The Transactions Cost Theory of Insurance: Contracting Impediments and Costs

Abstract

The Transactions Cost Theory of Insurance: Contracting Impediments and Costs Introduction It is well known that the insurance-as-pooling-of-risks paradigm, valuable as it is, cannot explain all demand for insurance. In the risk-management literature, for instance, it is often argued that large profit-maximizing firms should self-insure minor losses in order to avoid the loading costs of insurance. However, property and liabilities of relatively low value are often insured. Another phenomenon that is difficult to understand as pure risk pooling is the purchase of insurance policies that cover the replacement of buildings when replacement costs exceed expected flows of future returns (Doherty 1985, p. 277). Individuals also tend to over-insure. With loading charges of 20 to 40 percent of premiums, one would expect less insurance and larger deductibles than observed (Friedman, 1974, Pashingian, Schkade, and Menefee 1966, and Stuart 1983). Smith and Warner (1979), Mayers and Smith (1981, 1982, 1987), and Main (1982, 1983) argue that individuals in frictionless capital markets would adjust their portfolios so that there would be no demand for a resource-consuming insurance industry. They also argue that with well-functioning capital markets, insurers would have no obvious comparative advantage over banks or corporate firms in diversifying risks. Following Modigliani and Miller (1958), Mayers and Smith (1987) argue that, if corporate insurance purchases affect the value of the firm, they must do so via taxes, contracting costs or the impact of financial policy on the firm's investment decision. Mayers and Smith (1987) conclude that the corporate insurance purchases are motivated by: low-cost claims administration services provided by insurers, assistance by insurers in assessing the value of safety and maintenance projects, improvements in the incentives to undertake investments in safety and maintenance projects resulting from insurance, increased efficiency in the allocation of risk-bearing among the corporations' claimholders brought about by insurance, and a reduction in the firm's expected tax liability. This article is based on these seminal contributions to a new theory of insurance. If focuses on the contracting costs problem, which appears to be fundamental to an understanding of insurance. It is argued that insurance may be purchased by all agents (including widely held firms and risk neutral individuals) because of the impossibility of complete contingent claim contracts. The theory is outlined first, several examples are discussed, then conclusions are drawn. Insurance and the Costs of Contingent-Claim Contracting The general proposition here is that the insurance industry supplies services that reduce transaction costs in trade. Traders faced with the problems of contracting realize that a complete contingent claim contract that regulates all possible outcomes is infeasible because of the costs of identifying all events, negotiating, pricing, documenting that contracted liabilities have occurred, and enforcing the contract. The presence of these costs means that contingent-claims contracts are subject to a credibility problem: the parties cannot take for granted that the obligations of the contract will be fulfilled. Contingencies that are too costly to regulate contractually may be insured. When the risk is insured, it is sold (at a negative price) to a third party, the insurer. (1) To illustrate, assume that a manufacturer and a shipper enter into a contract for the transport of the manufacturer's machinery. Their contract specifies the price and date of delivery as well as some other basis details. However, the contract does not cover contingencies such as fire, storm, and explosion risks because they have too little knowledge of the risks to be able to price liability and precautions and because the liable party may not be financially able to fulfill the agreement if a serious accident occurs. …