Accounting for Externalities > English > Insurance and externalities

Antibodies in living things are used to recognize and protect against risk.
They only work when there is a precedent (prior sensitization). It helps to guard against a risk that the body alone would not be able to fight. Thus immunity is our best health insurance, and allows our body to adapt .
In the same way, an insurance company will learn from past events to protect companies from the risks they incur from third parties. Insurance immunizes the company from known risks.

However, when analyzing an externality, 2 sets must be considered:

  • A private set: the company, or the group of companies,
  • An external environment with whom the company will exchange resources,

What role does insurance play in this case?

The externality occurs when the private cost (borne by the company) is different from the social cost (cost borne by society). An insurance system, beyond monetizing and pooling risk, is also an intermediary that will bear social costs (which the company will not have to bear).
Let’s take the example of a company that insures itself against an industrial risk, and that includes compensation for victims.
If the event occurs (industrial disaster), then the various costs borne by the insurance are:

  • Rehabilitation of the factory: borne by the insurance,
  • Compensation of victims / residents: supported by the insurance,

The company only bears the cost of the insurance premiums.
Other costs are borne by the insurance.
In addition, an increase in industrial accidents impacts the value of insurance premiums.

The fact that there is a private cost different from the social cost can be seen as a source of externality.
Too high an occurrence in a company could mean that the company does not care or cares little about the induced risk.
In this case, the insurance company may increase insurance premiums in order to reduce the value of the externality borne by the mutualization system set up by the insurance company.

Thus, all mutualization systems are a source of externality:

  • taxes (discussed in a later item),
  • insurance mechanisms,

When the neglect of one causes costs for the others (increased insurance premiums), then the social cost deviates from the private cost, and creates an externality.

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