Arnold Kling  

Income Volatility, Saving, and Risk Pooling

Why Be Normal?... Bleg: looking for SAS help...

On my earlier post on income volatility, D-aquared asked why smaller risk pools would be efficient?

His point is that if the problem is volatility, risk can be diversified away. If 10 families pool their savings, volatility will be lower than if each family saves for itself.

The problem with this type of risk pooling is that there are deadweight losses. The income insurance fund needs rules for paying claims, and each possible rule gives rise to moral hazard.

  • If I can make a claim whenever my income is below normal, then I have incentives to take a year off or otherwise increase the volatility of my income.
  • If I can make a claim when I am unemployed, then I lose the incentive to find a new job--or to put up with my existing job.
  • The more insured I am against income fluctuations, the lower my incentive to save, and the lower will be the rate of capital formation in the economy.
There is also the issue of adverse selection. If I know that my income is going to be stable, I try not to join a pool. I tend to join when I have news that my income is going to be volatile.

The issue of adverse selection poses problems for private markets for income insurance. The issue of moral hazard poses problems for a government market for income insurance. My guess is that a case can be made that an increase in income volatility raises the need for both personal saving and for government-provided income insurance.

Note, however, that if taxes rise with income, that provides a form of income insurance. It is not clear that a new program is needed.

For Discussion. Do we not observe private markets for income insurance because of adverse selection, or because individuals really do not value income smoothing very much?

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CATEGORIES: Income Distribution

COMMENTS (8 to date)
Tony Vila writes:

Yeah, that's great. All you've said is that pooling risks will come with some costs. His main point that there is still great benefit out of risk pooling and diversifying is not contradicted. Deciding whether costs outweight the benefits is very different from assuming that small risk pools are automatically efficient.

Especially since most major financial actors go to great lengths to diversify their risks already.

Yes moral hazard is hard, but risk averse activity also bites (it can be just as antagonistic to long term planning as your fears about savings rates).

Randy writes:

Adverse selection. Those most at risk, and therefore most in need, cannot or will not afford it.

Lawrance George Lux writes:

Adverse Selection holds the key: High degree of Savings project a Secondary Income, while it is lack of secondary income which induces Demand for income insurance. A household which has already organized a private Income quarantee internally lacks the desire to witness a Cash flow out of the household, not under their control. lgl

Boonton writes:

Perhaps adverse selection can be defeated thru gov't mandate. Consider this type of policy, you are mandated to contribute 2% of your payroll per year to a private savings account. (Basically an IRA that you can set up at almost any bank). You cannot tap funds from this account less than 3 years old.

Assuming 0% interest and income growth, people will never have less than about 3.1 weeks worth of pay (6% of their income) in a savings account. Of course if people leave their money in the account they will have an even larger amount. While this may not reduce income volatility it may make it more tolerable.

Another issue is how to hedge against a drop in your income. Over on Jane Galt's site she discussed Robert Schiller's proposal for bonds whose dividends are linked to GDP growth. I noticed that such an animal would be an interesting way for a company to extract capital from its skeptics. Suppose Wal-Mart raised capital by selling stock & bonds whose coupon payments were based on US GDP growth. If you think that Wal-Mart will outperform the US economy, you would buy its stock. If you think the reverse you would by its bonds. In both cases Wal-Mart is able to raise capital from both its bulls and its bears!

If such bonds existed an 'income insurance' fund could hedge downturns in national income by shorting such bonds. In principle it seems feasible to set up such a fund as long as you could get around the deadweight loss of adverse selection.

Perhaps one way to do it would be to delay payouts. Suppose if your income dropped by a certain amount income will be deposited into your IRA/401K. Over time those who take on career paths with highly unstable income will be rewarded with a nicer retirement, but you have little incentive to ask your employer to lay you off today unless your comfortable enough to wait around for your payout.

Bob Knaus writes:

Actually, private income insurance does exist. I used to get pitches for it all the time. Typically, it would be linked to a credit card or health insurance or a car payment, something with a monthly bill. The idea was to get you to pay a little bit extra per month so that you'd get a payout sufficient to cover your credit balance plus maybe pay some of your debts, in case you were injured or disabled.

It's the sort of thing that credit counselors warn you loudly against, because the payout is awful. I think that, in general, only the impoverished and the ignorant purchase this kind of insurance.

Perhaps the answer to Arnold's discussion question is that adverse selection makes the insurance, when offered, a poor value.

dsquared writes:

I think that, in general, only the impoverished and the ignorant purchase this kind of insurance.

In that case there's a lot of them about; properly marketed, penetration ought to be about 66% on this kind of product.

Bob Knaus writes:
In that case there's a lot of them about; properly marketed, penetration ought to be about 66% on this kind of product.

Yikes! I hope it's not that popular. It really is a bad deal for the consumer. Most of the premiums are eaten up by the insurance company's overhead and profit.

A few years ago I bought a tumbledown house in a poor neighborhood, which had once been used as a crack house. Cleaning it out, I found a cache of cash reciepts dating back to the 1960's. Every week, the woman of the house paid 3 or 4 dollars to an insurance salesman who called personally. It was called "burial insurance" and was marketed to low-income blacks, by black-owned insurance firms, using black salesmen. So it was exploitation, not discrimination.

Even more amazingly, I saw a salesman come by every week to collect the same small premiums from the woman next door. This was less than a decade ago, I'll bet it still happens in poor neighborhoods.

The "income protection" insurance currently marketed is barely one step up from this racket.

Bernard Yomtov writes:

Who says we don't observe markets for income insurance?

Isn't ordinary disability insurance a form of income insurance?

And, while moral hazard and adverse selection are clearly problems for broader forms, I think another issue is high systematic risk - the probabilities are not independent. If Jack loses his job, the probability that Jill will lose hers goes up, because some of the time Jack's unemployment is the result of recession or the like, rather than simply being an independent event.

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