Class 18 Insurance and Risk Management

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Class 18Insurance and RiskManagement

• George D. Krempley
• Bus. Fin. 640
• Autumn Quarter 2006

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Reasons for Social Insurance

• To help solve social problems
• To provide a base of economic security
• To provide coverage for perils that are difficult
  to insure privately

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Social Insurance Background

• Industrial revolution economy changed from
  agricultural to an industrial basis
• Separation of people from the land
• Growing interdependence among people
• Far fewer families capable of self-sufficiency

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Early results of industrialization

• Initially, industrial revolution did not lead to
  uniformly high standard of living
• Great disparity in income between upper and lower
  classes
• Many were victimized by low wages and unsanitary
  living conditions

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Otto von Bismarck

• Bismarck first used force to try to destroy
  socialist movement
• Later, recognized economic misery fed socialist
  movement in Germany and elsewhere in Europe
• So, changed tactics
• Introduced social insurance to undercut the root
  of socialism

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Bismarcks Approach

• Funded by taxing current workers, thus insulating
  wealthy supporters
• Introduced in stages
• Medical insurance 1883
• Accident insurance (Workers Comp) 1884
• Old age and disability insurance 1889

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Spread of Social Insurance

• Rest of industrialized Europe faced similar
  political and economic problems
• Followed Bismarcks lead
• By turn of 20th century, social insurance
  programs were the rule in industrialized Europe

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Social Security in United States

• Response to the most serious economic problem in
  U. S. history the depression
• First enacted in 1935 as U. S. Old-age and
  Survivors Insurance
• Effective in 1937 - Some 45 years after the
  implementation of Bismarcks program

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Social Securitys Expansion

• Disability benefits added 1956
• In 1965, Congress added Medicare program
• Cost of living adjustment (COLA) added to
  benefits in 1975
• In 1977, indexing of qualifying wages began

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Current Social Security Program

• Old-Age, Survivors, Disability and Hospital
  Insurance (OASDI-HI)
• Two components
• OASDI
• HI (Medicare)

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Social Securitys Impact

• Nine out of 10 workers in occupations covered by
  Social Security
• In 2003, about 155 million Americans pay FICA
  taxes each year
• Over 50 million received a monthly cash benefit
  under Social Security
• Either retirement or disability
• About 40 million were covered under Medicare in
  2003

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Social Securitys Impact

• In 2003, OASDI benefit payments, totaled 470
  Billion.
• Medicare had total expenditures of 244 Billion.

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Social Security and the Federal Government

• OASDHI expenditures exceed any other federal
  program including defense.
• Equal to approximately 20 of total expenditures
  of the federal government
• OASDHI payroll taxes (FICA) represent 25 of all
  tax revenues.
• FICA Federal Insurance Contribution Act

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How is OASDI Financed?

• Sources
• Payroll (FICA) taxes
• Largest source of funds
• Employer and worker each pay 6.2 of taxable wage
  base
• Maximum taxable wage base in 2003 87,000
• Employer and worker also each pay HI taxes
  1.45 of all wages

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How is OASDI Financed?

• Sources (cont.)
• Income taxes paid by high income beneficiaries
• Interest on OASDI trust funds

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Social Security Vs. Private Insurance

• Participation
• Social Security is compulsory
• Insurance is a matter of free choice
• Benefits
• Social Security predetermined by formula
• Insurance benefits negotiated by purchaser and
  insurer

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Social Security Vs. Private Insurance

• Funding
• Social Security operates as a pay-as-you-go
  system
• It is self-supporting
• But also backed by the federal governments
  taxing power
• Insurance companies are required to be fully
  funded
• Change in Benefits
• Social Security benefits can be changed by
  legislation
• Insurance benefits are contractual and generally
  are not subject to change

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Social Security Vs. Public Assistance

• Contributions for benefits received
• Social Security recipients make contributions for
  the benefits they receive
• Welfare recipients make no such payments

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Social Security Vs. Public Assistance

• Demonstration of financial need
• Social Security benefits are the legal right for
  all eligible people
• Recipients do not have to demonstrate financial
  need
• Richest people in America are entitled to
  benefits, as soon as they become eligible
• Public Assistance recipients must demonstrate
  financial need
• Must pass a means test

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Social Security Vs. Public Assistance

• Demonstration of financial need
• Social Security benefits are the legal right for
  all eligible people
• Recipients do not have to demonstrate financial
  need
• Richest people in America are entitled to
  benefits, as soon as they become eligible
• Public Assistance recipients must demonstrate
  financial need
• Must pass a means test

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Covered Occupations

• Employees in private firms
• Virtually all
• Federal civilian employees
• After 1983 compulsory
• State and local governments
• Voluntary agreement between state and federal
  government
• Employees of nonprofit organizations
• If paid at least 100 during the year

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Covered Occupations (cont.)

• Self-employment
• If annual earnings of at least 400
• Domestic employees
• If they earn more than 1400 in 2004
• Other groups
• Ministers unless they elect out because of
  conscience or religious principles
• Railroad workers do not pay OASDI taxes directly

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Determination of Insured Status

• Fully insured
• Currently insured
• Disability insured

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Eligibility for OASDI Benefits

• Workers and their dependents are eligible
• Amount of benefits depends on
• Wages earned
• Amount of time working
• Unit of measurement
• earn a quarter of coverage for each 890 in
  annual earnings (in 2004) up to 4 per year

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OASDI Benefit Amounts

• Benefits are based on Primary Insurance Amount
  (PIA)
• Calculate average indexed monthly earnings (AIME)
• Index past earnings to growth in average wage
  rates so all earnings are comparable
• Index base for retirement benefits is second year
  prior to age 62
• Index base for death or disability benefits is
  second year prior to death or disability

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OASDI Benefit Amounts

• Take highest 35 years of indexed wages
• Divide by number of months
• PIA in 2002 90 of first 592 in AIME
• 32 of AIME between 592 and 3,567
  15 of excess
• 592 and 3,567 are called bend points

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EXHIBIT 24.2 Examples of Monthly OASDI
Retirement Benefits at the Full Retirement Age
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Retirement Eligibility

• To be eligible for retirement benefits, you must
  be fully insured.
• You are full insured for retirement benefits if
  you have 40 credits.

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Survivor Benefit Eligibility

• Require either
• Fully insured status, or
• Currently insured status
• You are currently insured if you have
• earned at least six credits during the last 13
  calendar quarters ending with the quarter of
  death.

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Disability Eligibility

• Number of credits required to be disability
  insured depends on your age when you become
  disabled.
• If you are age 31 or older, you must have earned
  a certain number of credits as shown by the chart
  on page 536.
• At least 20 of credits must be earned during the
  past 10 years immediately before becoming
  disabled.

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Types of OASDI Benefits

• Retirement
• similar to defined benefit retirement plan
• Survivor
• life insurance
• Disability
• disability insurance

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Relationship of PIA to AIME
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Other Features

• Cost of living adjustment
• Earnings test
• Retirement benefits are reduced if wages exceed
  certain thresholds
• Strong disincentive for elderly to work full time
• Income taxation of benefits
• Higher income individuals pay tax on part of
  their benefits

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Pay-as-you-go Financing

• Basic idea
• Current payroll taxes pay current benefits
• No pre-funding
• Exception
• Starting in1983, payroll taxes were increased to
  help fund future benefits
• Trust fund invests in government bonds

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Projected OASDI Deficits

• Projections indicate large deficits in the future
• Around 2018
• Projected OASDI income will fall short of
  benefits paid
• The OASDI trust fund will start to decline
• By 2042
• OASDI income will finance only 73 of scheduled
  annual benefits
• The OASDI trust fund projected to be exhausted

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Projected OASDI Deficits (cont.)
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Factors Affecting Benefits and Taxes

• Simple framework for understanding pay-as-you-go
  systems
• Average benefit
• payroll taxes/number of beneficiaries
• Payroll taxes
• (tax rate) x (average taxable wage) x (number
  of workers)
• Then, average benefit
• (tax rate) x (average taxable wage) x (ratio
  of workers to beneficiaries)

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Factors Affecting Benefits and Taxes

• If average benefits are kept constant and taxable
  wages remain constant, then
• tax rates must ?
• if the ratio of workers to beneficiaries ?
• Example
• ratio of workers to beneficiaries in 1997 3.4
• estimated ratio in 2030 2.0

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Implicit Rates of Return

• Compare taxes paid to benefits received to
  calculate an implicit rate of return
• Relatively high returns for retirees until the
  early 1990s
• Low expected returns in the future
• Using simple framework
• Long-run implicit return
• ? growth rate in wages population growth rate

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Why Have Social Security?

• Potential problem with private retirement plans
• Unexpected inflation reduces value of benefits
• Costly for private market to insure against
  inflation risk b/c of the high correlation across
  insureds
• Social security might be an efficient method of
  providing this insurance
• I.e., social security provides cost of living
  adjustments (COLAs)
• Wages track inflation payroll taxes increase
  with inflation benefits can be indexed to
  inflation

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Why Have Social Security?

• Potential problems with private retirement plans
• Some people will not save enough
• Transfers are therefore inevitable
• Social security might be a way of forcing these
  people to contribute something to their
  retirement income

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Proposed Changes to Social Security

• Changes that maintain the current structure
• Benefit reductions
• Tax increases
• Investing trust assets in common stock
• Crediting trust funds with any budget surpluses

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Proposed Changes to Social Security

• Changes that modify the basic structure
• Privatization
• Allow workers to invest their payroll taxes on
  their own
• Benefits to existing and new retirees would still
  have to be paid long transition period
• Convert to a welfare program
• Make benefits means tested
• Workers in their 40s, 50s, and 60s would lose
• Moral hazard problem many low income people
  would not save at all

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Medicare

• Pays medical expenses for persons
• aged 65 and above
• disabled people under 65
• Two main parts
• Part A Hospital Insurance (HI)
• coverage for 90 days of hospitalization
• deductibles and coinsurance
• hospitals are reimbursed according to a schedule

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Medicare

• Part B Supplementary Medical Insurance (SMI)
• pays for physician, outpatient, home health care
  services
• pays 80 of expenses
• above 100 deductible
• monthly premium is required
• physicians reimbursed based on a fee schedule

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Financing of Medicare

• HI
• Financed by payroll taxes
• Both worker and employer pay
• 1.45 of all wages
• Deficits are forecasted
• SMI
• Beneficiaries pay monthly premiums that cover
  about 25 of the costs
• Remaining 75 is financed from general tax
  revenues

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Key Medicare Topics

• Medicare financial crisis
• Medicare Advantage (formerly Medicare Choice)
• New prescription drug benefit beginning in 2006
• Medigap insurance

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EXHIBIT 24.5 Out-of-Pocket Drug Spending in 2006
for Medicare Beneficiaries Under New Medicare
Legislation
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Objectives of Unemployment Insurance

• Provide cash income during short-term involuntary
  unemployment
• Help unemployed workers find jobs
• Encourage employers to stabilize employment
• Help stabilize the economy by maintaining
  purchasing power

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Firms Covered by Unemployment Insurance

• Private firms
• State and local governments
• Agricultural firms under certain conditions
• Domestic employment under certain conditions

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Eligibility Requirements

• Have qualifying wages and employment
• Be able and available for work
• Actively seek work
• Be free from disqualification
• Serve a one-week waiting period in most states

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Unemployment Benefits

• Benefit amountvaries with the workers past
  wages, within certain minimum and maximum amounts
  that vary by state
• Duration of benefitsregular benefits paid for a
  maximum of 26 weeks in virtually all
  jurisdictions
• Extended benefitsup to 13 weeks of additional
  benefits in states with high unemployment

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Financing

• Employers pay a payroll tax.
• Tax revenues go into a federal trust fund.
• Experience rating gives firms with favorable
  records lower tax rates.

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Problems and Issues

• Decline in the proportion of unemployed who
  receive benefits
• Inadequate unemployment trust fund balances in
  many states
• Imperfect experience rating formulas

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EXHIBIT 24.6 Insured Unemployment as a Percent
of Total Employment Regular State Programs
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EXHIBIT 24.7 Average High Cost Multiples, by
State Calendar Year 2002
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Workers Compensation

• Based on the fundamental principle of liability
  without fault.
• Employer is held absolutely liable for the
  occupational injuries or disease suffered by the
  workers, regardless of who is at fault.
• Disabled workers are paid for their injuries
  according to a schedule of benefits established
  by law.
• Not required to sue their employers to collect
  benefits.
• Laws provide for the prompt payment of benefits
  to disabled workers regardless of fault and with
  a minimum of legal formality.

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Eligibility Requirements To Receive Workers
Compensation Benefits

• Two principal eligibility requirements
• Disabled person must work in a covered
  occupation.
• Worker must have a job-related accident or
  disease.

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Complying with Workers Compensation Law

• Employers can purchase a workers compensation
  policy.
• In some states, employers can purchase coverage
  from competitive or monopolistic state fund.
• Finally, many employers self-insure their workers
  compensation loss exposures.

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Reasons for Increased Litigation

• Suits by injured workers who are dissatisfied
  with their workers compensations awards and then
  sue for higher amounts
• Denial of claims by some employers, which result
  in lawsuits by the injured workers
• Court decisions that have eroded the exclusive
  remedy doctrine
• which states that workers compensation benefits
  should be the sole and exclusive remedy for
  injured workers.

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EXHIBIT 24.1 Social Security Full Retirement Age
and Reduction in Benefits by Age
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EXHIBIT 24.3 Real Rates of Return for All
Retirees
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EXHIBIT 24.4 What Age Must You Reach to Get Back
What Youve Paid In?
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Summary Basic Characteristics of Social
Insurance

• Compulsory programs
• Floor of income
• Emphasis on social adequacy rather than
  individual equity
• Benefits loosely related to earnings
• Benefits prescribed by law
• No means test
• In a sense, full funding unnecessary
• Financial self-supporting
• Social Insurance is not the same as public
  assistance or welfare