16.2 Insurance and imperfect information  (Page 2/33)

If each of the 100 drivers pays a premium of $1,860 each year, the insurance company will collect the $186,000 that is needed to cover the costs of the accidents that occur.

Since insurance companies have such a large number of clients, they are able to negotiate with providers of health care and other services for lower rates than the individual would be able to get, thus increasing the benefit to consumers of becoming insured and saving the insurance company itself money when it pays out claims.

Insurance companies receive income, as shown in [link] , from insurance premiums and investment income. Investment income is derived from investing the funds that insurance companies received in the past but did not pay out as insurance claims in prior years. The insurance company receives a rate of return from investing these funds or reserves. The investments are typically made in fairly safe, liquid (easy to convert into cash) investments, as the insurance companies needs to be able to readily access these funds when a major disaster strikes.

An insurance company: what comes in, what goes out

Government and social insurance

Federal and state governments run a number of insurance programs. Some of the programs look much like private insurance , in the sense that the members of a group makes steady payments into a fund, and those in the group who suffer an adverse experience receive payments. Other programs protect against risk, but without an explicit fund being set up. Following are some examples.

• Unemployment insurance : Employers in every state pay a small amount for unemployment insurance, which goes into a fund that is used to pay benefits to workers for a period of time, usually six months, after they lose their jobs.
• Pension insurance : Employers that offer pensions to their retired employees are required by law to pay a small fraction of what they are setting aside for pensions to the Pension Benefit Guarantee Corporation, which is used to pay at least some pension benefits to workers if a company goes bankrupt and cannot pay the pensions it has promised.
• Deposit insurance : Banks are required by law to pay a small fraction of their deposits to the Federal Deposit Insurance Corporation, which goes into a fund that is used to pay depositors the value of their bank deposits up to $250,000 (the amount was raised from $100,000 to $250,000 in 2008) if the bank should go bankrupt.
• Workman’s compensation insurance : Employers are required by law to pay a small percentage of the salaries that they pay into funds, typically run at the state level, that are used to pay benefits to workers who suffer an injury on the job.
• Retirement insurance : All workers pay a percentage of their income into Social Security and into Medicare, which then provides income and health care benefits to the elderly. Social Security and Medicare are not literally “insurance” in the sense that those currently contributing to the fund are not eligible for benefits. They function like insurance, however, in the sense that regular payments are made into the programs today in exchange for benefits to be received in the case of a later event—either becoming old or becoming sick when old. Such programs are sometimes called “social insurance.”