Academic journal article Journal of Risk and Insurance

The Simple Analytics of Job Displacement Insurance

Academic journal article Journal of Risk and Insurance

The Simple Analytics of Job Displacement Insurance

Article excerpt


Earnings losses following job displacement are large for long-tenured workers in the United States and similar economies (Canada and the United Kingdom). (1) These losses arise from a combination of unemployment spells and lower wages on the reemployment job. Of the long-tenured (3 or more years of service) workers in the 2012 Displaced Workers Survey displaced between 2009 and 2011, only 56 percent were employed in January of 2012, with another 26.7 percent unemployed and the remainder, 17.4 percent, out of the labor force altogether ((Bureau of Labor Statistics [BLS], 2012). For the reemployed, expected wage losses are substantial and strongly tied to job tenure. Farber (2004, p. 115), analyzing various Displaced Worker Surveys (DWS), reported that earnings losses of reemployed workers increase systematically with job tenure: 3.4 percent at 1-3 years of tenure, 10.1 percent at 4-10,20.5 percent at 11-20, and 28.1 percent at greater than 20.2

Consumption studies indicate that these large losses for long-tenured workers are poorly insured. (3) This is not because the risks are unknown or unattended to. In the United States, the workforce is covered by public unemployment insurance and often by employer-provided severance pay. Internationally, mandated severance pay is ubiquitous as is government supplied unemployment insurance in the industrialized world (Holzmann et al., 2012). This study stresses the importance of treating unemployment insurance and severance pay as an integrated job separation benefit package.

The early employment contracting literature considered severance pay as an alternative to unemployment insurance in second-best contracts (Baily, 1977), but severance pay also arises as scheduled wage insurance. The full job displacement insurance design question does not arise in many optimal unemployment insurance studies: (1) because the models ignored reemployment altogether, presumably in order to focus on unemployed status, or (2) because reemployed workers were assumed to receive wage offers equal to those in the displacing job. Parsons (2015) lays out informally the argument for severance pay as scheduled wage insurance as well as scheduled unemployment insurance and the need to integrate the two programs into a unified system. This article develops this argument formally.

In order to develop a deeper understanding of the coordination of the two primary instruments (unemployment benefits and severance pay), a single-period contracting model is employed. (4) A plausible outline of the first-best package is straightforward and requires little formal motivation--severance pay serves as wage insurance, covering the expected earnings losses (reemployment earnings less prior earnings), while unemployment insurance covers the loss of reemployment earnings during the unemployment spell. (5) In the model below, with additively separable state utility functions in consumption and leisure, insurance will be complete in the absence of administration costs and information problems.

The literatures on unemployment insurance and severance pay have focused on asymmetric information problems. The unemployment insurance literature has concentrated on search moral hazard concerns--the need to induce workers to search appropriately and reveal the receipt of job offers. (6) The severance pay (mandates) literature has focused on "firing cost" problems or what will be labeled here "layoff moral hazard." (7) Search moral hazard arises with actual loss linked unemployment benefits, but layoff moral hazard is a purely financial consideration. If the firm is the insurer of job separation and simultaneously is the only agent with reliable information on its own labor demand conditions, it has an incentive to misreport business conditions if job separation costs are onerous. Most severance plans are designed as government mandates of private firm provision and immediately raise layoff moral hazard concerns as do voluntarily provided severance plans. …

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