Consumption vs. Production of Insurance
NBER Working Paper No. 6225
Many forms of insurance are produced by groups themselves rather than purchased in the market. For example, coverage for workers compensation provided by employers is often produced by the employer, in the sense that the employer bears some or all of the financial risk associated with the insurance. This paper generalizes the theory of insurance to analyze what factors determine whether groups produce insurance internally by self-insuring or consume it by purchasing coverage in the market. The" theory makes cross-sectional predictions on which firms will choose to produce insurance, as well as how prices and loss experience will vary with the production decision; the theory also predicts which lines of insurance are likely to be associated with internal production and those in which coverage will be provided entirely by the market. Furthermore, the time-series properties of claims under various degrees of internal" production are analyzed, revealing a more pronounced lag structure for claims under partial risk-bearing than under full self-insurance or market insurance. These predictions are generated by a fundamental diseconomy of scale that offsets the standard scale economy associated with risk-pooling. The tradeoff facing a group in its make-or-buy decision is that self-insurance rewards self-protection but forgoes the pooling of risk" with members outside the group.