The process of forming contracts depends, of course, on the nature and relationship of the contracting parties. Voluntary individual insurance, under which contracts designed by insurers without significant constraint are offered to the public, is only one of several relationship structures that could be employed. Two of the most important alternatives are social insurance and group insurance.
Under social insurance, the insurer is the government; the risk insured may be a person’s life, health, or retirement income; and premiums (often designated as taxes) are paid either by the insured or by his or her employer. Social insurance is generally mandatory (coverage is required by law) although in a few instances government provides insurance for which participation is not required. If coverage is not mandatory, or if it is provided as an alternative to the private market, social insurance can be subject to adverse selection. This has caused difficulties for many state-run assigned risk pools for automobile insurance.
Mandatory social insurance is established by law, not by contract. No underwriting is required since coverage is provided to all who are eligible. Mandatory health insurance is subject to moral hazard and rent seeking by providers. Rent is formally defined as “that part of a person’s or firm’s income which is above the minimum amount necessary to keep that person or firm in its given occupation” (Henderson and Quandt 1971, p. 121). It is also necessary to introduce artificial allocation mechanisms such as queuing. In contrast, mandatory life insurance is rarely offered in meaningful amounts because of difficulty determining indemnification needs. Its beneficial aspects of mandatory participation would be lost if the amount of coverage were discretionary, but a uniform flat benefit, such as was offered with Social Security from the beginning of that program, must either be useless to many or an unaffordable windfall to most.
Group insurance provides coverage for risks pertaining to a group of individual participants under a single contract issued to a sponsor. Typically, the sponsor is the employer of the participants, although group-type coverage may be used in other contexts. Group insurance is achieved through a voluntary contract between the sponsor and the insurer. Participants are not parties to the contract itself, although a subsidiary arrangement may exist between the participant and the sponsor or insurer that creates legal rights. Participation in group insurance may be mandatory or voluntary, but in the latter case some minimum level of participation is usually required by the insurer as a condition of the contract. If the group is large enough, this condition obviates some of the difficulties discussed in this chapter and allows a premium to be set based on characteristics of the group, rather than on characteristics of each participant. In most cases, the premium can be revised periodically, often annually.
This feature also eliminates concerns that are important for other types of insurance. Underwriting for group contracts involves consideration of characteristics of the group, rather than of individual members of the group, for the most part. For example, the rate paid by the contract holder may depend on the nature of the work done by participants and on the distribution of ages and genders of the participants but rarely on health or hazardous avocations of individual members.
In some cases, individual underwriting is applied to members of the group if they have disproportionately large benefits. Group underwriting may be applied to contracts that are legally structured as individual policies. This is the case, for example, with corporate-owned life insurance, in which a company insures a number of usually high-level employees using individual policies. Groups are subject to another form of risk that does not affect individuals–concentration or accumulation risk. As concerns about terrorism arose in the early years of the new millennium, underwriting for concentration risk became important to group insurers. For terrorism, the concern is physical concentration, say of employees in a single high-rise building, but concentration risk may also have been present during the AIDS epidemic, even without physical proximity at work.