Foundations of Insurance Economics: Readings in Economics and Finance.

This book is a research guide in economic theory to all the researchers in economics and finance. The authors of the collected papers in this volume are eminent academicians, who analyze the foundations of (insurance) economic theory with masterly expertise. The academicians, practitioners, and policy makers will find this book of great interest, which covers the insurance economics since its inception during early 1960s. This book is definitely a "must" reading for all the researchers in economics as it presents, applies, and analyzes the fundamentals of economic principles with rigor. Insurance economics is a vast area and is quite multidisciplinary in nature as it includes the disciplines of law, medicine, health science, psychology, and sociology. The main thrust of this volume is on property-liability insurance. It would be very difficult to include theoretical foundations and empirical results into one volume with a fair treatment to both. The contributions in this book have a sound base in theoretical modeling. The editors may consider preparing a companion volume with contributions by academicians and practitioners from all walks of life, where the results of this book's theoretical models have been empirically tested.

The volume is divided into nine sections: Introduction; Utility, Risk, and Risk Aversion; Demand for Insurance; Insurance and Resource Allocation; Moral Hazard; Adverse Selection; Market Structure and Organization Form; Insurance Pricing; and Insurance Regulation. The thoughtful introductory essay by Dionne and Harrington is a scholarly work that presents the history of insurance economics and analyzes its theoretical foundations. In addition to the stimulating and thought-provoking introduction by the editors, the volume contains thirty-three papers previously published in the prestigious journals.

Resolved and unresolved issues associated with the choice under uncertainty have been examined by M. Machina who attempts to draw important implications for normative economics. He puts the relevancy of the probability theory to a rigorous test, and provides a colorful description of the expected utility model and framing effects. J. Pratt's paper deals with the various facets of risk aversion: local risk aversion, comparative risk aversion, increasing and decreasing risk aversion, and proportional risk aversion. In their first paper, M. Rothschild and J. Stiglitz claim that the addition of uncorrelated noise to a random variable would simply make it more variable than the initial variable. Furthermore, they present the mean-variance analysis and examine the integral conditions and partial orderings of distribution functions. Considering the issue of imperfect information, their second paper deals with the process of equilibrium in competitive insurance markets.

Analyzing the issues of maximum acceptable premium for full coverage, optimal coverage at given premium, optimal reinsurance quota, and optimal amount of deductible, J. Mossin investigates the effect of wealth on an individual's desire to buy insurance coverage. Under the assumption of decreasing risk aversion, this effect is found to be negative. H. Schlesinger and N. Doherty discuss the issue of incomplete markets for insurance and point out some possible causes for this incompleteness. They examine the desirability of insurance with multiple sources of risk, the optimal level of coverage, and the optimality of deductibles. In their first paper, D. Mayers and C. Smith argue that the demands for insurance and other assets are determined simultaneously. Their second paper investigates the reasons for corporate demand for insurance. There is a possibility that the wealth effect may not be negative. I. Ehrlich and G. Becker find market insurance and self-protection to be complements. P. Cook and D. Graham have provided a general theoretical model for demand for insurance and protection for the case of irreplaceable and invaluable items.

K. Arrow points out that insurance contracts are essentially exchange of money for money on the condition of the happening of certain events. K. Borch investigates the issue of equilibrium in a reinsurance market which has a broader applicability for all other markets where entities desire an optimal distribution of risk. A. Raviv explains that the cost sharing between the counterparties or risk leads to coinsurance. He analyzes the intricacies of the Pareto optimal policy. R. Kihlstrom and A. Roth provide a game-theoretic model to analyze the effect of risk aversion and discuss the issue of bargaining over insurance contracts.

Can an insurance policy represent a compromise between no coverage and full coverage? How valuable is the imperfect information about care? The first paper of S. Shavel analyzes the issue of moral hazard, while his second paper investigates the judgment proof problem where he considers the problems of inadequate compensations of victims, risk bearing by injurers, and overindulgence of injurers in risky ventures. S. Grossman and O. Hart address the principal-agent problem where principal is assumed to be risk-neutral and agent's attitudes with respect to income risk are not dependent on action.

B. Dahlby studies the Canadian automobile insurance sector to provide a lucid commentary on adverse selection and statistical discrimination. If gender or any such characteristic is used to classify individuals into various risk-groups, a statistical discrimination is said to have occurred. While examining the multi-period insurance contracts, an explanation for incomplete insurance and insurance rating is furnished by R. Cooper and B. Hayes. G. Dionne considers the problem of adverse selection, where he studies the optimal choice of insurance coverage for the one- and multi-period cases. Do insurers tend to keep information on customers private? For the insurance markets, H. Kunreuther and M. Pauly consider the market equilibrium with private knowledge. Categorization, costs, and efficiency are considered and analyzed by K. Crocker and A. Snow. They have examined the market equilibrium under both costless and costly categorizations.

P. Joskow's paper is well balanced between theoretical and empirical studies, where he analyzes the pricing behavior in and the structure and performance of the property and liability insurance industry. The empirical findings of J. Cummins and J. VanDerhei appear to support the conclusions of Joskow's contribution with regard to the relative efficiency of exclusive agency companies over independent agency companies. The empirical work of D. Mayers and C. Smith is an excellent study on ownership structure across lines of property-casualty insurance, where they have analyzed alternative ownership structures and tested various hypotheses.

Do regulators disturb market equilibrium? Insurance pricing and its regulation are examined by N. Biger and Y. Kahane who present both single-line and multi-line cases. N. Doherty and J. Garven have constructed a contingent-claim model to estimate the fair rate of return and have discussed the implicit solutions for the case of property-liability insurance. J. Cummins prepares models for premium calculation and provides interesting observations on premiums for ongoing insurers and for a policy cohort. Are insurance prices set according to rational or irrational behavior? Are cycles created by intervention? Addressing these issues, J. Cummins and J. Outreville analyze the underwriting cycles in property-liability insurance. Do prices deviate from costs in a cyclical manner? The first paper by S. Harrington provides an illuminating empirical study on prices and profits in the liability insurance market, presents evidence on growth in premiums and losses, points out the causes of underwriting cycles, and draws some important policy implications. Harrington's second paper studies the effect of regulation on auto insurance. For the period 1976-81, he finds that the rates declined as a result of regulation.

Under what conditions will the regulation of insurer reserves be beneficial? J. Finsinger and M. Pauly present the restricted and unrestricted models and provide a discussion on the optimality issue. Insolvent firms may be prone to writing automobile insurance. P. Munch and D. Smallwood provide empirical analysis of the effects of solvency regulation and point out the characteristics of insolvent companies.

The contributors of this volume provide thorough descriptions and analyses of the subject matter. The volume can be used as a required reading for advanced upper division undergraduate and for graduate courses dealing with the economic theory and insurance economics. A companion volume with heavy emphasis on empirical investigation of the insurance market, however, would be very useful to practitioners.