The social welfare created by insurance is unquestionable. Insurers can pool and diversify large idiosyncratic risks that have potentially catastrophic consequences for individuals and businesses. In competitive markets, insurance is priced on an actuarial basis, leaving tremendous utility gains to the previously exposed individuals and businesses.
The breadth of the role of insurance in the global economy is therefore not surprising. For example, in the United States premiums paid by families and companies each year for financial security and for business risk reduction are a significant proportion of GDP. According to the National Association of Insurance Commissioners, in 2008, Life and Health insurers collected $788 billion in premiums (although a significant portion of this reflects investment rather than insurance), while Property Casualty companies received $495 billion, for a total of $1.28 trillion or 9.0% of 2008's nominal GDP of $14.29 trillion.3 Table 1 summarizes this information.
The last year has led to considerable analysis of the regulation of the core institutions of the global financial system, especially the commercial banks, investment banks, and brokers. In the United States the regulators of these institutions include the Federal Reserve, the CFTC, the SEC and the Office of the Comptroller of the Currency. Given that the financial crisis has revealed several crucial weaknesses in the regulation of insurance entities, it is surprising that their regulation has been largely omitted from this discussion. Yet as mentioned above, American insurers are a fundamental part of the financial structure, played a significant role in the breakdown of the structure, and as the ultimate "risk-management agents" in the economy have significant potential to restore strength to the currently broken structure.
It is commonly agreed in economics that there is an important role for public sector involvement and regulation even in a competitive insurance industry. Insurance markets are exposed to the two fundamental problems of asymmetric information: adverse selection and moral hazard. Adverse selection arises because those seeking insurance are more likely to suffer losses, leading to a breakdown of the aforementioned pooling equilibrium. Moral hazard arises because the insured, when insulated from risk or the consequences of their actions, take on more risk than is socially optimal or otherwise act in a dysfunctional fashion. Much of insurance mechanism design and government regulation deals with these problems.
