The Marginal Revolution Podcast
Episode: The Economics of Insurance
Date: November 19, 2024
Hosts: Alex Tabarrok (A), Tyler Cowen (B)
Episode Overview
In this engaging episode, Alex Tabarrok and Tyler Cowen take a deep dive into the economics of insurance—exploring its history, core mechanisms, puzzles about market structure, forms it has taken over centuries, and its cultural and moral context. Their lively discussion ranges from mutual aid systems in rural India to the rise of formal maritime and life insurance, the idiosyncratic evolution of attitudes toward insurance, and enduring agency problems in the sector.
Key Discussion Points
1. The Scale and Function of Insurance
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Insurance as a “Near Free Lunch”:
- Alex highlights insurance as a form of risk-sharing, where many people make small contributions to cover the rare, large losses of a few, creating peace of mind on aggregate. However, actual costs include the need to pay real people and employ real resources to manage these pooled funds.
"It is almost a free lunch. How can it be? Well, think about it really. What insurance is doing is transferring money...offering peace of mind and certainty to everyone."
—Alex, [00:03]
- Alex highlights insurance as a form of risk-sharing, where many people make small contributions to cover the rare, large losses of a few, creating peace of mind on aggregate. However, actual costs include the need to pay real people and employ real resources to manage these pooled funds.
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Resource Cost and Psychological Factors:
- Tyler probes the real opportunity cost of insurance, raising questions about moral hazard, signaling, and whether anxiety-alleviation might be achieved more cheaply in other ways.
"When people buy insurance, to what extent is that a rational decision that actually improves their resource allocation over time? ...I tend to think this is often the case with life insurance. You feel you're supposed to buy it, but an alternative strategy is just to spend less money."
—Tyler, [01:13]
- Tyler probes the real opportunity cost of insurance, raising questions about moral hazard, signaling, and whether anxiety-alleviation might be achieved more cheaply in other ways.
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Value Is Greatest for Large Risks:
- Alex explains why insurance makes sense for big risks but not for small, everyday products (e.g., electronics warranties).
"You don't want to insure small, small amounts. But on the big questions...there are big risks in life, and the ability to cover those risks and create some peace of mind is extremely valuable."
—Alex, [02:32]
- Alex explains why insurance makes sense for big risks but not for small, everyday products (e.g., electronics warranties).
2. Informal vs. Formal Insurance and Its Economic Effects
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Mutual Insurance in Villages:
- Referencing research in Indian villages, Alex explains traditional mutual insurance as risk-sharing across a community—a useful but high “marginal tax” on those who succeed, hampering growth.
"If you want to predict the consumption of a member of the village, the best thing to know is not how much that member produces, but how much the village produces."
—Alex, [02:51] "I informally estimated it once at 80%. You're expected to help out...and when the village should be growing. That's a huge tax, right?"
—Tyler, [05:03]
- Referencing research in Indian villages, Alex explains traditional mutual insurance as risk-sharing across a community—a useful but high “marginal tax” on those who succeed, hampering growth.
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Why Formal Insurance Emerges:
- Formal insurance uses contracts to clearly distinguish between risk-sharing and redistribution, mitigating problems where social norms could be exploited.
"That's one reason why formal insurance is better than informal...Within a formal insurance, you have a contract."
—Alex, [05:23]
- Formal insurance uses contracts to clearly distinguish between risk-sharing and redistribution, mitigating problems where social norms could be exploited.
3. Historical Evolution of Insurance
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Maritime and Fire Insurance:
- The discussion covers early maritime insurance and the importance of risk subdivision, as well as Nicholas Barbon’s pioneering fire insurance in London after the Great Fire of 1666.
"He creates the first fire office in London...private fire brigade to protect the insured properties. Now, this makes a lot of sense because he's got the incentive to stop fires..."
—Alex, [11:19]
- The discussion covers early maritime insurance and the importance of risk subdivision, as well as Nicholas Barbon’s pioneering fire insurance in London after the Great Fire of 1666.
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The Role of Incentives and Moral Hazard:
- The incentive alignment—e.g., a fire insurer also running a private fire brigade—prompted reflection on why we don’t see more hands-on insurance product hybrids (e.g., health+life insurance bundles).
"It is a general puzzle in the history of insurance why you don't have more combinations of insurance with other things. So insurance so often is hands off."
—Tyler, [12:50]
- The incentive alignment—e.g., a fire insurer also running a private fire brigade—prompted reflection on why we don’t see more hands-on insurance product hybrids (e.g., health+life insurance bundles).
4. Moral Hazard, Selection, and Agency Problems
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Selection Effects:
- Discussing how sometimes insurance markets attract the better risks ("positive selection") rather than the typical adverse selection narrative.
"You might think in a naive economic model, that would make sense...But there's often positive selection into insurance."
—Tyler, [12:50]
- Discussing how sometimes insurance markets attract the better risks ("positive selection") rather than the typical adverse selection narrative.
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Hidden Agency Problems:
- Persistent unsolved agency problems: The insurer might not pay in the end, or assets held to back insurance may prove insecure.
"My worry is the agency problems behind insurance never have been solved...So the core thing that goes on with life insurance is they take your money and they hold it for decades. And it's not insured the way the FDIC is."
—Tyler, [45:31]
- Persistent unsolved agency problems: The insurer might not pay in the end, or assets held to back insurance may prove insecure.
5. Life Insurance: Puzzles, History, and Social Attitudes
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Statistical Innovation and Life Insurance:
- The growth of life insurance relied on improved understanding of probabilities and large numbers, but Tyler questions whether “scientific” risk measurement truly underpinned its historical rise.
"But I worry about all these accounts for a few reasons. ...I just see too many cases where people can make businesses work...before they know the underlying probability structure."
—Tyler, [21:42]
- The growth of life insurance relied on improved understanding of probabilities and large numbers, but Tyler questions whether “scientific” risk measurement truly underpinned its historical rise.
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Legal and Moral Repugnance:
- Life insurance often faced moral and theological opposition; it was sometimes illegal or stigmatized as “gambling on death.”
"Life insurance was illegal in France until 1850...insurance replaces the services of humanity by the services of money and undermines the sense of compassion which should form the basis of society."
—Alex, quoting Zelizer, [27:53] "It is meanly selfish for you to be so absorbed in heaven that you forget what is to become of your wife and children after you are dead...It is a mean thing for you to go to heaven while thee go to the poorhouse."
—Alex, quoting 1880s sermon, [37:54]
- Life insurance often faced moral and theological opposition; it was sometimes illegal or stigmatized as “gambling on death.”
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Tontines and Annuities:
- Tontines: a hybrid of life insurance and annuity, rare and conceptually bizarre, yet Alex notes elements of tontine logic in family arrangements. Both question why annuities and reverse mortgages aren’t more popular, given theoretical advantages.
"I just think of that in the abstract. It makes sense. But one thing I find trying to use economic intuition to think about insurance markets can very rapidly lead you astray."
—Tyler, [30:13]
- Tontines: a hybrid of life insurance and annuity, rare and conceptually bizarre, yet Alex notes elements of tontine logic in family arrangements. Both question why annuities and reverse mortgages aren’t more popular, given theoretical advantages.
6. Big Risks We Fail to Insure
- Absence of Macro Markets:
- Despite obvious “big risks”—economic collapse, stagnation, scientific stagnation—robust insurance markets or futures contracts (e.g., on national GDP) are lacking, puzzling the hosts.
"But still, it doesn't happen. ...There are some very big risks which most of us take on, which we can't really diversify away from very easily."
—Alex, [35:01]
- Despite obvious “big risks”—economic collapse, stagnation, scientific stagnation—robust insurance markets or futures contracts (e.g., on national GDP) are lacking, puzzling the hosts.
7. Cultural and Institutional Evolution
- Repugnance and Social Change:
- Ideas of “repugnance” are mutable; what was once taboo (insurance, paying blood donors) can become normalized, providing hope for future market innovations.
"The fact that the moral view of life insurance could change so quickly...gives me hope that there are many other institutions which could have a great flowering."
—Alex, [41:33] "I have a corresponding fear, which is that we'll find more things repugnant. ...Maybe we just become objecting more. ...Over time, we object to more and more markets and gum up the works."
—Tyler, [44:05]
- Ideas of “repugnance” are mutable; what was once taboo (insurance, paying blood donors) can become normalized, providing hope for future market innovations.
8. Insurance and the Financial System
- Insurance vs. Banking:
- Growth in insurance markets may be a response to banking sector regulation and under-performance; insurance is sometimes used as shadow banking.
"I also wonder if the relative growth and success of insurance is not in part a response to overregulating banking or banking not going so well."
—Tyler, [51:18] "There are some people who like to use a whole life insurance policy as their own bank, the so-called infinite banking."
—Alex, [52:25]
- Growth in insurance markets may be a response to banking sector regulation and under-performance; insurance is sometimes used as shadow banking.
9. Research on the Economics of Insurance
- Disappointing Academic Literature:
- Both hosts lament the lack of high-quality, intellectually satisfying economics research and books on the subject.
"It really struck me how little high quality economics research there is on most insurance. ...I found it a surprisingly disappointing literature."
—Tyler, [54:45]
- Both hosts lament the lack of high-quality, intellectually satisfying economics research and books on the subject.
Notable Quotes and Memorable Moments
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The Fire Insurance/Private Fire Brigade Innovation:
"He starts a private fire brigade. ... He's got the incentive to stop fires because he's the one who's going to have to pay out on the insured property if there is a fire."
—Alex, [11:19] -
Prediction Markets and Life Insurance:
"For a while at least in England you could buy life insurance and then sell that to other people and they did not have to have an insurable interest in you...there were in essence betting markets on when a person would die."
—Tyler, [23:46] -
On Social Acceptance:
"And indeed, in the advertising of life insurance, life insurance, I like this, was described as the unseen hand of the provident father reaching forth from the grave and still nourishing his offspring."
—Alex, [38:40]
Important Timestamps
- 00:03 — Introduction to insurance as a "near free lunch"
- 01:13 — Tyler's questions on the resource cost and rationality of insurance decisions
- 02:51 — Mutual insurance in Indian villages and its economic trade-offs
- 11:19 — The history of fire insurance and the innovation of a private fire brigade
- 21:42 — Critique of the idea that scientific risk assessment enabled life insurance
- 27:53 — The moral and legal repugnance towards life insurance in history
- 30:13 — Tontines and their puzzling rarity
- 35:01 — Absence of insurance for the biggest macro risks
- 41:33 — Changing social norms and the hope for future market acceptance
- 44:05 — The fear that societies will find more and more things repugnant
- 51:18 — Links and distinctions between insurance and banking sectors
- 54:45 — Lack of quality literature on the economics of insurance
Takeaways
Alex Tabarrok:
- Insurance markets are built on deep institutional, mathematical, and moral foundations—requiring state record-keeping, probability theory, and evolving social attitudes. Changing moral attitudes can unlock new, beneficial markets over time.
Tyler Cowen:
- Insurance, especially life insurance, presents deep puzzles—history doesn’t conform to textbook economic intuition, and agency problems remain unsolved. Also, Charles Ives was not just a composer but an astute commentator on insurance economics.
Recommended Reading:
- Morals and Markets: The Development of Life Insurance in the United States by Vivian Zelizer
- Betting on Lives: The Culture of Life Insurance in England, 1695–1775 by Geoffrey Clark
End of content summary.