Editors' Summary

Imagine a society where no one could insure against the costs of being treated for a life-threatening disease; where drivers could not insure against the costs of accidents, to themselves or third parties; where homeowners could not protect themselves against the financial costs of fires and windstorms; and where firms and professionals could not protect against the financial costs of liability for harm to third parties. Without the ability to transfer these types of financial risks to insurers, members of such a society would be much less willing to take risks in consumption and investment decisions that are critical to the dynamism of capitalist economies. And consequently, such a society would be far less productive than the one in which we now live.

Yet as important as insurance is to the functioning of modern economies, it is probably the least well understood of all the financial services commonly sold in the marketplace today. Various events in recent years, however, have focused public attention on the insurance industry. Controversy surrounding the system of medical malpractice insurance has again surfaced, with insurance rates for certain specialties skyrocketing in some states and critics charging that the current approach compensates victims poorly, entails enormous overhead costs, and fails to discipline malpractitioners effectively. Recently, even homeowners' insurance has raised public policy concerns as insurers attempt to limit their exposure to new types of litigation, such as that over toxic mold in homes, as well as to catastrophic losses. And, most notably, the terrorist acts of September 11, 2001, prompted the U.S. Congress to enact legislation providing federal reinsurance to private insurers for losses caused by terrorist acts beyond a certain threshold. This legislation will expire next year, unless Congress takes action.

Thus it seemed appropriate for insurance to be the focus of the seventh annual conference on financial services issues sponsored by the Brookings Institution and the Wharton School of the University of Pennsylvania, held at Brookings in January 2004. This summary presents the key findings and conclusions contained in the six papers prepared for the conference. All of the papers stimulated lively discussions among the experts who attended the conference, and these discussions are summarized following each paper.

The Theory and Practice of Insurance: Why the Disjunction?

Economists and insurance experts have studied the industry for many years and have developed a series of theoretical concepts to explain how insurance markets function. This view of the demand for insurance was summed up by one conference participant who noted that an economically rational consumer would understand that, apart from certain tax benefits, when you buy insurance, you are making a bet with an insurance company, which the insurance company wins, on average, because it must cover administrative costs and earn a competitive return for its shareholders. From this perspective, it makes sense to insure only against very large potential losses that would make a difference in your standard of living.

But that is not how consumers behave in many circumstances. For example, one of the fastest-growing insurance markets is repair or replacement insurance for relatively inexpensive electronic products that seldom fail. Usually the insurance is priced as if the risk of failure were much higher than it actually is. Nonetheless, for some products nearly 80 percent of consumers opt for insurance, even though the loss would not have an appreciable impact on their standard of living. Similarly, consider the case of a seventy-year-old widow with three children, all of whom are richer than she. The greatest risk she faces is loss of income, and thus she should buy annuities rather than life insurance. But if the widow behaves like her peers, she is seven times more likely to buy life insurance than annuities.

Just as the demand for insurance seems to diverge from the theoretical, rational paradigm, the supply of insurance also seems to depart from the standard model. For example, in most markets, an increase in demand raises the price and increases...