The Geneva Risk and Insurance Review 2010: We Have Learned Much Since Willett and Knight

The Geneva Papers, 2011, 36, (476 – 487) r 2011 The International Association for the Study of Insurance Economics 1018-5895/11 www.genevaassociation.org The Geneva Risk and Insurance Review 2010: We Have Learned Much Since Willett and Knight Jean-Franc¸ois Outreville HEC Montreal, 3000 cote Sainte Catherine, Montreal, Quebec, Canada H3T 2A7. E-mail: The purpose of this paper is to review and summarise the papers published in The Geneva Risk and Insurance Review in 2010. Historical reference to Willet and Knight is emphasised to illustrate the importance of risk and uncertainty in our modern economies and how it is still the starting point of economic research not only in public finance as proposed by Agnar Sandmo, but also in other papers published in this volume. Many issues touch upon anomalies like adverse selection, asymmetric information, moral hazard and rating restrictions that can influence the performance of insurance markets. These issues are of particular relevance for insurers and the proper functioning of insurance markets. The Geneva Papers (2011) 36, 476 – 487. doi:10.1057/gpp.2011.17 Keywords: risk and uncertainty; asymmetric information; insurance Introduction Regardless of the manner in which risk is defined, its existence affects the economic performance of agents and therefore imposes constraints on the optimum allocation of resources and on the economic development of all nations. Individual as well as business decisions are made under conditions of uncertainty. In 1901, A.H. Willett refers to the costs of uncertainty arising out of (1) the unexpected losses that do occur and (2) the uncertainty itself even if no losses occurs. He also refers to uncertainty as a disutility. The prudent individual response to uncertainty (as to whether a loss will occur) is to engage in safe actions rather than risky ones. At the society level, this behaviour may cause distortions in the optimal allocation of productive resources. “The existence of risk in an approximate static state causes an economic loss. The assumption of risk, on the other hand, is a source of gain to the society as a whole”.1 Although the idea of risk may be difficult to conceptualise, risk is of considerable importance for the functioning of all economies and economic agents.2 Frank H. Knight (1885–1972) is usually credited for having presented the distinction between decisions under “risk” (known chance) and decisions under “uncertainty” in his 1921 book.3 It is interesting to note that Knight defined profit as a reward for assuming risk 1 Willett (1901, p. 32). Bernstein (1998) walks that path. Against the Gods follows the intellectual development of risk management and how people throughout the centuries have changed their views of what constitutes risk and how risk can be mitigated. See also Outreville (1998, Chapter 2). 3 Knight (1921). 2 Jean-Franc¸ois Outreville The Geneva Risk and Insurance Review 2010 477 4 and claimed that only uncertainties create an economic problem. The convention in finance is to interpret risk in the spirit of Willet and Knight.5 The remarkable story of risk and uncertainty touches on the most profound aspects of psychology, mathematics and statistics. Knight discussed several biases in human decision-making and described features of risky choice (a function of anticipatory futures) that were to become key components of prospect theory.6 The basic principle of insurance is also described at length by Knight: “risks will be borne in groups large enough to reduce the uncertainty to substantially negligible proportions”, but at the same time he recognises that “practical difficulties may prevent insurance even where the risk is determinate”.7 LeRoy and Singell8 produced an interpretation on the distinction made by Knight between situations in which insurance markets can operate smoothly (risk) and situations in which insurance markets would collapse because of moral hazard and adverse selection (uncertainty). The conceptual link between insurance and risk—with risk being a calculable subset within a larger set of uncertainties—has been subject to a fair amount of study in the literature. Recent sociological and historical work by Ericson and Doyle9 has explained how insurance risks very often are not reliably calculable, although the risk has already been transformed into an all-too-measurable loss. Insurance is an “uncertain business”, characterised by competition for premiums that pushes insurers into the unknown and the performance of insurance market is affected by the presence of anomalies that may affect the risk-taking behaviour of agents and the optimal allocation of insurance in the economy.10 In light of this background, the purpose of this paper is to review and summarise the papers published in The Geneva Risk and Insurance Review (GRIR) in 2010. This volume of the GRIR is particularly important, not only because it includes a paper by Agnar Sandmo,11 who discusses the role that the economics of uncertainty has played in the theory of public finance, but also because several papers touch upon the anomalies that can influence the performance of insurance markets. A paper examines premium cross-subsidies and how it affects the risk-taking behaviour of agents. Other papers are looking at issues such as the relationship between risk and coverage under adverse selection, the probability distributions of risks or wealth effects on self-insurance when an unfair premium encourages risk-averse individuals to purchase a partial coverage of insurance. 4 See Brooke (2010) for a discussion on the contribution of Frank Knight. For a different point of view, see Holton (2004). 6 See Rakow (2010) for a discussion on the psychological insights of Frank Knight. Knight (1935) developed the idea in The Ethics of Competition: “The first question in regard to scientific economics is this question of how far life is rational, how far its problems reduce to the form of using given means to achieve given ends”. 7 Knight (1921, Chapter 2, Part I). 8 Le Roy and Singell (1987). 9 Ericson and Doyle (2004). 10 Eeckhoudt et al. (2005, Chapter 3). 11 Sandmo (2010). 5 The Geneva Papers on Risk and Insurance—Issues and Practice 478 The following sections of this paper present an overview of the major topics explored in eight papers published in GRIR 2010. The last section will summarise the results and brief remarks conclude the paper. Uncertainty in the theory of public finance In 1713, the basis of the modern mathematical probability theory developed by Jacob Bernoulli in “Ars Conjectandi” is published (eight years after his death) in Basel. In 1738, Daniel Bernoulli published his answer to the game known as the “St. Petersburg paradox”. In his approach, he suggested that the outcome of a lottery should be valued according to the “expected utility (EU)” that it provides rather than the mathematical expectation.12 It is surprising that economists did not apply the i (...truncated)