University of Latvia

Uldis Berķis





of the

Doctoral thesis

for the acquisition of the scientific degree Doctor of Economics (Dr. oec.)

Field of Science: Economics

Branch of Science: Econometrics

Riga 2004


Insurance market is a vitally important economic institution where mutually beneficial exchange between consumers - insurance takers and vendors - insurance companies is carried out. Consumers purchase the promise of the insurer to cover the financial consequences of a possible loss, paying the insurance premium for this service. The insurers take the liability to cover the losses in case of a probable harmful event and issue a special document testifying the power of the contract - the insurance policy. Information is crucial for market exchange to occur - consumers have to possess the information about supply and prices, vendors - about demand and paying ability of their clients. Modern economic theory attributes to the market an important innovative function too - the market encourages vendors to create new products and bring them to the market in response to the emerging demand for them.

Security for the future strongly influences the welfare of people by making better the personal well-being and by allowing for more risk taking activities unfolding the entrepreneurial spirit in an environment where insurance against harmful loss is available, therefore fostering the way to a higher economic performance. Therefore, the insurance industry is an extremely important element of any national economy and social policy, it has been irreplaceable during the early capitalism and centralised economy era, and its role does not diminish in free market economy.

Unfortunately market mechanisms are not always successful in creating new products in response to market demand for them. In the transition type economy of Latvia the extent of problems due to impossibility to insure some groups of items and processes under risk is permanently increasing. It occurs due to the absence of suitable offers for insurance or incompatibility of the demand and supply characteristics. This was the main cause why it was not possible to design the health financing reform in 2002-2003 where the cornerstone of the reform was the introduction of private mandatory health insurance in contrary to the present centralised public system. Occasionally problems are caused by the weak agricultural insurance sector. In cases of severe accidents inflicted by dangerous cargo transporters, the liability proved to be insured in very rare cases. But even in the areas where total insurance premium income is high, heavy structural market problems remain present. In 2003 a new discussion started regarding the compulsory motor third part liability (MTPL) insurance in connection with decentralisation of the tariff system - shifting from nation-wide unified tariff tables to individually determined tariffs by each company. In cases of fire at wood

processing factories only exceptionally they appeared to have been qualified for property insurance. This scope of problems in the thesis is analysed for the non-life insurance sector.

Microeconomic theory has shown the leading role in market failures of the unequal distribution of information. However, advanced economies have created efficient tools and adopted market mechanisms, "which help to control for these information distribution effects in a manner that the extent of the market failure is significantly reduced. The scope of problems, why such mechanisms are absent or are not efficient enough in transition type economies, will be analyzed in detail in thesis.

Statistical data of Latvian insurance sector reveal a strong upward dynamics in 1996-1999 when insurance penetration increased from 1.38% to 2.42%. Starting with 2000 until 2002 stagnation and even a downtrend followed where penetration dropped to 1.99% in 2002, despite the big annual

increases of the GDP, e.g. 7.7% in 2001.

Formulation of the research problem. Importance of research

According to risk assessment and management methods the insurance market can be split up in two main segments: mass (standardized) insurance and industrial (special) insurance.

In case of standard insurance statistical methods of risk assessment are prevailing. Only a limited number of previously determined characteristics of the object under risk are involved into premium calculation. In case of industrial insurance special risk assessment methods are used. Complicated technical tools are implemented; expert methods are of high importance.

Thesis is devoted primarily to the mass insurance segment.

In Latvian insurance market for certain mass insurance products one can observe severe market failure. It is therefore an important obstacle for increasing the welfare of people und barrier for the successful development of small and medium enterprises. Market failure takes the following forms:

- Demand is not justified by any kind of supply of product demanded -
total market failure. Other possibility - parameters of demand and supply
are incomparable, therefore almost no exchange can occur. Examples -
long-term health insurance, lawyer's expenses insurance, agricultural

- Supply is present on the market, but risk assessment and/or premium
calculation methods are by far not optimal:

Ø MTPL insurance - risk rating methods based on collecting data about insured's loss history, storing this information in a common shared

database, are not employed due to overaggressive marketing methods dominating the market, even despite the fact that use of this shared database is prescribed by law;

Ø no common database about insurance objects bearing elevated risk and cases of insurance fraud is maintained (private TPL); there are no common rules of information exchange about dubious loss cases while the information exchange occurs only in informal bilateral way (motor insurance);

Ø economic characteristics of insurance operations, e.g. the share of administrative expenses show a high inefficiency in global comparison (life insurance, accident insurance).

The actuality of the research topic is determined by the overall importance of described problems for the national economy of Latvia (shown in part 1 of the thesis). Recent efforts to solve these problems have been unsuccessful, market failures persist. The role of information in appearance of market inefficiencies and failures, as shown by microeconomic theory, is very important (review- in part 2 of thesis). However, in countries with traditionally well developed insurance markets problems caused by information asymmetry are efficiently controlled, insurance products, not available on Latvian market, are offered in these advanced economies on the free market by private insurers. Therefore, the research of specific properties of transition economies related to market failures in insurance market is an up-to-date and valuable research topic.

The object of study is the insurance market in Republic of Latvia during economic transition from centrally planned to market economy.

Aim and objectives of the research project

Via analysis and evaluation of the role of information on insurance market with special emphasis on economies in transition, to formulate the role and place of information aspects in economic reforms and optimisation processes in the insurance industry, and to characterise the opportunities of information technologies in the process management in insurance market under conditions of information asymmetry.

To accomplish the aim of the research project, the following research tasks were formulated:

1. To analyse classic theories of information asymmetry in the insurance
market and their recent developments with special attention to possible
specific emphasis for transition type economies.

2. To analyse the experience of health financing reforms in countries with
a decentralised, private full health insurance. A special emphasis must
be put on solutions of selection problems and risk balancing
mechanisms, especially - the problems of statistical data availability for
building of these mechanisms.

3. To evaluate capabilities of information and communication
technologies on reduction of the information defect from the
microeconomic and from ethical point of view with special emphasis
on bioethical dilemmas in case of health insurance.

4. To evaluate selection problems in case of insurance sales over the

5. To evaluate the experience of cooperative behaviour of the companies
in the insurance sector such as advanced western, Baltic and other
Eastern European economies, and impact of this behaviour on branch-
wide information management.

6. To study quantitative relationships between information flow and
market equilibrium.

7. To formulate a programmatic approach for elaborating information
aspects in economic reforms, at first - in health care financing.

8. To offer proposals for further research, especially in the field of
consumer risks where the asymmetric distribution of the information
about insurer is dominant. Both direct and indirect consumer risks
have to be considered.

Theoretical and methodological foundations of the research

The theoretical basis for the research process consists of scientific works of recognized scientists. The methodological basis was created after thorough and extensive analysis of scientific literature. These scientific works were used while preparing the thesis and they are listed in the bibliography section. For fieldwork, statistical data collections of Latvia and other economies in transition have been used, including special checklist about Internet use in sales. Statistical data sources of advanced western economies and international organisations, especially of OECD, WHO, CEA have been

investigated for the research. Reliable Internet sources, broadcasting and printed media were used.

The most recognised authors working in the research field are:

- Information asymmetry in insurance markets - K. Arrow, G. Akerloff, J.
Stiglitz, M. Rotshild, Ch. Wilson.

- For research on economic theory of insurance D. Farny, health and life
insurance - S.S. Hubner (his work was followed by K.Blake and H. Skiper),
P. Zweifel. From earlier authors works of A.Manes must be mentioned.

- Economic theory of health insurance - K. Arrow, A. Enthoven, P.
Diamond in USA, V. van der Ven in the Netherlands, P. Zweifel in
Switzerland, M. Graf von Schulenburg in Germany.

- In Latvia there is little research on problems of insurance. In the field of
risk management research was done by E. Vasermanis, A. Jaunzems. In the
field of social and economic forecasting - E. Vasermanis, D. Šķiltere, B.
Sloka, L Frolova. In actuarial science research projects were carried out by
J. Carkovs at Riga Technical University and A. Reinfelds at University of
Latvia. Research about e-business was conducted by U. Rozevskis. Some
research on health care economy was carried out at Medical Academy of
Latvia and University of Latvia.

The innovative research reflected in thesis has been carried out and published in scientific articles and presented on scientific conferences by the author.

Research methods

In the thesis general epistemological methods were used - formal and constructive, inductive and deductive logics, historical and international comparisons, expert methods. Methods of economics were employed -microeconomic analysis, statistical and econometric methods, mathematical modelling in economics. For the exploration of mathematical models, methods of differential calculus, mathematical programming - conditional and discrete optimisation, solution methods for nonlinear equations were employed. For simulations - numerical methods have been used.

Limitations of research scope

Doctoral thesis cannot contain comprehensive reform plans because there are other important factors acting on the insurance market beyond information. For instance, in case of health insurance there is the insurance market and the market of medical services. Thesis is devoted only to the insurance market. Thesis does not contain actuarial considerations and topics about asset

management in insurance companies. At this stage of research it was not possible to include investigations about strategies based on statistical analysis of extreme values, a rigorously developing topic of modern mathematics.

Structure of thesis

Thesis consists of 3 parts, conclusions and proposals and the list of bibliography (216 units). 11 supplements are added at the end of thesis.

Thesis is designed as a problem-oriented systemic analysis. The first pan of thesis deals with the economic importance of the problem under study (system outputs). Second part contains the problem analysis based on theoretical methods and the comparisons (reveals the system mechanism). Therefore the second part is much larger than other parts because of strong practical implications, which are given already in this part. The third part of thesis is devoted to programmatic considerations and practical implications (control via system management and external inputs). Conclusions and recommendations are given at the end of thesis.

The theoretical direction of thesis is information economics and econometrics; the emphasis is put on new developments that have emerged due to the progress in information technology and communication, best known as network industrial organization theory. If the original microeconomic views on market asymmetry which emerged in 60, 70-ies of the 20th century were purely theoretic, then now it is possible to find technological solutions for information asymmetry problem. The areas of research pertinent for investigation of economies in transition have been emphasized. From management science, the concept of absorptive capacity has been used.

Original contribution of thesis author

1. The specific features of market failure due to information asymmetry
in case of transition type economy have been characterised. Economic
mechanisms of market failure have been characterised in case of
empirically evident failures of health (long-term compulsory), liability
and crop insurance.

2. Analysis is done on information asymmetry control methods in
connection with inefficiencies and failures in insurance market in
Latvia as a transition economy. Practical recommendations have been
elaborated and corresponding technological solutions described.

3. The role of data analysis and processing methods in risk management
mechanisms and their impact on control for information asymmetries
in insurance market with a special emphasis on transition economies is

described. Analysis of enforced risk balancing mechanisms and their impact on market failures is presented.

4. A mathematical model of risk balancing measures between insurance
companies on the market, partially counteracting the market failure, is
elaborated. This partial risk-balancing model has separability
properties and does not depend on accounting statements presented by
companies externally. A logically empirical sequential algorithm for
implementation of risk balancing measures in case of insurance product
innovations has been proposed.

5. A 10-point program for evaluation of information asymmetry aspects
in case of reforms in health care financing is proposed.

Practical relevance of the results of the thesis

Thesis covers topics from different fields; therefore applications are of diverse nature.

Research topic about information technology support for decision processes in insurance companies acting on market with severe information asymmetry is used in developing a portfolio management system. It is directly related to insurance business server as a wide spectrum solution to cover information needs of an insurance enterprise.

As to insurance business servers the following theoretical considerations have direct implications:

- OLAP and OLTP integration as risk management method with
remote processing and instant data delivery capabilities;

- business server as an important source of information for various user
levels and types. The transformation rules of information for users at
various levels are stored in the business server. Business server can
offer business intelligence processes — data mining, warehousing and
knowledge management. The practical rules and channels for
knowledge dispersion in insurance company via business server are

Regarding the use of shared databases for MTPL insurance, the author of thesis participated in regular workshops organised by Latvian Traffic bureau where questions about cooperative use of shared databases were thoroughly discussed.

It must be mentioned that in advanced insurance markets shared databases function successfully and are an integral part of risk assessment methods in these markets. However, considerations of the information privacy and

intellectual property allow distributing only very little information about these data bases.

The part of research concerning the role of shared databases in health care system and the management of aggregate risks was used in preparing the teaching courses "Data base technologies for health management" and tutorial course "Statistical methods for aggregate risk management" offered for students of public health at Latvian Academy of Medicine in 1999-2001. A course in quantitative methods including Bayesian risk was offered to students of occupational therapy in the joint project with Lund University.

Accompanying the research activities 8 scientific publications were written according to Latvian "Provision about promotion". Results of the Research were presented at annual EAEPE1 conferences in 2001 in Siena, Italy and in 2002 in Aix-en-Provance, France, and at a number of conferences in Latvia.

Synopsis of the research results

1. Analysis of problems in Latvian economy related to insurance

Looking at the development of the insurance sector in Latvia during the transition from the centralised to the market economy, two remarkably different periods can be recognised. In 1996-1999 a rapid growth of GDP has been accompanied by even faster growth in the insurance sector, especially non-life insurance. Origins of the growth are product innovations, especially the introduction of MTPL in 1997.

On the contrary, in the 2000-2002 period, despite the fact that GDP increase regained its speed, previously lost, due to Russian currency default in 1998 and the global slowdown in 1999, no comparable growth in Latvian insurance sector was observed, the market penetration decreased and is still decreasing in 2002.

Cross sectional analysis of new markets (countries in transition and developing countries) reveals overall tendency for non-life insurance to grow faster than the GDP. A hypothesis that supply side (not sensitive to income increases) problems due to lack of product innovations caused macroeconomic stagnation in the insurance industry during 2000-2002 period is proposed, in contrary to demand side (income elastic) problems dominating in the first phase of the transition until 1999. Therefore the first task the thesis is concerned with is the detailed analysis of market segments

1 European Association of Evolutionary Political Economy, http://www.eaepe.org/

where significant problems for product innovations prevail despite the demand present in the market. In 2003 there is to expect an increase in non-life market grow, however, the leading force will be not the product innovations, but the explosion of issued private mortgage amounts and the requirement to insure the property purchased on a loan. In this way specific trapping effects are created - insurance takers are bound to their insurer, even if the premiums they pay are increased selectively - more for clients which are already tied to the insurer.

The most important segment of the market scrutinized is the long-term and/or mandatory private health insurance. In case of Latvia it plays a special role - in 2002 a new reform in health care financing was proposed by the political party "New Era". This was without any doubt planned as the most radical reform in health care financing in Latvia and one of the most remarkable economic reforms at all. The cornerstone of this reform design would be the decentralisation of health care financing in Latvia with private insurance companies as major finance managers.

Analysing the present state of the Latvian private health insurance market, a conclusion is drawn that insurers offer only short-term contracts, full insurance cover is offered only when insuring groups - usually the whole staff of firms (but premiums are not always paid by the employer therefore it can not be characterised as employer's paid insurance). Due to short-term character of contracts the insured persons can not get the European-type life­long insurance guaranties, despite the fact that Latvian Insurance contract law already prohibits premium adjustment in health insurance due to risk reassessment. Affiliation of the insurance with the employer decreases mobility of labour and therefore acts against principles of free competition in the labour market causing macroeconomic suboptimality. However, this affiliation js beneficial for the insurance companies because it is an effective way of risk aggregation with indirect selection properties, since severely ill persons are rare in labour market, especially in a transition economy where social protection is low. The form of insurance as three-sided group contract discourages insured persons from lawsuits against the insurer as it collides with interests of employer, besides that, it is an effective way to decrease premium collection costs.

The aim of the decentralisation of health care financing into hands of private insurers in Latvia is the expected increase of welfare due to increases in the economic efficiency. Besides that, private insurance can stimulate the insurance takers to increase their contributions because individual differences in insurance cover can be guaranteed. This point corresponds well to similar market oriented reforms all over the world. However, empirical observations

show that in case of mandatory private health insurance (without risk selection possibility by companies) like in Switzerland und the Netherlands, special risk balancing mechanisms operate in the insurance market in order to eliminate the misbalance in aggregate portfolios of companies caused by selection problems. Therefore analysis of these balancing mechanisms can give a hint to which extent such mechanism will be necessary in case of Latvian reforms. Remarkably - reinsurance plays a minor role in Latvian health insurance market with share ca. 1 %.

The proposed reform was unable to start because a severe market failure emerged - insurance companies did not offer mandatory full health insurance products necessary to carry out this reform. Despite the fact that a new large segment of national economy was offered to be serviced by private insurance companies, which could double the present turnover of insurance industry, companies avoided to enter this market. An additional drawback of this reform, as viewed by insurance companies, is the "big bang" approach, forcing most of the population at some time moment to seek for an appropriate insurance.

In case of Latvian MTPL insurance, the bonus/malus system for premium determination is based on the data about previous period losses, allowing selective premium changes based on them. Therefore the shared database plays an imperative role in tariff calculations in this branch. However, despite the fact that such information is available, insurers do not use it. Price discount wars persist in this branch reducing the total premium income. Joining the EU will put new requirements on MTPL, especially - to increase sums insured. The decision of the government is to decentralise entirely this insurance branch and not to empower higher importance of shared data for selective premium calculations. In this case insurance companies can experience a big problem due insurance takers switching their insurer after a loss. This way the share of high risks among insurance seekers would be increased.

In case of motor insurance (against theft and damage) statistical data reveals significant increase in premium rates after 1999 for contracts insuring the vehicles belonging to physical persons. At the same time no shared database exist for the prevention of double insurance and other forms of insurance fraud and for control of moral hazard. Therefore selective increases of premiums are applied only in cases where the company already is in possession of the data about elevated risk or if such information is obtained via informal bilateral exchange. Such informal information exchange may cause complications as regards protection and data privacy standards in the EU. Empirically non-selective premium increases are observed which lead to

drop of demand as observed by decrease of the total sum insured for this branch.

In case of private liability insurance, a very low number of contracts can be counted in Latvia. Insurance of lawyer's expenses is absent in Latvian market. Severe problems are caused by animal's owners' liability, but insurance contracts in this branch are very rare. All these branches are characterised by high potential of insurance fraud, in case of Latvia- by absence of effective tools of moral hazard control too. These points determine the low numbers of contracts, as these insurances are not readily offered on the market. In case of carrier's liability insurance, the society demands to make it mandatory. However, the strong lobby of oil transporting companies can easily produce contra-arguments to the mandatory character of this insurance because premium rates demanded in the market for dangerous materials carrier's liability insurance are inappropriately high.

Agricultural, especially crop insurance is a very severe economic and social problem in Latvia. The analysis of this problem reveals that the main reason is the non-differentiated approach in calculating the subsidies paid by the government to farmers in order to partially cover the insurance premiums. But the probability of loss due to weather conditions in case of crop insurance in Latvia is different form place to place. The cause why subsidies are non-differentiated is the lack of effective risk assessment tools because statistical data exist only in a coarse aggregated form. This problem of risk assessment has an impact on insurers too: as the assessment procedures show a low forecasting power, the premium surcharge due to uncertainty is high, and therefore will be not accepted by farmers. In case of crop insurance, the risk must be managed for long periods of time; however, in case of transition economies such long-term approach is difficult to attain- the profit is calculated for almost every product for every year and decisions depend on these short-term statistical measures.

In case of life insurance, the main problem is the overall high share of administrative costs. Therefore this branch is excluded from further consideration, as it is not directly related to the main research topic.

Managers of insurance companies attribute the stagnation in the market to prevailing downward pricing tactics followed by some companies. However, downward pricing is obvious only in case of MTPL. Besides that, during periods of very high GDP growth irrational price decreases in markets for private consumers are not characteristic. Cases reviewed in part 1 of thesis

state that significant supply side problems exist in Latvian insurance market, not attributable to downward pricing.

Study of selling channels, as a possible cause of market capacity confinement, reveals the high resistance of Latvian insurers to selling insurance products over the Internet. In Latvia at present it is possible only to fill in the application forms over the Internet. Surveys reveal that the dominant point of view is that insurance products are not eligible for Internet sales due to lack of institutions, which support that process. However, there is other specific trait of transition economies as well - technical problems are evaluated as unimportant, showing that transition economies in technological matters are sometimes more advanced as is the case in western economies.

2. Information economics in insurance

2nd part of thesis starts with the description of the basic theoretical concepts of information economics related to insurance market. They are followed by thorough analysis of theoretical models applied to case studies regarding these markets.

Chapter 2.1 is devoted to notions of risk, risk balancing, insurance, insurance company and insurance market. Connection between earlier definitions and present developments are discussed.

Chapter 2.2 is devoted to foundations of information economics. At first various notions of information theory are reviewed. The notion of information asymmetry is introduced, defining it as a property of mutual interaction where one of the interacting sides has more (qualitatively or quantitatively) information than the other side. In case of market that means - either the customer is better informed or the vendor about some entity relevant to their intended exchange in the market. Thesis covers predominantly the situation where the insurance buyer is better informed about the object she/he wants to insure than the insurer is. Two main forms of information asymmetry are considered - adverse selection and moral hazard.

Chapter 2.3 is devoted to industrial organisation of insurance industry especially in connection with risk balancing principles. The production process of insurance company is defined as the management of the aggregate risk - portfolio. Aggregate risk is a random variable - therefore a risk in the strong sense. In models considering premiums and losses as a random value, the profit of an insurance company is under the entrepreneurial risk. The process of risk underwriting together with aggregate risk management determines the entrepreneurial mission of an insurance company. If the risk

management in company's portfolio is inadequate due to incomplete risk assessment methods or the manager has not the whole power over selection of clients as in the case of mandatory insurance then secondary risk balancing methods come into play, two most important being coinsurance and reinsurance. Alternative forms of risk balancing are mentioned, the simplest being the insurance pool. Organisational specifics of insurance companies in transition type economies, in connection with empirical evidence, are scrutinized.

The optimal strategy of the insurer in the market with information asymmetry where insurer is the less informed side is considered in chapter 2.4. Profit maximisation problem of the insurer is formulated. Classic theory of market equilibrium in presence of information asymmetry is reviewed. Differences between optimal strategy in market with symmetric information, in monopoly market with asymmetric information and in free market with information asymmetry are discussed. In case of free market the nature of the equilibrium depends on endogenous parameter r - the share of high-risk objects in the market. Depending on r a separating stable or a pooling unstable equilibrium states are possible. The concept of E2 equilibrium of Ch, Wilson is reviewed, formulated as antagonistic prisoner's dilemma game.

If for the actual value of r a stable equilibrium does not exist but the particular market is of high importance for the national economy and social policy, the only possibility to escape from the market failure is the interaction with this market beyond insurance companies. In the best case reinsurance or coinsurance treaties can be put in power, and market failure is eliminated because the reinsurance company can attain better characteristics of consolidated risk on secondary market. In cases where severe unavoidable information asymmetry is present in the market or selection procedures are very restricted as in case of mandatory insurance, reinsurance plays a minor role. In this case the enforced risk balancing among primary insurance market participants can be a solution. That means deviation, but only temporarily, from the freedom of the insurance market. However, the enormous severity of such market failures, observed in case of transition economies, according to views of thesis' author, is backing the introduction of enforced risk balancing mechanisms deviating from market freedom. However, the main obstacle is - these balancing mechanisms are complicated and highly depend on risk assessment mechanisms, therefore they must be tailor-made for each insurance branch. Besides that, the efficiency and drawbacks of these mechanisms are impossible to determine before these mechanisms are put into play.

The extent of risk balancing between players on the primary market depends on risk assessment methods available for such balancing mechanism. Risk assessment methods depend on the amount of statistical information usable for creation and tuning of such methods. It can happen that in case of governmental risk balancing system, more statistical data are available to estimate parameters of risk and therefore more exact risk assessment devices can be created as possible for a single insurance company. Risk balancing in primary market can never be complete. In practice risk balancing starts with the most primitive form - cost balancing system between market participants. As it counteracts with the free competition, risk balancing must develop in the direction of more a priori methods, as they keep free competition principles more intact.

Chapter 2,4.7 considers a mathematical model of insurance market under information asymmetry where the internal state parameter g - share of high-risk objects - depends on information inflow into market, making g to obey some law of dynamics. Two models are created to show the portfolio dynamics of vendors, assumed they enter the market consecutively. Using numerical simulations it has been shown that for broad range of model parameters the company, which enters the market as the second, is the winner in this market game. Every next intruder attains a higher profit norm, but the share of market the next intruders (3, 4...) can attract is significantly smaller, therefore smaller is the total amount of profit they can get. In case of market segments where significant lock-in investments are required, nominal profit poses determines a strong limitation on market entry decisions. Conclusions about enforced risk balancing are drawn. This leads to the idea that in the initial phases, after marketing opening, when lack of statistical data for elaboration of risk assessment methods persists, mathematical methods can be used instead of econometrical ones in order to create such redistributive mechanism in the market that the market failure can be prevented.

Chapter 2.5 is devoted to methods of information asymmetry reduction. If in the case of instrumental methods and methods using shared data bases the conduct of asymmetry control and ethical regulations is pretty clear, then in case of signalling - allowing the insurance takers to deliver reliable information that his/her risk is lower - very severe ethical dilemmas emerge, especially in case of health insurance, determined by bioethics.

Selling of insurance over the Internet is discussed in the chapter 2.6. It is stated that, if the buyer expects that in case of personal interaction the seller will exploit him via bargaining mechanisms, as is usually the case of insurance

offered sales representatives, then the buyer can prefer an anonymous market, as is the Internet.

Due to historical traditions and due to recent developments in optimal contract and incentive theory, the aspects of information asymmetry from the viewpoint of optimal contract concept is discussed in chapter 2.7 The analysis of Latvian insurance legislation makes us conclude that it is effective enough to exhaust the information asymmetry control possibilities via designing optimal contracts. Regarding the economic legislation, also the second type of insurance asymmetry - the insured is less informed about insurance company's solvency and the true quality of reserve assets as the company self, is scrutinized. A proposal to make Latvian legislation more efficient is to reduce the extent of residuary rights which generally are used too extensively in transition type economies where power groups have sometimes almost unlimited power.

Chapter 2.8 covers analysis of information asymmetry specifics in various insurance branches. The conclusion drawn is that there are very significant differences between asymmetry extent and possibilities for asymmetry control. That corresponds well to empirical observations that market failure due to information asymmetry is observed only in some branches, but never in all.

According to authors' special interests the emphasis in thesis is put on the health insurance. Chapter 2.9 is devoted to an essential study of health domain in connection with financing schemes und the role of insurance. Here a very strong distinction must be made between long-term and short-term health insurance. In case of Latvia the market failure for long-term health insurance can be observed. The offer of short-term insurance is abundant, however, absolutely predominantly as a group insurance.

At first the historical process of decentralised (public or private) health insurance emergence is reviewed. It can be concluded that the emergence of this type of health insurance was strongly favoured by the insurance organisation in a very strong affinity to professional groups; health expenses could be forecasted based on the occupational parameters of an insured person. Today the emergence of decentralised health insurance schemes this way is impossible since most of the working population are employed in service sector where occupational hazards are not characteristic. As a consequence - the life style impact on health is much greater than the impact of occupational parameters. Increasingly important are becoming the hard measured risk determinants associated with consumer's behaviour and external influence on consumers, e.g. advertising. Therefore the character of

uncertainty in health insurance today is of thoroughly different nature as it was when first organised decentralised health funding units emerged. Information asymmetry therefore bears very complex nature in health insurance and the potential of exaggerating losses in an insurer's portfolio due to adverse selection is high. Therefore information asymmetry can explain the initial market failure in case of Latvia - as the insurers expect the adverse selection to cause the market failure, they do not offer any insurance products in this market segment at all. Reinsurance plays a minor role in case of Latvian private health insurance market, and mostly reinsured is the traveller's health insurance. Therefore, as a solution of market failure in invention of long-term (in fact, life-long) and/or mandatory health insurance only enforced risk balancing measures among insurers in the primary market will remain. From the viewpoint of risk theory, long-term insurance is not equivalent to mandatory insurance; however, this broad discussion is omitted in thesis as market failure is observed in both cases.

International comparisons show that the sustainability of free market mechanisms depends crucially on the presence of a priori risk assessment mechanisms. If such mechanisms are not available to insurance companies, it can happen that due to higher amount and quality of data, effective risk assessment mechanisms can be created by national institutions. But enforced risk balancing can be viewed only as a temporary measure as it counteracts with market freedom. In real life the evolution of the risk balancing systems can be observed: for instance, in the Netherlands, the initial balancing system was based on cost determinants, and is evolving more and more towards nation wide a priori risk rating system consistent with free market principles. A well-known example of such a priori risk rating system, partially implemented in the Netherlands's present system and consistent with free market principles is the groundbreaking CCHP (consumer choice health plan) system developed in the USA by a group of economists lead by A. Enthoven. Therefore in the thesis the causes why CCHP could not be implemented in the USA (but its elements are still used in various countries) — predominantly due to pressure from various interest groups - are analysed. CCHP is a very good example where a market oriented system can be more socially fair as the existing solidarity based systems. For reform evaluations access motive to health insurance plays an important role.

A duality in private health insurance market can be observed: either there are risk assessment methods available to private insurers and they have an option to perform risk selection procedures, as is the case in the USA and private substitutive health insurance in Germany, countries with big populations and therefore big amount of statistical data available to statistical

estimation procedures. Or there is the obligation for the insurer to accept every risk (mandatory insurance) and nation wide risk balancing system adjusting the risk among the market participants, like in Switzerland and the Netherlands, is functioning. In case of mandatory insurance "cream skimming" poses an important problem, where in case of transition economy additional indirect selection of preferred risks is possible as bad payment discipline discourages selectively the high-risk individuals.

In developing risk assessment mechanism in health insurance, significant statistical problems arise - distributions of costs do not obey the normal distribution, in fact, they are of complex discrete - continuous type. For estimation of parameters, the fitting procedures require high amounts of data collected, from homogeneous risk groups. Insurers, as a rule, are not in possession of such data. Serial correlation due to outrageous trends in population health may persist, for instance, in obesity indicators.

Next chapters are devoted to information technology aspects. With the development of network industries technological solutions for asymmetry problems have emerged, however, causing significant ethical dilemmas. The main idea is to use OLAP solutions to support not only strategic, but also tactic decisions. OLAP methods cause fewer conflicts with information privacy legislation.

The spectrum of most important IT solutions associated with insurance company consists of operative IS supporting everyday activities, mainly in form of transactions, and the management information system which supports strategic decisions. Next level, implemented by far not every company, are business intelligence (BI) solutions. The simplest BI solutions are quantitative analysis systems - data warehouse systems processing hard facts stored in dimension-measure models. More complex are the knowledge management systems that can process soft facts - of qualitative and/or fuzzy type.

The chapter in conclusion of the 2nd part deals with the cooperation between insurance market participants. Collective strategies are analysed by using case studies from Latvian market. These strategies include the rules for information delivery, use and access rights to shared information. The first example is the MTPL insurance. In this case law prescribes the shared database implementation and risk ratings must take in account information stored in this database when determining the tariff premiums. However, insurance companies do not use this information. The resulting non-cooperative equilibrium is modelled by prisoner's dilemma type game; the matrix of game is calculated and the properties of emerging non-cooperative

equilibrium are scrutinized, from diacritical point of view too. The conclusion is drawn that this non-cooperative equilibrium is stable and there will be no solution to this problem inside the present MTPL system (author's publication in 2000). Indeed, in 2003 there is a law amendment, which decentralises the premium calculation principles in MTPL insurance, postponing the shared data base use - tariffs will be determined by companies itself. But that can cause significant increase in premiums as risk rating procedures are not improved by the decentralisation. Another example discussed here is the shared database for motor insurance (against theft and damage) as means against insurance fraud. This is modelled by public goods game and conclusion is drawn that in market without a market leader the initial process of shared database approach is very problematic. Concluding remarks in this chapter mention results of experimental economics, especially strategic theory of evolution of cooperation invented by R. Axelrod and it's implications for non-cooperative equilibrium in insurance market.

3. Strategic use of information in insurance

In the last 3rd part factual material and programmatic proposals reflecting the theoretical analysis and case studies in the previous parts are presented. Implementation of IS for information flow optimisation in insurance industry is discussed, technical solutions are proposed.

At first the facts are discussed about impact of the market structure on cooperative behaviour of insurance companies. The conclusion is -cooperation is facilitated by presence of a market leader as in Poland and Lithuania or by a small number of players in the market as in case of Estonian economy (MTPL is conducted in Estonia with very intense use of shared data base). Therefore the clear absence of market leader and the big number of players in the market explains prevailing non-cooperative behaviour of firms in case of Latvian insurance market.

The absolutely necessary prerequisite of cooperative behaviour is - it must not facilitate the market entry by new competitors, otherwise the situation of present vendors in the market will get worse, as they have already incurred losses in order to gain the information stored in shared database. Setting the price for information can solve this problem. Complexity of rules and potential of moral hazard calls for strong institutionalization of such market for information. Enormous treat to shared information use poses disinformation, examples of that can already be observed in case of credit reporting in Latvian consumer loan market; it can be expected also for shared data bases in insurance.

The author formulates hierarchical approach to product innovations in insurance market under information asymmetry. Risk balancing in the market is emphasized as the last instance where all more market oriented secondary risk balancing measures have failed. It must be of temporary or self improving nature in order not to destroy competitive forces. In this way insurance operations can be initiated in segments where severe market failure persists. The construction of risk balancing system will require significant investments, but they will be compensated by welfare gains arising from product innovations.

Regarding programmatic approach to reforms in health care financing the aims of reforms in this area are the following.

- Achieving a higher level of economic efficiency. In Latvian situation
this can be only a long-term goal as present balance sheets reveal
relatively high share of costs.

- Investment appeal to consumers. If consumers get aware that
premiums they pay for long-term health insurance today will offer
them access to medical services in older years, significantly above the
level guaranteed by the public health system, they can deliver
significant financial resources to health sector now. This holds true
both for full insurance and for supplementary insurance. In this case
the psychological framing can serve for increased financial resources
flow into health sector.

- Private insurance can better define rights to use health services, and is
generally more efficient for moral hazard control.

Therefore the following 10-point practical programme is proposed for the evaluation of health care financing reforms based on decentralisation and competition from the viewpoint of information asymmetry.

1. Selection procedures available for insurance seeker in the market. In
2002-2003 Latvian reform plans free choice of insurer was intended.
However, if the consumer can choose the vendor freely then the risk
policy and even resource planning procedures of the insurer do not
make sense, the insurance process will be of purely experimental nature
and this uncertainty will cause premium surcharges and "cream

2. Will the insurance be offered on the market by specialized health
insurance companies or daughter firms of the existing companies with
separated balance sheet or will the insurance be offered similarly as it is
being done now - without financial separation from operations in

other branches? In the last case the risk balancing mechanisms based on costs are problematic.

3. Supply side: will be product variations allowed? Will there be any price
discounts and product bundles allowed?

4. Control of delivery of medical services: how the market for medical
services will be managed in case of private insurance? Which
mechanism will be employed for moral risk control (deductive,
limitations of total amount available for some services during the


5. Will the premiums at 100% be paid from the public sources - state
budget (subsidy type system) or some part will be paid by the insured
(premium type system)? How far will risk rating be allowed? Which
premium differentiation criteria will be allowed?

6. Which risk balancing mechanisms are possible? How will "cream
skimming" on the market be prevented?

7. How will losses from insurance operations be (if at all) covered for
companies with respect to enormous social importance of health
insurance? What will be done if the total profit for this market segment
will be negative? One has to take into account that EU standards
discourage national governments to impose on private insurers'
operations, especially long-term, which are in general unprofitable.

8. Will the insurance companies pay sickness allowances too? If not, they
will lack effective stimulus to perform the curative process as fast as
possible, in order to avoid cost-intensive measures they will prolong
the sickness period.

9. How preventive measures and public health promotion procedures
will fit into the insurance scheme?

10. How will the actual family and occupational status of the insured fit
into insurance scheme if premium payments are planned?

Conclusions and recommendations

National economy level

Causes of market failure

1. Information asymmetry plays a major role in emergence of market
failure also in transition economies - the consequence is the absence
of necessary insurance products in the market. If during the initial
phase of transition demand side problems were responsible for
market weakness, then in the next phase- after 1999- supply side
problems play the main role, where information asymmetry is the
most coherent explanation of product innovation shortages.

Non-cooperative character of information use and insufficiency of data resources for effective asymmetry control determine the long-term nature of market failure. The lack of statistical data for the development of effective risk assessment tools is a problem, especially important in transition economies. This problem explains the risk differentiation difficulties and, as a consequence, the lack of products for crop insurance, lawyer's expenses and long-term health insurance. The increased impact of information asymmetry also explains the impossibility of historically reductionistic reforms in the field of health care financing.

Health insurance

2. Reform concepts providing mandatory risk transfer from consumers
to private insurers cannot reach their goal if they do not provide risk
balancing mechanism because insurance companies do not want to
absorb all selection risk in market with severe information
asymmetry. In case of "big bang" type reform, as the one planned in
Latvia, the balancing mechanism must be defined already at the initial
phase of the reform. The development of (enforced) risk balancing
mechanism in primary market can be conducted via sequential
procedure: initially balancing after cost characteristics is employed,
moving toward a priori risk balancing mechanism (consistent with
free competition) depending on information accumulation.

The goals, which can be reached by decentralisation of health insurance into hands of private insurers, are introduction of more competition into insurance market in long-term and inflow of additional resources into health industry in medium-term. These

processes can be initiated by full cover as well as by supplementary health insurance.

3. The present marketing strategy of insurers selling health insurance on
Latvian market reflects the approach of shareholders - predominantly
foreign insurers and reinsurers - to protect the investments by high
precaution and avoiding market segments where high oscillations of
loss amounts are combined with long-term liability. Therefore in the
private health insurance "cream skimming" prevails now - insurance
is offered only for groups and only as short-term contracts, which
after the expiration of the contract term must be renegotiated.
However, from the social point of view, long-term contracts are
strongly preferable. Transition from short-term to long-term
contracts poses a big challenge to insurance companies and requires
high investments into principally new risk assessment mechanisms.

4. 10-point exhaustive program for the evaluation of information
asymmetry aspects in health care financing reforms is elaborated (page
49 of synopsis). The proposal is - to use this program in the
evaluation of health hare financing reforms in case of transition type

Market failure in other insurance branches

5. The cause of market failure in crop insurance is the not actuarially fair
nature of subventions paid by the government for covering insurance
premiums; therefore adverse selection is a big danger to the insurer. In
carrier's liability insurance the cause of high premium surcharges and
following market failure is the significant uncertainty due to the lack
of structured data for statistical estimation of loss probabilities. In
case of private TPL and lawyer's expenses insurance, the leading
problem is the control of moral hazard. In case of transition
economies switching costs are not an appropriate method for moral
hazard limitation because they have neither technological nor
economic reasons.

MTPL insurance

6. Shared data resources, which must be used in present MTPL
insurance risk rating methods, are avoided due to aggressive
marketing strategies. Bonus/malus system with a nation-wide shared
database is optimal for this type of insurance. The decentralisation of
tariff determination into private companies can be economically
equivalent to shared data resources method only if the possibility for
a customer to change the insurer is limited or if switching costs are

introduced. If switching costs are introduced, in order to conform to market freedom principles in the EU, the actual risk rate of an insurance taker must be publicly available. Future of downward pricing practice based also on non-cooperative behaviour regarding the information use will depend on the strategy chosen by insurance companies - increasing the market share vs. maximizing the profit. If new companies will enter the market, then the non-cooperative behaviour is more likely to aggravate. If strong fusion tendency will prevail, then cooperation between insurers is more likely to proliferate.

Solutions for information deficit problem

7. In those branches of insurance where the most profound problem is the lack of data resources for establishing a risk assessment and balancing system, the product innovations can be still possible if private information resources of companies and information from governmental sources can be used jointly. However, it cannot be expected that the incentive to build innovative risk assessment systems this way will come from companies because the necessary investments in R&D are high but the possibility of exclusive use of the results of these inventions is low - m transition economies due to long-lasting institutional reform, free-rider problem is very significant. The cooperation of insurers for joint R&D in Latvia has been unimportant in the past. Data privacy issues pose additional problem, some types of information has very limited circulation availability for private users.

These considerations lead to the following proposal. The most appropriate decision in this situation is the establishing of an independent but firmly constituted insurance institute dealing primarily with actuarial evaluations of real-life data, research about risk balancing mechanisms in order to facilitate product innovations in those insurance branches, where in case of Latvia severe market failure persists. The product of this institute will be normative documents for the insurance industry, statistical surveys and analyses, actuarial tables in order to facilitate product innovations in local market and to attract foreign insurers with significant experience in development of insurance products necessary for Latvian economy but absent due to market failure.

Insurance industry level

Common information pool

8. In areas, where moral hazard poses the main problem as motor
insurance, TPL insurance and lawyer's expenses insurance,
development of shared information resources is the main tool to
overcome market failure. Common data pool must be created by
insurance companies self as a risk rating method. The analysis of
emergence of cooperation in antagonistic setup suggests that the main
cause of non-cooperative behaviour in transition economies has been
the prevalence of short-term approaches, especially the tendency to
increase the market share vs. profit considerations.

Information price

9. A complex problem is posed by the information price. If pricing for
information from shared sources is omitted then market entry process
is facilitated and will occur at the costs of present market members
leading to even more non-cooperative behaviour of present players.
According to considerations in the thesis, the information price can be
determined by a posteriori hierarchical decision if information
exchange occurs by way of strategic alliance, or it can be determined
in the market for information goods if the value of information can be
appraised a priori, e.g. by a scoring system.

Further research

Threats caused by information

10. New types of threats come into play in case of shared information
use, requiring development of new methods for their identification
and control.

- Failure of shared database, disinformation, distortion of
information and hiding of information.

- Leak of information causing significant damage to the insured
person, especially in case of life and health insurance. Identification
of the exact source of the leak and definition of corresponding
liability. Transparency of information flows.

Consumer risk

11. Consumer risk in the insurance market - random variable with values
corresponding to consumer's losses due to insolvency or violation of
contract by the insurance company. Reliable ratings of companies

became important in Latvian insurance market after the first significant insolvency of the stock company "Alianse".

Proposal. A reliable rating system must be developed in Latvia for the evaluation of insurance products (as experience and credence goods) and for the rating of insurance companies with respect to their solvency, and these ratings must be available, at best - in the Internet.

In case of transition economies the indirect consumer's risk - the probable welfare loss due to some insurer's not meeting his obligations, is a significant problem. This problem must be studied from the viewpoints of economics, statistics and law.

Author's publications reflected in thesis

1. Berkis U. Historical reductionism in Eastern European transition:
Constitutional order, sectorial structure of economics, public health system. -
EAEPE 2002 Conference proceedings, Aix-en-Provance, 2002. - 13 p. CD

2. Berkis U. Institutional aspects of shared business databases in transition type
economies. - EAEPE 2001 Conference proceedings, Siena, 2001. - 8 p., CD and
in Internet httpy7www.econ-pol.unisi.it/eaepe2001/download.htm, available
on SCIRUS (www.scirus.com)

3. Berķis U. Shared business databases: institutional and evolutionary aspects//
Acta Universitatis Latviensis, 2002; (647): 61 -71 p.

4. Berķis U. Strategies of information use in insurance (in Latvian - Informācijas
izmantošanas stratēgijas apdrošināšana)// Acta Universitatis Latviensis, 2001;
(634): 387 -395 p.

5. Berķis U., Skrodelis M. Role of information asymmetry in health insurance (in
Latvian - Informācijas asimetrijas loma veselības apdrošināšanā)// AML/RSU
Scientific papers 2001. Riga: AML, 2002.: 237-240 p.

6. Berķis U., Skrodelis M, Teibe U. Information and institutional
complementarities in private health insurance (in Latvian -Informācija un
institucionalas komplementarit
ātes privātajā veselības apdrošinašanā)// RSU
scientific papers 2002, Riga: RSU 2003 - 157-167 p.

7. Berkis U. Complexity aspects in economic reforms (sectorial reform and health
sector reform) (in Russian – Аспекты сложности в экономических реформах (ceторная реформа и реформа в сфере здравоохранения))// Философия xозяйства , 2003, 26(2):166-180 Moscow:: HTPK publishers, published by Moscow State University and Academy of Social Sciences of the Russian Federation

8. Berķis U. Decentralization and privatisation of health insurance in Latvia: asymmetric information aspects revisited// Acta Universitatis Latviensis, 2003; (658):31-40 p.

Conference presentations

Global conferences

1. Berķis U. Institutional aspects of shared business databases in transition type
economies. - EAEPE Conference 2001, Siena, Italy, http://www.econ-
pol.unisi.it/eaepe2001 (full time presentation of research paper)

2. Berķis U. Historical reductionism in Eastern European transition:
Constitutional order, sectorial structure of economics, public health system. -
EAEPE Conference 2002, Aix-en-Provance, France (full time presentation of
research paper)

International conferences

3. Berķis U. Information and institutional complementarities in private health
insurance, scientific conference of Latvian Academy of Medicine/Riga

Stradina University 2002 (presentation of paper)

Local conferences

4. Berķis U. Principles of group formation and information management in
health insurance. - Scientific conference of the Latvian Academy of Medicine/
Riga Stradins University, 2003 (poster)

5. Berķis U. Risk balancing methods, which are independent on balance sheet
data. - 62nd conference, University of Latvia, 2004 (full time presentation)

6. Berķis U., Teibe U., Skrodelis M. Risk balancing method in health insurance. -

Scientific conference of the Riga Stradins University, 2004 (poster)

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