1995). Unlike with large groups organized for purposes other than health insurance, there is no reason to pool individual plans except for purposes of health insurance. Providers of individual plans try to avoid adverse selection by taking steps to screen potential insureds--e.g., examining medical records, excluding pre-existing conditions from coverage, and limiting the provider's maximum exposure. In the limit, risk-rated contracts establish a premium for each insured appropriate to that insured's expected medical costs during the life of the contract. Thus, in the individual market the insurer would tend to charge very expensive plans for those few disadvantaged by poor health. [2] This result might explain the fact that risk-rated policies tend to result in a growing number of uncovered medical conditions and uninsured doctor and hospital bills. Like individual plans, small group plans make it more difficult to diffuse risks than do large plans. When a group gets larger, the average expected medical cost would be less likely to vary. According to Aaron and Bosworth, insurance premium for groups of fewer than 10 employees commonly are 25 to 30 percent above those for groups of 50 or more. Also, around 73 percent of small firms with fewer than 10 employees did not offer health insurance in 1990. In contrast, only 2 percent of large firms with more than 100 employees did not provide health insurance (Aaron and Bosworth, 1994). This article develops an equilibrium pricing model examining the nature of health insurance contracts by considering the relationship between information about risk type and price equilibrium, given different assumptions about individual health states, risk types, and adverse selection. The author shows that either a pooling or a mixed equilibrium is possible, based on the assumption of equilibrium concept suggested by Wilson (1977). [3] The assumption of asymmetric information at the time of contracting means that information costs are critical to determining the type of equilibrium policy because it is costly to collect detailed information on the riskiness of individual customers. [4] Between a community-rated policy without verification costs and a risk-rated policy with verification costs, insureds will choose the policy with the smaller premium. …

This article presents a model of the important health-policy dilemmas of risk selection and moral hazard. When providers can increase revenues by selecting favorable risks, capitation or purely prospective payment is unlikely to be optimal. A second best payment system may involve mixed levels of both demand- and supply-side cost sharing: consumers may prefer to pay deductibles and co-payments rather than to have their healthcare providers receive large financial rewards for skimping on care or discriminating against expensive-to-treat patients. Risk adjustment can improve the terms of the social trade-off between inefficient utilization and inequitable coverage. The role of professional ethics is also considered. INTRODUCTION It has been recognized for a long time that how we pay healthcare providers and how we insure consumers against the risks of medical expenditures--that is, how we design health insurance-provider payment systems--can have significant consequences for the equity and efficiency of a healthcare system. Health insurance creates a problem of moral hazard: fully insured consumers tend to overuse services that appear to be "free" or are heavily subsidized. Demand-side cost sharing (e.g., deductibles and co-insurance), often used to discourage this over-utilization, compromise the purpose of insurance by making the consumer pay unpredictable, nontrivial co-payments. Alternatively, providers can be given financial incentives to restrict care. Since providers have considerable influence over treatment decisions, supply-side cost sharing can be a powerful instrument for controlling healthcare costs. Along with the good incentives to curb wasteful over-utilization, however, are bundled perverse incentives to deny benefic ial but costly services and to shun the sickest patients (risk selection). Part of the recent backlash against managed care in the United States stems from consumer discontent with such potentially quality-damaging cost-control measures. [1] This article develops a simple model to illustrate the incentive trade-offs associated with the dual "market failures" of moral hazard and risk selection. Previous theoretical results on optimal payment systems emerge as the special case of our model when there is no consumer heterogeneity. The model suggests that when providers can increase revenues by selecting favorable risks, demand- and supply-side cost sharing [2] can no longer in general achieve the social optimum. The "second best" optimal payment system may involve mixed levels of both demand- and supply-side cost sharing. Purely prospective or capitation payment is unlikely to be optimal. The results underscore the fact that policymakers seeking cost containment, patient choice, and universal access must attend to selection incentives when designing or reforming healthcare systems. The article is organized as follows. The first section gives an overview of the policy significance of risk selection. The next section presents the model. Then, the article focuses on how the presence of risk selection alters previously derived results on optimal payment systems. A simple extension to risk adjustment of provider payments is presented in the fourth section. The following section puts the model in the context of previous theoretical work. The conclusion discusses limitations and other potential extensions. THE POLICY IMPORTANCE OF RISK SELECTION A healthcare provider-insurer or health plan has a financial interest in trying to enroll consumers at low risk for treatment and to discourage high-risk consumers from enrolling. Such behavior is called risk selection. Newhouse (1996) defines selection as "actions of economic agents on either side of the market to exploit unpriced risk heterogeneity and break pooling arrangements, with the result that some consumers may not obtain the insurance they desire" (p. 1236). [3] Selection leads to inefficiency as well as inequity [4] because it defeats risk pooling and prevents individuals from being able to buy insurance against becoming a bad risk in the future or having a child who is a bad risk (ibid. …

This article examines the need for public long-term care (LTC) insurance within an overlapping generations model. The discussion revolves around two items: financing methods and inefficiency of privately provided LTC insurance. Special attention is paid to the inefficiency caused by the individual behavior regarding health investment under a privately provided LTC insurance system. The authors' analysis shows that this inefficiency is improved by introducing public LTC insurance.

Insurance coverage through preferred provider organizations (PPOs) now dominates the market for health insurance, covering more than 40 percent of insured employees. Yet there are few analyses of PPO performance, much less of how PPOs achieve results and report these results to employers. This article presents accounting-based reports of PPO cost savings that result from management activities and features regression analysis of costs among plan designs. On average, accounting-based reports of average cost savings (10 percent of total cost) are only two-thirds as large as regression-based estimates of incremental cost-savings (14 percent of total cost). Further, the correlations between accounting-based reports and regression-based estimates are quite low. Accounting-based reports should be viewed as complementary evidence on plan performance, not as a substitute for statistical analysis.

Previous research into workers compensation risk-financing choices has considered only the alternatives of risk transfer in the form of full insurance and risk retention in the form of self-insurance. However, self-insurance is only one of two forms of risk retention. How determinants influence the choice of the other form of risk retention, the large-deductible plan, was not examined in prior research. This study empirically examines all three risk-financing choices for public entities, using a sample of Texas school districts and their workers compensation coverage decisions. It finds that some determinants contribute differently to the two risk-retention choices: severity of loss, cost of insurance, and size of firm influence the choices of these two programs in opposite directions, relative to the choice of full insurance. Also, cost of insurance and frequency of losses were found to influence the choice of full insurance in the opposite direction from that expected. That these findings fail to agree with expectations suggests a need to refine the theory to differentiate between the two risk-retention programs, especially for public entities.

Risk-adjusted capitation payments from a central fund to competing health insurers or health plans form an essential feature of market-oriented healthcare reforms in many countries. If these premium-replacing payments do not adequately reflect risk, it may lead to solvency problems for plans with relatively many high-risk members and to selection against such individuals. Mandatory pooling across insurers may alleviate both problems by making the market as a whole financially responsible for high-cost or high-risk individuals. To finance the pool, every insurer would be obliged to pay, for each of its members, a uniform contribution that would depend on the projected size of the pool. The statistical analysis indicates that mandatory pooling may substantially mitigate solvency and selection problems while retaining incentives for efficiency and cost containment.

This article examines the design of an optimal policy for an insurable risk in the presence of another uninsurable risk. In the context of incomplete markets, indemnity payments are made whenever the insurable realized index is lower or higher than a critical level, depending on whether the policyholder's revenue increases or decreases with this index. These results are illustrated in an agricultural context in which crop insurance is available and price risk is uninsurable. Under the principle of increasing uncertainty, price risk induces the prudent producer to reduce his or her optimal price selection. The effect of direct subsidies on the optimal price selection is shown to depend on the producer's temperate behavior. INTRODUCTION Early literature on the theory of insurance, such as Borch (1962), Arrow (1971), and Raviv (1979), focused on optimal insurance purchasing in the context of a complete set of insurance markets for future risks. In recent years, the insurance-buying decision in incomplete markets has been examined when the insurable risk interacts in an additive manner with the uninsurable background risk, which can be correlated with the former (see Doherty and Schlesinger, 1983; Gollier, 1996). The purpose of this article is to investigate the optimal insurance policy when the indemnity is contingent only on an imperfect signal of the policyholder's revenue. More specifically, his or her random revenue is a function of an insurable random index and an independent background risk, which is assumed uninsurable. This source of uninsurability can stem from asymmetric information between insureds and insurers. In this context of incomplete markets, the design of an optimal insurance contract is derived. The optimal form depends on the effect of an increase in the insurable index on the policyholder's revenue. If the principle of increasing uncertainty (Leland, 1972) is satisfied and if the policyholder exhibits prudence (Kimball, 1990), an upper or lower bound associated with the slope of the optimal marginal coverage can be defined. Full insurance against the index is shown to be optimal if and only if the insurance premium is actuarially fair. These results are illustrated in an agricultural context in which the producer faces both yield and price uncertainty and in which a crop insurance market is available. Under a multiple peril crop insurance program, the producer selects a yield guarantee and a price selection at which a unit loss of output is compensated. The article first examines the effect of demand uncertainty on the optimal price selection and then analyzes how the payment of direct subsidies affects this price selection. To sign this effect, the concept of "temperance" introduced by Kimball (1992) is used. After the model has been presented in the next section, the design of an optimal insurance contract in the presence of background risk is derived. In the fourth section, these results are used to examine the producers' rationale for purchasing crop insurance when output price risk cannot be hedged. THE MODEL The problem of the insurance-purchasing decision of a risk-averse producer is considered in a static model. His or her revenue is based on an index, or a proxy, y, which is assumed insurable, and on a background risk [epsilon], which is assumed uninsurable. [1] The stochastic dependence between revenue risk and index risk is formalized by the deterministic revenue function R(y, [epsilon]), where [epsilon], where is independent of y and E([epsilon]) = 0, E denoting the expectation operator. The support of the cumulative distribution function associated with random variables y or [epsilon] is contained in [0, [y.sub.max]] or [[[epsilon].sub.min], [[epsilon].sub.max]] with [y.sub.max] [less than] 0 and [[epsilon].sub.min] [less than or equal to] 0 [less than or equal to] [[epsilon].sub.max], respectively. The revenue function is assumed strictly monotonic in the background risk and, without a loss of generality, a larger value of the [epsilon] risk generates a larger revenue; i. …

This article introduces a class of distortion operators, ga(t) = D[44-(u) + a], where D is the standard normal cumulative distribution. For any loss (or asset) variable X with a probability distribution Sx(x) = 1Fx(x), ga [Sx(x)] defines a distorted probability distribution whose mean value yields a risk-adjusted premium (or an asset price). The distortion operator ga can be applied to both assets and liabilities, with opposite signs in the parameter a. Based on CAPM, the author establishes that the parameter ca should correspond to the systematic risk of X. For a normal (L,aU2) distribution, the distorted distribution is also normal with '= u + aa and a5' = a. For a lognormal distribution, the distorted dis

In this article, a model of life insurance holding is formulated. It takes into account the liquidation values and liquidity of estate assets and the ability of life insurance death benefits to bypass the probate process. Tobit regressions based on the model are run using the U.S. Survey of Consumer Finances 1989 data set. The results showed net worth (fixing net liquid assets and annuity wealth) and annuity wealth (fixing net liquid assets and net worth) to be positively related to life insurance holding. Moreover, net liquid asset holding (fixing net worth and annuity wealth) and charitable motives also affect life insurance holding.

Since changes in the firm-specific or unsystematic risks faced by a corporation have no effect on firm value, corporate insurance purchases might seem unwarranted. However, more than 57 percent of insurance premiums are paid by businesses. This apparent contradiction has motivated researchers to suggest factors other than simple risk reduction that create corporate incentives to purchase insurance. This article tests the practical validity of most of the analytic arguments regarding corporate demand for insurance. In general, the empirical evidence from corporate property insurance purchases is consistent with the various theoretical arguments regarding corporate demand for insurance. The results suggest insurance helps to reduce various agency costs associated with stakeholder conflicts, provides real services, and reduces taxes. Finally, the less risky nature of regulated industries compared with unregulated industries is believed to lessen the various corporate incentives to purchase property insurance.

Genetic testing is a concern for insurers if they cannot use test results in underwriting. We model adverse selection in an insurance market with genetic testing for breast and ovarian cancer. Increased forces of mortality resulting from a family history of cancer or a positive test for a BRCA mutation are calculated. Using a Markov model, we estimate costs of adverse selection, assuming various testing and insurance purchase behaviors. Adverse selection should be controllable if companies apply strict underwriting rules, requesting cancer history and onset age for all first-degree relatives. If insurers fail to correctly identify the family history of the application and use it in pricing, adverse selection costs could become unbearable. GENETIC TESTING AND THE FEAR OF ADVERSE SELECTION Adverse selection can be defined as the process by which prospective policyholders may gain financial advantage through insurance purchase decisions based on risk characteristics known to them, but unknown and not revealed to the insurer. It is a source of concern for insurance companies because it could result in underpricing. Recent developments in the Human Genome Project, while offering medical promise, have further increased insurer fears about this issue. Indeed, in many jurisdictions, insurers are not allowed to ask for results of genetic testing. Several years ago, two gene mutations that affect the likelihood of developing breast and ovarian cancer were discovered. Commercial tests to detect the presence of these mutations are now available. Women who learn through genetic tests that they are at higher risk of death for breast or ovarian cancer may purchase more life insurance, which to them looks inexpensive since it is priced at rates set for average risks. Women who learn they are at lower risk after a negative test may purchase less life insurance. These two forces combine to increase the aggregate mortality of the insurance purchasers. If insurers do not have access to the test results, they are unable to identify which women are at higher risk and which are not. They have to increase premiums for everyone, driving those at lower risk out of the pool. This creates a spiral of increasing prices and a decreasing number of policies issued, which may threaten the financial solvency of the insurer. The debate about insurer access to genetic screening information has industry representatives pointing to the risk of adverse selection. They advocate mandates that would require that all test results provided to individuals also be made available to insurers. These insurers' request for a "level playing field" contrasts with efforts by consumer groups to increase the privacy protection of genetic information. Consumers are concerned that test information may find its way to employers or result in employment and social discrimination. They fear that the use of genetic testing by insurers could result in the creation of a biological underclass of uninsurable individuals. The issue is highly emotional and very political. While risk classification is unchallenged in some lines of business (smokers/nonsmokers in life insurance, distance from nearest fire station in homeowners' insurance), the use of genetic tests comes into conflict with social and moral concerns of society in the 1990s. These concerns have prompted legislators to regulate the use of genetic testing. Wisconsin was the first state to introduce a genetic testing law in 1992. Thirty-four states have now enacted laws prohibiting insurers of different types from using genetic information in their underwriting decisions. As of early 1998. more than 200 bills have been proposed in various state legislatures throughout the country that try to limit insurers' access to and use of genetic information (Jones, 1999). In March 1999, Sen. Olympia Snowe (R-ME) introduced a bill, backed by President Clinton and included in the GOP Patients' Bill of Rights, that would block insurers from denying coverage or setting premiums base d on genetic information or family history (Government Relations Weekly Update, 1999). …

Consider individuals facing an uncertain lifetime (and hence uncertain future income). Each individual must go through (identical) medical checkups. The choice of a medical expert who interprets the results, and hence provides more information about the random lifetime, must be made before the checkup. We show that, in the absence of a life insurance market, a better medical expert is preferred by all individuals. However, when a life insurance market exists, and the medical checkup is carried out before purchasing a life insurance policy, some individuals may choose the inferior medical expert even though the checkup has not yet taken place.

Cass, Chichilnisky, and Wu (1996) show in an endowment economy that mutual insurance and securities contingent on aggregate states support optimal risk-sharing. We extend their result to a model with production in which risk is endogenous and beliefs about the aggregate state vary across individuals. We use the model to interpret the role of new securities that are contingent on measures of total damage from natural catastrophes. Plausible special cases of the model predict the trade pattern in such securities across diverse regions and predict that such securities will not represent actuarially fair gambles. INTRODUCTION Cass, Chichilnisky, and Wu (1996) show in an endowment economy that if the structure of uncertainty resembles an individual insurance situation, then a combination of mutual insurance and securities contingent on aggregate states supports optimal risk-sharing. In other words, in such settings, a complete set of Arrow-Debreu markets is not needed. We extend their result to a model with production in which the amount of risk depends on individual decisions--as when houses are built in areas prone to hurricanes. Our model is of a static economy in which the aggregate amount of resources subject to risk is the result of individual investment decisions and in which beliefs about the aggregate state vary across individuals. For that model, we show that a Pareto efficient allocation can be supported by a competitive equilibrium with two types of securities: mutual insurance that provides for risk sharing among individuals who are ex ante similar, and a set of state-contingent securities that are indexed by the aggregate exogenous state. This extends the result in Cass, Chichilnisky, and Wu (1996) to the case of a productive economy where the level of aggregate risk is endogenous. We go on to show that the state-contingent securities can be replaced by securities contingent on aggregate losses rather than the exogenous state, despite the fact that aggregate losses are endogenous. For special cases of the model, we describe the implied pattern of trade in the contingent contracts and how they are priced. We show that there is no theoretical basis for believing that the damage-contingent securities are priced in an actuarially fair manner. If individuals have identical beliefs, then the price of a damage contingent security will in general include a risk premium that rewards individuals for taking on this risk. After presenting those results, we conclude with a brief discussion of recent policy initiatives and related discussion concerning losses from natural catastrophes. A MODEL WITH ENDOGENOUS DAMAGE We present a static model that is designed to represent, in a simple way, regions which end up being subject to different amounts of risk. The economy consists of a finite number of islands that are indexed by h from 1 to H. Island h is inhabited by [N.sub.h] people of type h. Each island is perfectly round and has a plateau in the middle of it. The land on the coast is subject to the risk of damage (from storms), while land located on the plateau is safe. Each person on island h is endowed with an ex ante identical slice of land, which includes some coastal land and some plateau land, and with a resource, [y.sub.h], which can be interpreted as labor. The only use of the resource is as an input into production of a single good, rice, on the coastal land or on the plateau land owned by that person. All type h people are identical in terms of von Neumann-Morgenstern utility function, endowments, and technologies. We let [u.sub.h]: [R.sub.+] [right arrow] R denote a type h person's von Neumann-Morgenstern utility function (for rice consumption), and we assume that [u.sub.h] is strictly increasing, strictly concave, and continuously differentiable. The technologies determine the distribution of output resulting from the decision about dividing [y. …

This study identifies factors exogenous to individual insurers that are statistically related to the overall rate of life-health insurer insolvencies. This is a departure from the methodologies of prior studies, which have focused primarily on firm-specific characteristics in assessing insolvency risk. Empirical analysis is based on quarterly data from 1972 through 1994. Results indicate that life-health insurer insolvencies are positively related to increases in long-term interest rates, personal income, unemployment, the stock market, and to the number of insurers, and negatively related to real estate returns. Findings support the hypothesis that economic and market variables are important predictors of life-health insurer failure rates.

Regulators, investors, consumers, and insurance brokers use insurer financial strength ratings to evaluate the insolvency risk of insurers. This article investigates the factors influencing the decision to obtain a rating or multiple ratings, the determinants of ratings for the three major insurer rating agencies, and reasons for differences in ratings across agencies. This study indicates that insurers obtain ratings to reduce ex ante uncertainty about insolvency risk. It also provides evidence that specific rating determinants and their weights differ across agencies. Evidence of sample selection bias is found only in relation to Best's ratings.

This article investigates whether the contractual exclusion of third-party extended warranties should be legally permissible, using a model incorporating consumer heterogeneity. The welfare effects of competition in the market for extended warranties are shown to depend on the degree of competition in the product market. In contrast to the approach typically adopted by the courts, the article argues that manufacturers should not generally be permitted to practice requirements contracting in extended warranties, even when the product market is competitive. INTRODUCTION Competition authorities and economists have recently been wrestling with the question of whether manufacturers should have the right to monopolize aftermarkets for their products. An important class of such aftermarkets, characterized by adverse selection, is extended warranties and service contracts. This paper investigates the problem of whether the contractual exclusion of third-party extended warranties should be legally permissible. Consumer heterogeneity sometimes leads manufacturers to offer a menu of warranty contracts, typically implemented as a base warranty and an optional extended warranty. For most products on which a manufacturer offers an extended warranty, it faces competition from third-party service contracts. Some manufacturers, however, make it a condition of supplying a retailer that she carry only the manufacturer's extended warranty. A recent case is typical of the legal dilemma. Ford of Canada announced that as a condition for the use of its financing plan, dealers had to commit to exc lusive sales of Ford's extended warranty program. When the Federal Automobile Dealers Association threatened to take it before the Competition Bureau, Ford withdrew the condition, leaving dealers free to continue selling third-party extended service contracts. Should manufacturers generally have the right to impose such exclusivity conditions on retailers? This article argues that competition in extended warranties has an important effect on the base warranty, and therefore on welfare. In both the United States and Canada, the legality of such requirements contracting is still uncertain, despite the magnitude of the extended warranty and service contract markets. Extended warranties are one of the most commonly purchased forms of insurance and marketed along with most large and many small appliances. Sears alone is reported to have sold over $1 billion worth of extended warranties in 1991 in the United States. Ford recorded profits in excess of $100 million from sales of extended warranties in 1988, despite fierce competition from independent insurers. [1] Around 40 percent of all automobiles and major appliances are sold with some form of extended warranty, typically with a large profit margin. [2] For retailers of products carrying extended warranties, the profits can be significant: Some analysts estimate that around half of operating profits for big consumer electronics chains come from sales of extended warranties. [3] Although extended warranties are a form of insurance, they have quite unique features. Unlike most other forms of insurance, warranty contracts do not usually vary by amount of insurance but by duration instead. The reason for variation in the duration could be heterogeneity in consumer risk aversion or heterogeneity in the consumer's expected intensity of use. I model it as the latter in this article. This suggests that there will be opportunities for third degree price discrimination and the resulting welfare losses that come from distorting contracts for low intensity users to keep high intensity users from buying those contracts. The presence of third party extended warranties complicates the situation and may increase or decrease welfare. What is critical here is that because the warranty contract varies by duration and not by amount of coverage, the standard screening analysis employed in most insurance problems (beginning with Michael Rothschild and Joseph Stiglitz (1976) and Charles Wilson (1977)) doe s not apply directly to the warranty case. …

This article investigates the valuation effects of equity issuances by insurance companies on rival firms. The literature has documented the existence of contagion effects associated with the revelation of information in industries characterized by asymmetric information, i.e., both the banking and insurance industries (see, e.g., Slovin, Sushka, and Polonchek, 1992; Avila and Eastman, 1995; and Fenn and Cole, 1994). We argue that because of high monitoring costs investors holding insurance company securities are rationally uninformed about the quality of insurance company portfolios. In this environment characterized by asymmetric information, if the market interprets an equity issuance by an individual insurer as a signal regarding the quality of insurance company portfolios in general, then we would expect to observe cross-firm effects associated with insurance company equity issuance announcements. Our results are consistent with the hypothesis that the announcement of an equity offering reveals informati on about the quality of both the announcing firm's portfolio and the quality of rival firms' portfolios. In addition, when we split the sample by industry grouping, we find that announcements by life insurance firms generate significant cross-firm effects. We argue that these results are a consequence of the different types of state-contingent contracts offered by insurers in different segments of the industry. Investors holding securities of companies that issue short-term state-contingent contracts find it economically rational to be relatively well informed about the quality and riskiness of an insurance company. Equity issuance announcements by insurers that offer short-term state-contingent contracts do not produce cross-firm effects. Before the well-publicized asset quality problems in the life insurance industry in 1990, it appears that the perceived risk of holding insurance company securities was low and the perceived quality of insurance company assets was high. Because of these perceptions regardin g asset quality and risk, investors were relatively uninformed. When we examine insurance company equity issuance announcements before and after 1990, we find that it is the announcement of equity offerings made by life insurance firms before January 1, 1990, which results in significant contagion effects. INTRODUCTION The passage of time has seen the evolution of a considerable literature investigating the market's reaction to securities issuance announcements. The empirical results documented in the literature are consistent with the models of Myers and Majluf (1984) and Miller and Rock (1985), which hypothesize that securities issuance announcements are viewed by the market as a signal of private information about expected future cash flows by the management of a firm. The reported announcement period effects for equity issuances of non-financial firms are approximately -3.1 percent (see, e.g., Asquith and Mullins, 1986; Barclay and Litzenberger, 1988; Mikkelson and Partch, 1986; and Masulis and Korwar, 1986). Comparable announcement period returns for utility equity offering announcements are approximately -0.75 percent (see, e.g., Asquith and Mullins, 1986; Masulis and Korwar, 1986; and Pettway and Radcliffe, 1985). The literature documents that the announcement period returns for exchange traded commercial banks are b etween the comparable announcement period returns for utilities and non-financial firms. Polonchek, Slovin, and Sushka (1989), Wansley and Dhilon (1989), and Keeley (1989) report announcement period returns for bank equity offerings of approximately -1.2 percent. Polonchek and Miller (1996) investigate securities offerings by insurance companies. They argue that private information associated with an insurance company's asset portfolio increases the market's expectation of adverse selection by the firm's managers. Consistent with this expectation, they find statistically significant announcement period returns of -3. …

This study provides evidence regarding the risk-subsidy and monitoring hypotheses by investigating the relation between insider ownership and risk-taking in the property-liability insurance industry. The structure of guaranty funds provides incentives for owners to encourage insurer risk-taking. However, the ex post funding mechanism and incompleteness of guaranty funds may create monitoring incentives that inhibit risk-taking. Moreover, the extent to which managers engage in risk-taking may depend on how well their interests are aligned with those of the owners. The empirical results provide support for the risk-subsidy hypothesis and demonstrate the essential link between insider ownership and risk-taking. INTRODUCTION The institutional details of insurance industry guaranty funds have the potential to create competing incentives regarding risk-taking by insurers. Guaranty funds use an ex post financing mechanism to assess surviving insurers for the losses generated by insolvent insurers, and, at the same time, the assessments do not account for the riskiness of the insurers. Lee, Mayers, and Smith (1997) use the risk-neutrality and ex post funding of guaranty funds to develop two hypotheses regarding the impact of guaranty funds on the risk-taking behavior of insurers. They refer to these hypotheses as the risk-subsidy hypothesis and the monitoring hypothesis. They examine the relative strength of these hypotheses, and their empirical evidence leads them to conclude in favor of risk-subsidy. This study complements the work of Lee, Mayers, and Smith (1997) and addresses several additional issues. For stock market-based measures of risk, the evidence shows that the risk-subsidy hypothesis appears to hold, and the extent of risk-subsidy-related behavior is directly related to insider ownership. This point is related to the ownership structure hypothesis advanced by Lee, Mayers, and Smith (1997). [1] In addition, the authors are able to validate this result by exploiting the option characteristics of the risk-subsidy. Specifically, the study shows that the relation between risk and ownership is stronger for insurers whose put option is closer to being in the money. Finally, as monitoring and risk-subsidy are not mutually exclusive, the authors attempt to avoid a complete dismissal of the monitoring hypothesis by examining a series of piecewise linear relations between risk and ownership. This approach effectively relaxes the condition under which the authors might conclude in favor of the existence o f monitoring. The results appear to have important implications for the effectiveness of guaranty funds and other financial institution insurance programs. BACKGROUND, THEORETICAL ARGUMENTS, HYPOTHESES The Insurance Guaranty Fund System During the years 1969 to 1981, all states enacted laws to establish guaranty funds to protect the policyholders of insolvent insurance companies. [2] The protection provided by these state guaranty funds, however, is far from complete. [3] For instance, the funds typically limit the maximum amount that can be recovered to $300,000 per claim ($100,000 in some states), including all loss adjustment and defense costs. Deductibles are also common. In addition, certain lines of insurance typically have no coverage (e.g., reinsurance and marine insurance), and some states provide no protection for commercial insureds that exceed a particular net worth limit. Beyond these restrictions, payments from a guaranty fund are likely to be delayed compared to payments from a solvent insurer. In addition, guaranty funds do not provide reimbursement for the risk management services that the solvent insurer would have provided. The funding method used by insurance guaranty fund programs is also very important. Guaranty fund programs are funded on a post-insolvency assessment basis. [4] Thus, surviving insurers are responsible for paying the guaranty fund obligations created when one of their peers becomes insolvent. …

This study investigates the differences in cash holdings across property-liability insurers. We conclude that relative cash holdings are less for insurers with better access to cash through capital markets and/or other group members. We also conclude that larger insurers, higher quality insurers, insurers that write longer tail lines of business, and firms with higher degrees of leverage hold less cash. Also, we find that insurers with a higher variance of cash flows tend to hold more cash. Another interesting finding is that, contrary to what managerial discretion arguments might suggest, stock insurers tend to hold more cash than do mutuals. INTRODUCTION This article examines the variation in cash holdings across property-liability insurers during the three-year period from 1993 to 1995. For the property-liability insurer, virtually all business transactions occur in cash. Premiums are received in cash, and claims are paid in cash. As a result, the insurer's decision regarding the amount of cash to hold is critical to its operations and therefore to its overall financial stability. In making that decision, an insurer may choose to hold a large amount of cash; such a strategy affords much flexibility to the insurer, but the flexibility gains are offset by the opportunity costs resulting from the lower returns generated by cash compared to less liquid assets (Amihud and Mendelson, 1986). On the other hand, an insurer may choose to hold a small amount of cash; such a strategy maximizes returns by investing the cash in higher yielding assets but exposes the insurer to transaction costs--and potentially unfavorable economic conditions--when assets must be liquidat ed to meet obligations. Because there are competing costs and benefits of holding cash, the insurer must compare the marginal costs of holding cash to the marginal benefits of holding cash when determining its optimal level of cash (Opler, Pinkowitz, Stulz and Williamson, 1999). Cash holdings vary considerably across insurers. [1] Such differences can be expected for a number of reasons, including the degree of agency conflict among the insurer's management, owners, and policyholders; the ability of the insurer to generate cash from alternative sources; the nature of the insurer's operations; and the composition of the insurer's portfolio of non-cash assets. In order to determine which insurer characteristics affect the extent of cash holdings, we employ regression analysis on a large sample of property-liability insurers over a three-year period. Our examination of cash holdings by property-liability insurers serves several purposes. First, it contributes to the large body of literature investigating corporate cash holdings (Chudson, 1945; Baumol, 1952; Meltzer, 1963; Frazer, 1964; Vogel and Maddala, 1967; Gertler and Gilchrist, 1994; Kim, Mauer and Sherman, 1998; Opler, Pinkowitz, Stulz and Williamson, 1999). Because prior literature has excluded the analysis of financial firms, investigation of insurer cash holdings provides the opportunity to evaluate the extent to which past findings hold for a totally different class of firms. Perhaps more importantly, the unique aspects of the insurance industry, such as the different organizational forms available to insurers and the phenomenon of insurer groups, provide the opportunity to generate additional insights into cash holdings. Additionally, the examination complements previous research investigating other components or aspects of insurer investment portfolios (Colquitt and Hoyt, 1997; Cummins, Philli ps and Smith, 1997; Lee, Mayers and Smith, 1997; Cox, Gayer and Wells, 1998). Finally, the examination demonstrates that insurers choose cash balances systematically based on their organizational and operational characteristics. This information should benefit stakeholders, regulators, and academics in their attempts to understand and predict insurer behavior. …

Financing long-term care is an issue of concern to many Americans, yet private long-term care insurance product sales have experienced slow growth. Pricing problems may in part explain this phenomenon. This study provides the first empirical evidence on pricing in the long-term care insurance market and analyzes the relationship between insurer operating characteristics and premium. The results suggest that prices vary across firms due to size, organizational form, default risk, and tenure in the market, but not due to differences in distribution system. The evidence is also consistent with significant price differences due to contract design variables that control moral hazard and adverse selection. INTRODUCTION Financing long-term care has become an issue of increasing concern to many Americans. Long-term care includes a range of social and medical services needed by individuals unable to care for themselves due to physical or cognitive disability. Care may be provided in nursing homes, at home, in other residential facilities, or at adult day care centers for the elderly or disabled. People of all ages use long-term care, but the need is especially acute for the elderly (i.e., those over age 65). Private long-term care insurance is one solution to the financing issue. However, this product has experienced relatively slow growth in recent years, possibly because price and policy characteristics are not sufficiently appealing to generate strong sales. This study analyzes the relationship between insurer operating characteristics and the price of insurance. In particular, the importance of insurer organizational form, size, financial strength, distribution system, and tenure in the market is documented and analyzed. M oral hazard and adverse selection effects with respect to particular policy design features are also examined. This article begins with a review of the context in which long-term care insurance is sold. Next, the research methods used in the study are discussed, and the data set and the expected results are described. The empirical results are then reported, followed by a discussion of the major conclusions and implications of the study. THE LONG-TERM CARE INSURANCE MARKET Concern about long-term care financing has increased for several reasons. First, demographic trends show that the elderly are the fastest growing age group in the nation. Figure 1 depicts past and projected growth trends for the elderly to the year 2020. Kemper and Murtaugh (1991) estimate that 43 percent of the elderly will use nursing home care, that over half of those in nursing homes will stay for at least one year, and that 20 percent will remain five years or longer. The concern about paying for nursing home care will become more pronounced in the future, as the proportion of younger persons relative to older persons decreases, thereby making family care less feasible for many. Extended life expectancies, due to advances in medical science and increasingly healthy lifestyles, further increase the likelihood that long-term care outside of the family unit will be needed. Concern about long-term care financing arises not only from increasing utilization of services, but from the high cost of such services. Typical nursing home costs range from $35,000 to $65,000 or more per year, and costs are rising faster than inflation. Community-based residential care or home care is less expensive, but can still be prohibitive for middle- and-lower-income families. In 1995, national aggregate long-term care expenditures exceeded $100 billion annually, of which 44 percent was paid by Medicaid, 16 percent by Medicare, and 30 percent by individuals and their families. Private long-term care insurance represented only about 2 percent of benefit payments. [1] Reductions in state Medicaid funding are likely to have a significant impact on the financing of long-term care in the future, and another public sector solution to the problem of funding long-term care is unlikely, given efforts to control federal spending. …

Government high-risk insurance plans vary in terms of structure and operation. In automobile insurance, most states have an assigned risk plan (ARP), while a few have a joint underwriting association (JUA). ARPs and JUAs are similar in their purpose: to provide state-mandated automobile insurance coverages to high-risk drivers. They are, however, fundamentally different in their structure and operation. This article analyzes the differences in claims payment practices between these two forms of automobile residual market facility used in the United States. This study predicts that, due to differences in incentives, JUAs result in higher claims payments on the part of insurers. The empirical results are consistent with the prediction.

INTRODUCTION Recent studies suggest that both chiropractors and physicians provide effective care for back pain, but the relative costs of chiropractic and physician care are still debated (USDHHS, 1994). Manga et al. (1993) argue that chiropractors are less costly than physicians. Carey et al. (1995) use data on charges to conclude that primary care physicians are the least-cost providers. The relative costs of health care are not, however, the appropriate comparison for work-related back pain. Workers' compensation insurers and self-insured employers pay health-care costs and disability benefits for persons with work-related injuries. From the payers' viewpoint, relatively costly modes of health care are efficient if the care produces sufficiently large savings in indemnity benefits by reducing durations of work absences. The authors use data from a workers' compensation insurer (the Zenith Insurance Co.) to compare the sum of health care and indemnity costs for non-surgical back patients treated by chiropractors or physicians. The data refer to approximately 850 closed claims for episodes of back pain that began and ended between 1991 and 1993. The comparison groups are (1) cases treated by a physician but not by a chiropractor and (2) cases treated by a chiropractor but not by a physician. The authors' measures of health-care costs are payments to providers, rather than health-care charges. Charges are deceptive because payment discounts vary among providers. The authors compare chiropractors' and physicians' pricing, service mix, and service utilization, and describe how each contributes to the differences between the average health-care costs of claimants treated by chiropractors and physicians. The measures of outcomes are the distribution of injured workers among claim types (medical only, temporary disability only, and permanent partial disability) and the durations of temporary disability claims. The authors estimate an ordered logit model to determine the relative effect of chiropractic treatment on the distribution of claim types, controlling for differences between the characteristics of chiropractic and physician patients. The authors estimate a Weibull duration model to determine the relative effect of chiropractic treatment on durations of work absence within the temporary and permanent disability groups. One limitation of the study is that severity of injury is unobserved. The problem of unobserved differences between chiropractor and physician patients is addressed by estimating a second set of models in which support points are added to control for the effects of unobserved worker heterogeneity. To the authors' knowledge, this is the first application of the method to the problem of unobserved differences that can include the severity of health conditions. The cost data are unusual because they include both payments for health care and disability benefit payments. The results show that the average total costs of back claims treated by chiropractors are lower than the average total costs of back claims treated by physicians. Part of the cost differential reflects the fact that a relatively large proportion of chiropractic patients are not paid disability benefits because they return to work within California's three-day waiting period. This result is similar to Ebrall's (1992) findings for Australian workers. The apparent superiority of chiropractic care disappears, however, when the probability of returning to work in less than four days is estimated from multivariate models that control for unobserved heterogeneity in the characteristics of individual workers. These results show no significant differences in the effectiveness of chiropractic and physician care in determining the probability of returning to work within the waiting period. The estimates of the effects of care on durations of work absence for temporary and permanent disability claims do, however, weakly support the conclusion that chiropractors are more effective than physicians in reducing durations of work absence. …

INTRODUCTION In recent years, profitability has returned to the workers' compensation insurance market. Insurers have experienced a dramatic improvement in their combined loss ratios and the frequency of workers' compensation indemnity claims has been on the decline.(1) Nationally, combined ratios after dividends were greater than 110 percent for every year in the 1983-1992 period. They dropped to 109 percent in 1993, 101 percent in 1994, and 98 percent in 1995. At the same time, the use of deductibles for workers' compensation insurance has more than doubled since 1992, accounting for approximately $8 billion in premium credits in 1994.(2) Though state workers' compensation reforms are often cited as the major reason for the improved underwriting results, this article explores the possibility that deductibles, through the creation of incentives for employers to prevent injuries and control the cost of claims, also have contributed to the downward turn in loss ratios. A number of safety and loss control incentives are inherent in the state workers' compensation systems. These incentives include statutory waiting periods for income benefits, income replacement rates, the workers' compensation experience rating system, self-insurance, retrospective rating,(3) the deregulation of insurance rates, and insurance deductible options, and they can potentially impact the behavior of both employees and employers. For instance, an increase in the real income replacement rate creates an incentive for employees to stay off work longer and it also creates an incentive for the employer to invest more resources in safety to avoid these higher benefit payments. To date, few empirical studies have involved risk-sharing insurance arrangements and their impact on employer costs. Although some studies found no evidence that experience rating workers' compensation premiums reduces injury rates (Chelius and Smith 1983 and 1993) or the duration of lost time from workplace injuries (Krueger 1990, Kralj 1995), most studies support the notion that loss control incentives reduce employer costs. Ruser (1985 and 1991) and Worrall and Butler (1988) found that the closer firms came to being fully experience rated(4) (i.e., their premiums are based solely on their own experience as opposed to their class experience), the lower their workers' compensation claim rates. Thomason (1993) found the probability of permanent partial disability to be lower for experience-rated employers obtaining insurance through private-sector insurance carriers. A study that tested the effects on fatality rates in Canada of a transition from a flat or manual premium rating system to an experience rating system provides strong evidence to support the hypothesis that experience rating improves workplace safety (Bruce and Atkins 1993). Moore and Viscusi (1990) found that as benefit levels increased, the risk of work-related deaths decreased. They concluded that the use of death rates, as opposed to injury rates, eliminates moral hazard problems from the analysis, and the findings of their study provide strong evidence that employers do invest in safety when faced with the risk of higher costs. Victor (1985), utilizing a simulation model to measure the injury prevention and loss control incentives associated with the experience-rating system, provides compelling arguments that experience rating may provide greater incentives than self insurance, which is not subject to experience rating. Among the loss-control incentives cited, loss-sensitive insurance arrangements such as insurance deductibles seem to offer employers the greatest direct benefit from investing in injury prevention programs and improved claims management strategies. Large deductible policies, which incorporate elements of self insurance and experience rating, may prove to have the most powerful safety/loss control incentives yet. In theory, a firm which selects a large deductible policy (typically ranging from $100,000 to $5 million per accident)(5) takes on the majority of the policy risk and should have a strong incentive both to prevent injuries from occurring and to manage claims in a cost-effective manner. …