ANÁLISIS DE LOS RIESGOS

In economic theory, a perfect competitive industry requires large numbers of sellers and

buyers, a homogeneous commodity, free entry and exit, perfect information, and prices

determined by the interaction of supply and demand. In the long-run equilibrium state of a

competitive industry, the marginal cost of production is equal to the price, economic profits are

zero; and each firm operates at the lowest unit cost. Thus, resources are employed at maximum

production efficiency under competition. Competition decentralizes and disperses power

between buyers and sellers. The resource is allocated through the interaction of supply and

demand on the market, and not through the conscious exercise of power held in private hands

regulation). Hence, competitive market processes solve the economic problem impersonally, and

not through the personal control of entrepreneurs or bureaucrats. A competitive market system

sets no barriers for entries and exits, which entails freedom of opportunity for individuals.

Individuals can freely choose what to trade, only constrained by their own talents, abilities and

financial capitals (Scherer, 1979).

In reality perfect competition can not be realized, but “workable competition” can be

attained, which functions well and provides most of the benefits of a perfect competition

(Scherer, 1979). A workably competitive market generally is characterized by numerous sellers

and buyers, low entry and exit barriers, good information, and the absence of artificial

restrictions on competition. Workable competition reasonably approximates the conditions for

perfect competition to the degree that little regulation is required to achieve an efficient

allocation of resources (Scherer & Ross, 1990). Cummins and Weiss (1991) analyzed the

structure and conduct of property-liability insurance industry and showed that this market is

competitively structured, with numerous firms competing for business in most lines and low

entry barriers.

However, market failures occur under certain market conditions, such as market power,

externalities, incomplete information, transaction costs, etc. (see Bator, 1958; Williamson, 1971).

In the context of insurance industry, given its relatively lower market concentration and lower

entry barriers (Cummins & Weiss, 1991), market failures include severe asymmetric information

problems and principal-agent conflicts, which imply that the information problems arguably are

the industry’s most important market imperfections11_.

Asymmetric information problems exist when one party to a transaction have superior

information that the other does not have. Insurance consumers, particularly individuals and

households, face significant challenges in judging the financial conditions of insurers due to their

limited knowledge and lack of professional expertise. Also, some individuals may have difficulty

properly understanding the complex insurance contracts and products. On the other hand,

insurance consumers have better information about their risks, and high risk buyers have more

incentives to purchase insurance, which adverse selection problem arises. The insurance market

may fail in this case (Akerlof, 1970).

Principal-agent problems arise when insurance consumers have difficulty monitoring and

controlling the behavior of insurers after they purchase policies and pay premiums. The insurer

might make high risk investments that are hazardous to policyholders’ interests by failing to

fulfill its obligations to policyholders. In case of insurer insolvency, it is very difficult for

policyholders to recover funds or force the insurer to meet its obligations. Moreover, the problem

can be exacerbated because of unequal resources and bargaining power between insurers and

individual consumers.

Besides incomplete information, market power can also lead to market failure. Market

power is the ability of one or a few sellers (or buyers) to influence the price of a product or

service. In the insurance context, for instance, one or several big insurers in certain business lines

could exercise collusion price to consumers for excessive returns, which leads to an inefficient

allocation of resources and harm consumers’ benefits.

To fix the above market failures, theories of regulation and governmental interference

have been proposed and applied to enhance economic performance, which will be introduced in

the next part. A detailed review of these theories may not be necessary, but it is important to

understand the implications to stakeholders in insurance markets, including insurers,

3. 2 Theories of Government Regulation

Economic analysis of government regulation has proceeded rapidly12. There are several

explanations for regulation, each mirroring a facet of reality. One is the "pubic interest theory",

where regulation is required to correct matters and serve the public interest in case market

failures occur (see Bonbright, 1961). In the insurance context, the public interest argues that the

regulation of insurer solvency is used to address the inefficiency caused by costly information

and agency problem (Munch & Smallwood, 1981). Insurers have diminished incentives to

maintain a high level of financial safety because their personal assets are not at risk for unfunded

obligations to policyholders that would arise from insolvency. It is costly for policyholders to

assess an insurer’s financial condition. Insurance is a technical and complicated subject, and the

true financial strength of an insurance company can only be determined by expert examination.

There is also embedded principle-agent problem – insurers can increase their risk after

policyholders have purchased policy and paid premiums.

A second hypothesis states that regulation occurs because there are well-organized vested

interests expecting to benefit from regulation (see Jordan, 1972; Peltzman, 1976; and Stigler,

1971). This "interest group pressure" theory suggests that regulation is acquired by groups with

their own interests and is designed and operated primarily for groups’ benefit. Under this

scenario, regulators are motivated to maximize political support rather than economic efficiency.

Meier (1988) further set up a model to explain the ideological motivation of regulators. In his

model of the political economy of insurance regulation, he hypothesized that the insurance

industry should favor regulatory policies that benefit it and oppose policies that restrict it. Meier

observed that the insurance industry is not a monolith and that different segments of the

insurance may have different views with respect to certain regulatory issues. The ability of the

industry to influence regulation is hypothesized to be a function of its political resources,

including its size and wealth.

Insurance is important to the welfare of the individuals, households, firms and the overall

economy, and it warrants close government attention. It also implies that the public interest

should be the paramount consideration in guiding government intervention, though regulators are

also influenced by political factors. Hence, the rationale for government intervention in case of

market failures is based on promoting or restoring economic efficiency. Optimal regulation

should be directed by an ideal set of policies that attempt to replicate the conditions of a

competitive market and maximize social welfare.

Another aspect of insurance regulation in practice is how social preferences impact the

public policy used to enhance efficiency in a free market economy. For example, the public

would prefer lower premiums in general regardless the real risk status. Lower prices suppressed

by regulation might benefit consumers in the short-run until firms leave the market and the

supply of insurance contracts. This artificially-induced unavailability of insurance seems against

the public interest in the long-run, but there is strong political support for low prices. In this

sense, the regulation or public polices influenced by voters or special interest groups may

diverge from the economic rationale, resulting adverse consequences or “government failures”.