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Bolivian pesos. By 1985, the year of the Bolivian hyperinflation, more than 60 per cent of time deposit balances
were denominated in dollars.
What caused high inflation in Latin America? Many Latin American countries borrowed heavily during the
seventies and agreed to repay their debts in dollars. As interest rates rose, all of these countries found it increas-
ingly difficult to meet their debt-service obligations. The high-inflation countries were those that responded to
these higher costs by printing money.
The Bolivian hyperinflation is a case in point. Eliana Cardoso explains that in 1982 Hernan Siles-Suazo
took power as head of a leftist coalition that wanted to satisfy demands for more government spending on do-
mestic programs but faced growing debt-service obligations and falling prices for its tin exports. The Bolivian
government responded to this situation by printing money. Faced with a shortage of funds, it chose to raise
revenue through the inflation tax instead of raising income taxes or reducing other government spending.
Insurance
By Richard Zeckhauser
Insurance plays a central role in the functioning of modern economies. Life insurance offers protection
against the economic impact of an untimely death; health insurance covers the sometimes extraordinary costs of
medical care; and bank deposits are insured by the federal government. In each case a small premium is paid by
the insured to receive benefits should an unlikely but high-cost event occur.
Insurance issues, traditionally a stodgy domain, have become subjects for intense debate and concern in re-
cent years. The impact of the collapse of savings and loan institutions on the solvency of the deposit-insurance
pool will burden the federal budget for decades. How to provide health insurance for the significant portion of
Americans not now covered is a central political issue. Various states, attempting to hold back the tides of
higher costs, have placed severe limits on auto insurance rates and have even sought refunds from insurers.
An understanding of insurance must begin with the concept of risk, or the variation in possible outcomes of
a situation. “A” shipment of goods to Europe might arrive safely or might be lost in transit. “C” may incur zero
medical expenses in a good year, but if she is struck by a car, they could be upward of $100,000. We cannot
eliminate risk from life, even at extraordinary expense. Paying extra for double-hulled tankers still leaves oil
spills possible. The only way to eliminate auto-related injuries is to eliminate automobiles.
Thus, the effective response to risk combines two elements: efforts or expenditures to lessen the risk, and
the purchase of insurance against the risk that remains. Consider “A”'s shipment of, say, $1 million in goods. If
the chance of loss on each trip is 3 per cent, on average the loss will be $30,000 (3 per cent of $1 million). Let
us assume that “A” can ship by a more costly method and cut the risk by 1 percentage point, thus saving
$10,000 on average. If the additional cost of this shipping method is less than $10,000, it is a worthwhile ex-
penditure. But if cutting risk by a further percentage point will cost $15,000, it is not worthwhile.
To deal with the remaining 2 per cent risk of losing $1 million, “A” should think about insurance. To cover
administrative costs, the insurer might charge $25,000 for a risk that will incur average losses of no more than
$20,000. From “A”'s standpoint, however, the insurance may be worthwhile because it is a comparatively inex-
pensive way to deal with the potential loss of $1 million. Note the important economic role of such insurance.
Without it “A” might not be willing to risk shipping goods in the first place.
In exchange for a premium, the insurer will pay a claim should a specified contingency, such as death,
medical bills, or shipment loss, arise. The insurer is able to offer such protection against financial loss by pool-
ing the risks from a large group of similarly situated individuals. With a large pool, the laws of probability as-
sure that only a tiny fraction of insured shipments is lost, or only a small fraction of the insured population will
be hospitalized in a year. If, for example, each of 100,000 individuals independently faces a 1 per cent risk in a
year, on average 1,000 will have losses. If each of the 100,000 people paid a premium of $1,000, the insurance
company would collect a total of $100 million, enough to pay $100,000 to anyone who had a loss. But what
would happen if 1,100 people had losses? The answer, fortunately, is that such an outcome is exceptionally
unlikely. Insurance works through the magic of the Law of Large Numbers. This law assures that when a large
number of people face a low-probability event, the proportion experiencing the event will be close to the expected
proportion. For instance, with a pool of 100,000 people who each face a 1 per cent risk, the law of large numbers
dictates that 1,100 people or more will have losses only one time in 1,000.
In many cases, however, the risks to different individuals are not independent. In a hurricane, airplane
crash, or epidemic, many may suffer at the same time. Insurance companies spread such risks not only across
individuals but also across good years and bad, building up reserves in the good years to deal with heavier
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