Lecture 5 Insurance, the Archetypal Risk Management Institution: Its Opportunities and Vulnerabilities
In the beginning of the lecture, Professor Shiller talks about risk pooling as the fundamental concept of insurance, followed by references to moral hazard and selection bias as prominent problems of the insurance industry. In order to provide an explicit example from the insurance industry, he elaborates on the story behind American International Group (AIG), from its creation by Cornelius Vander Starr in Shanghai in 1919, to Maurice “Hank” Greenberg’s time as CEO, until its bailout by the U.S. government in 2008. Subsequently, he turns toward the regulation of the insurance industry, covering state insurance guarantee funds, the role of the McCarran-Ferguson Act from 1945, as well as the impact of the Dodd-Frank bill on the insurance industry. He devotes special attention to two branches of the insurance industry–life insurance and health insurance–and emphasizes, among other aspects, the consequences of the health care overhaul in the U.S. from 2010. He discusses the example of earthquakes, with insurance in Haiti and catastrophe bonds in Mexico. At the end of the lecture, he critically reflects on the role of the insurance industry in the face of catastrophes.
- Introduction [00:00:00]
- Concepts and Principles of Insurance [00:03:53]
- The Story behind AIG [00:19:14]
- Regulation of the Insurance Industry [00:35:51]
- Specific Branches of the Insurance Industry - Life and Health Insurances [00:50:04]
- Insurance in the Face of Catastrophes [01:03:18]
Professor Robert Shiller: OK, good morning. I’ve been running to get over here. I just got back from The World Economic Forum. We talked to a lot of the world’s financial leaders. And I was thinking what I would tell you about it, but then I realized, it’s all off the record, so I’m not supposed to say anything to you.
I was going to talk instead today about insurance, which is one of the major risk management institutions that is not always considered part of finance, because people think of finance and insurance as separate.
Professor Robert Shiller: We talked about basic principles of risk management in the preceding lecture. It’s all the same for finance and insurance. And yet, we tend to consider them as separate businesses. That’s partly, I think, an accident of history, and it’s partly a product of regulation because of certain ideas–that we’ll come to in a few minutes–that has kept the insurance industry separate from other financial industries. Last period, we talked about the mean-variance risk management problem, and about the Capital Asset Pricing Model. That’s fundamental to insurance as well. The basic idea is pooling of risks and preventing people from being subjected to extreme risks through the concept of risk pooling.
So, what I wanted to start today is talking about insurance, starting with the concept of insurance. And then, I wanted to reiterate a theme of this course, that financial institutions are inventions, they’re structures that someone had to design and make work right. Sometimes they don’t work right. Then, I wanted to move to a particular example of insurance, which was until recently the biggest insurance company in the world, called the American International Group, or AIG. And it’s particularly important that we talk about this example, because on March 2 we have the former CEO of AIG, Maurice “Hank” Greenberg, coming to our class. So, I thought it’s appropriate that we use AIG–well not only because it was the biggest insurance company in the world, but also because he’s coming here.
And then, I want to talk about regulation of insurance, that the insurance industry has always been subject to government regulation. I’ll talk about types of insurance. Your chapter in Fabozzi et al. is mostly about types of insurance, so I think you can mostly get that from the textbook, but I wanted to say some things about it. And then, I was going to conclude with thoughts about insurance, and how important it is to our lives, and what progress it still has to make.
5.2 Concepts and Principles of Insurance
So, insurance, it doesn’t sound like a very exciting topic, does it? I’m going to try to make it more exciting. I guess you think of the insurance salesman coming, knocking on your door. They don’t do that so much anymore, they used to go around door-to-door. And that was a depressing moment, when the life insurance salesman came. And if you invited this person into your house, he would tell you about the probability of dying, how tough it will be on your family, that sort of thing. But, to me, I think insurance is an exciting issue, because it’s about making our lives work. And it’s really about preventing horrible catastrophes from–and it involves mathematical theory that underlies the concept. To me, it’s exciting, but I don’t know if I can convey that.
The fundamental concept, again, is risk pooling. The idea of insurance goes back to ancient Rome, but only in very limited forms. But the idea of risk pooling is kind of an obvious one. People form organizations partly to risk-pool. So, in ancient Rome, a common form of insurance was death insurance that would pay funeral bills. People in the ancient world believed that you had to get a proper burial, or your soul would wander forever. So, insurance salespeople associated with guilds or business organizations would sell funeral insurance. But they didn’t have a very clear idea of the risk pooling concept. It must have underlain their thinking.
But it wasn’t until much later that people began to understand the concept. There were examples of insurance throughout ancient and medieval times, but they’re very blurred and sparse. I remember reading an insurance, supposedly, an insurance contract written in Renaissance Italy, translated into English, but it was hardly recognizable to me as an insurance contract. They didn’t have the concepts down. It seemed to have a lot of religious language in it, which normally we don’t think of as something that’s part of an insurance contract. But it seems like insurance came in in the 1600s, at the same time that certain concepts of mathematics began to be developed. Notably, the concept of probability became more widely known in the 1600s. According to one historian, the oldest known description of the insurance concept goes back to a Count Oldenburg. Actually, it’s an anonymous letter to Count Oldenburg, written in 1609.
And the letter says, why don’t we start–I’m paraphrasing at the moment–why don’t we start a fund, in which people pay 1% of the value of their home every year into the fund, and then we will use the fund to replace the house if there’s a fire? And now, quoting this anonymous writer, this writer said he had “no doubt that it would be fully proved, if a calculation were made of the number of houses consumed by fire within a certain space in the course of 30 years, that the loss would not amount, by a good deal, to the sum that would be collected in that time.” OK? It was just intuitive. He said, there can’t be that many fires. And if we collect that amount of money every year, we can pay for all the houses that are burned down. So, he didn’t express any mathematical law, but it’s the concept of insurance. You don’t find that before that, before 1609. So, I guess we don’t have any clear statement of insurance before then.
Actually, you can find an approximate statement of the law of large numbers–and I’m thinking of Aristotle, the philosopher. This is in ancient times, and I’m quoting from De Caelo, his book. Aristotle: “To succeed in many things or many times is difficult. For instance, to repeat the same throw 10,000 times with the dice would be impossible, whereas to make it once or twice is comparatively easy.” He doesn’t have the language of probability, but he knows you can’t throw the dice 1,000 times and come up with the same number every time.
Now, we have a probability theory about it. So, we know that if you have n events, each occurring with the probability of p, then the average proportion out of the n events that occur–I’m sorry, we have n trials, an event occurring with probability p–then the standard deviation of this proportion of events that occur is
And that’s a theorem from probability theory. The standard deviation of the proportion of trials for which the event occurred, assuming independence, is given by this. And so, you note that it goes down with n. As n increases, it goes down with–I should say, the √n. So, that means that if n gets very large, if you write a lot of policies, then the probability of deviating from the mean by more than one or two standard deviations becomes very small, which is what Aristotle said.
But making insurance work as an institution, to actually protect people against risk, is rather difficult to achieve. And that’s because things have to be done right. So, let me just remind you, what are the basic types of insurance? This is what Fabozzi talks about. There’s life insurance that insures people against early death. Of course, you still die. What it really insures, is your family against the loss of a bread winner, the father or the mother. So, life insurance is suitably given to families, especially with young children, to protect the children. It used to be very important when there was a lot more early deaths. Now, very few young people lose their parents. So, life insurance has receded in importance.
Another example is health insurance. This is insurance, of course, that you get sick and you need medical care. Then, there’s property and casualty insurance, insuring your house or your car. And then, there’s other kinds of [what] you might call investment-oriented products, like annuities. This is a table in your textbook by Fabozzi, which lists these categories of insurance. But any of these insurance types are inventions, and I want to specify that. We have the idea that an insurance company could be set up that would, say, insure houses against fires. And we just heard it, intuitively, in this letter to Oldenburg long ago. But to make it work, and to make it work reliably, involves a lot of detail. You can think of the idea of making an airplane, but to make it really work, and to make it work safely, is another matter.
So first of all, insurance needs a contract design that specifies risks, and excludes risks that are inappropriate. An issue that insurance companies reach is moral hazard.
Professor Robert Shiller: Moral hazard is an expression that appeared in the 19th century to refer to the effects of insurance on people’s behavior that are undesirable. So, the classic example is, you take out fire insurance on your house, and then you burn it down deliberately in order to collect on the house. Or another example is, you take out life insurance, and then you kill yourself to support your family. These are undesirable outcomes, and they could be fatal to the whole concept of insurance, because if you don’t control moral hazard, obviously the whole thing is not going to work. So, what they do in an insurance contract is they exclude risks that are particularly vulnerable to moral hazard. And so, that means you would exclude certain causes of death that might look like suicide. You can do other things to control moral hazard than excluding certain causes.
You can also make sure that you don’t insure the house for more than it’s worth. Right? If someone insures a house, and the insurance does not cover the full value of the house, then there’s no incentive to burn it down. You might as well just sell the house, right? No point in burning it down if you’ll still lose a little bit of money. So, that’s one of the problems that insurance companies face. And part of the design of [the] insurance contract has to prevent moral hazard from becoming excessive.
An analogous thing is selection bias. That occurs when–chalk keeps breaking–selection bias occurs when the people who sign up for your contract know that they are higher risk. For example, health. People who know they have a terminal disease and are about to die, they’ll all come signing up for your life insurance contract. That will put immense costs on the insurance company, and if they don’t control the selection bias, they will have to charge very high premiums. And that will force other people, who don’t know they’re going to die, out of buying insurance. And so, that’s the fundamental problem. Again, something has to be done to define the policy. So, one thing you can do is, exclude, in life insurance, certain causes of death that are likely to be known. And you only put on causes of death that people wouldn’t be able to predict about themselves.
Another aspect of insurance is that you have to have very specific, precise definitions of the loss, and what constitutes proof of the insured loss. If you’re not clear about that, there’s going to be ambiguities later, which will involve legal wrangling and dissatisfaction. We’ll see, in a minute, that these problems are not minor and they keep coming up. It’s a constant challenge for the insurance industry. Third, we need a mathematical model of risk pooling. Well, I just wrote one down here, but it might be more complicated in some circumstances. This is assuming independence. If you don’t assume independence, you can make more complicated models. Then, fourth, you need a collection of statistics on risks, and you need to evaluate the quality of those statistics. So for example, in the 1600s, people started collecting mortality tables for the first time. There was no data on ages at death. It began in the 1600s, because people were building an insurance industry and they needed to know those things.
Then, you need a form for the company. What is the insurance company? Who owns it? It could be a corporate form. There are shareholders who are investing in the company. And they’re taking the risk that some of our policy modeling, or handling of moral hazard, or selection bias wasn’t right. Some insurance companies are mutual, rather than share. The insurance is run for the benefit of the policyholders, and they’re like a nonprofit in the sense that the founders of the company pay themselves salaries, but the benefits go entirely to the policy holders.
Then, you need a government design, so that the government verifies all of these things about the insurance company. The problem with insurance is that people will pay in for many, many years before they ever collect, right? Especially if you’re buying life insurance, you hope never to collect. And so, you don’t know whether it’s going to work right. That’s why you need government regulation, you need government insurance regulators. And that’s part of the design of insurance. It doesn’t work if you don’t have the regulators, because you wouldn’t trust the insurance company. So, these are problems that have inhibited making insurance work.
5.3 The Story behind AIG
I wanted to give you an example. I think it makes it more concrete if we start off with talking about a particular example. And I said I was going to talk about AIG, which is a very important example, not only because it was the biggest insurance company. It was also the biggest bailout in the entire financial crisis we’ve seen now. And it has an interesting story.
Professor Robert Shiller: So AIG, it’s an interesting story. It was founded in 1919 in Shanghai. And you wonder, why is it called American International Group if it’s founded in Shanghai? It was founded in Shanghai, called American Asiatic Underwriters. And it was founded by Cornelius Vander Starr, who was an American who just decided to go to Asia and start an insurance business. Shanghai, in 1919, was a world city. It was not really under the Chinese government, it was something like Hong Kong. It had constituencies representing many different countries. And so, it was a very lively business center. It’s kind of interesting that the biggest insurance company in the world emerged from Shanghai, and also one of the biggest banks in the world, HSBC. You know what HSBC means? They don’t emphasize it anymore. It’s Hong Kong and Shanghai Bank Corporation [correction: Hong Kong and Shanghai Banking Corporation]. So, AIG was founded by Mr. Starr in 1919, and started doing an insurance business in China. And moved their headquarters to New York just before Chairman Mao took over at China. And then, it became kind of a Chinese investment company in the United States.
Cornelius Vander Starr ran the company from 1919 until he died in 1968. So, he was CEO for 49 years, a half-century. And then, just before he died, he appointed Hank Greenberg, who will visit us, as the CEO in 1962. So, that was 49 years under Starr, and then Greenberg took on, and then ran the company until 2005. So, it was 37 years under Greenberg. So, two men ran the company for almost a century. Since 2005, Greenberg has been succeeded by three CEOs, the usual thing. The usual company turns over CEOs. There’s another interesting story that we might ask about Hank Greenberg.
He joined the U.S. Army and fought in World War II. And among his jobs, then, was to liberate Dachau, which was a concentration camp. This is not one of the extermination camps, it was a concentration camp for Jews and others under the Nazis. And people were starving and dying, it was awful. At a Council on Foreign Relations meeting, Greenberg met with Mahmoud Ahmadinejad, who is the president of Iran. And Ahmadinejad said something about the Holocaust, doubting that it ever happened. Greenberg stood up indignantly and said, it happened. I saw it. I was there. It’s kind of interesting to me to think about this.
This is an aside, momentarily. The other person I’ve met who–do you know Geoffrey Hartman, who’s a professor here at Yale in literature? He and his wife, both Jewish, were teenagers during World War II. And Hartman escaped by what they called Kindertransport. But his wife, Renee, was in another concentration camp. Not Dachau, it was in Bratislava. And she was starving to death. And it really happened, by the way. It’s awful. And I asked her, why do you think they were starving you to death? And she said, we didn’t know. We thought maybe they were keeping us as hostages, or something. So anyway, we could ask him about that.
What did these people do? Both Starr and Greenberg created a wide variety of risk management products. It became the largest underwriter of commercial and industrial insurance in the world. It became a very large automobile insurer, and also a travel insurance company. But Greenberg was forced out of the company after 37 years, when Eliot Spitzer, who was the Attorney General for the state of New York, claimed that there were some irregularities. And Greenberg was forced to resign. It turns out, though, that nothing that Spitzer said has held up, so apparently Greenberg was innocent of any of the allegations. The real problem occurred with AIG after Greenberg left. So, Greenberg left in 2005, and then the company absolutely blew up, and it absolutely had to be bailed out.
The reason they had to be bailed out was, it was almost entirely due to a failure of the independence assumption, I would say. That under their risk modeling, namely, the company became exposed to real estate risk. And the idea that their risk modelers had was that it doesn’t matter that we take on risk that home prices might fall, because they can never fall everywhere. They can fall in one city, but it won’t matter to us. That’s just one city, and it all averages out. But what actually happened after Greenberg left was the company took huge exposures toward real estate risk and it fell everywhere. Home prices fell everywhere, just exactly what they thought couldn’t happen.
So, the company was writing credit default swaps–I told you about those before–they were taking the risk. They were insuring, basically, against defaults on companies whose credit depended on the real estate market. They were also investing directly in real estate security, in mortgage-backed securities that depended on the real estate market for their success. And when all this failed at once, the AIG was about to fail. That meant that the federal government decided, in 2008, to bail out AIG. And the total bailout bill, well, the total amount committed by the U.S. federal government was $182 billion. It didn’t all actually get spent. It was $182 billion committed to bail out AIG. That’s a lot of money, I think that’s the biggest bailout anywhere, at any time.
A lot of people are angry about this. Part of this bailout came from what we called TARP. This is the Troubled Asset Relief Program, which was created under the Bush administration. And it was a proposal of Treasury Secretary Henry Paulson. It was initially run by Paulson. But it was not just TARP. There was also loans from the Federal Reserve. It was a complicated string of things that were done to bail out AIG. So, why did they do that? Why did the government bail out this insurance company? The main reason why they did so was their concern about systemic risk. I’ll come back to other kinds of bailouts of insurance companies.
The problem was that AIG–if it went under, all kinds of things would go wrong. All kinds of things would go wrong. All these insurance policies that it wrote on people’s casualties, their travel insurance, any of these policies, would all now be subject to failure. Because people who had these insurance would find that the company that they bought it through was disappearing. But it would go on even beyond that. Lots of other companies, investment companies, banks, would fail too, or may fail too, because they’re involved in some kind of business dealings with AIG, which would now become part of the AIG bankruptcy. If AIG failed, anybody who had any business with AIG would be starting to wonder, what’s this going to mean to me? AIG owes me money, what’s going to happen? And so, there was a worry that it would destroy the whole financial system.
This was big enough to cause everybody to pull back, and if everybody pulls back, then the business world stops. It would be like a stampede for the exits. Everyone hears, AIG goes under, and so many people do business with AIG, they decided it was intolerable. And so, the government came up with the money, massively and quickly. If you remember the story, Henry Paulson, who was Treasury Secretary, first went to Congress asking for a blank check. He didn’t say to bail out AIG, but that’s what he did. He got sort of a blank check from Congress, because Paulson told the story that if we don’t do this, if we let the company–he didn’t say AIG, he actually asked for the TARP money before the AIG bailout–but he said if we don’t do something to prevent a collapse, we could have the Great Depression again.
Nobody liked to hear that, but they believed him, and they didn’t know what else to do. And so, they allowed the TARP money, and they allowed the Federal Reserve to bail out this company. Some people misunderstand what this in fact means, though, for the shareholders in AIG. The AIG shareholders lost almost everything, because the government arranged the bailout in such a way that AIG got practically wiped out. The government took preferred shares in the company at a very low price in exchange for helping the company survive. And that diluted down the other shareholders in the company into a very low status. The company lost over 90% of its shareholder value, despite this bailout.
In July of 2009, AIG did a 1-to-20 split. Remember, I told you about splits before? That’s a reverse split. Usually, the stock goes up in a company and the shares, which originally sold for $30 a share, are now selling for $100 a share. And they think, well that’s too high a price per share, so let’s do a three-for-one split, and let’s make every share into three shares. That’s the usual split story. This is going the other way massively. They made every 20 shares into one share. So, if you look at the price recently, it’s been something like $30 to $40 dollars a share. That’s what we do on the stock exchange, we always like to keep it, it’s an American tradition. Not so much true in other countries, they have different traditions about what is the preferred price about a stock. So, AIG lost–the shareholders lost just about everything. So, the public anger about a bailout of AIG is really a little bit inappropriate, because they lost almost everything. They could’ve lost everything. This company did not fail, it was bailed out and it survived. But it lost almost everything. I think the real anger is not anger about the shareholders of AIG, who lost almost everything.
The real anger is that the business partners of AIG didn’t lose anything, notably Goldman Sachs, which was a major partner taking the other side of contracts with AIG. It didn’t lose a penny, all right? But, of course, Goldman Sachs was not being bailed out. It was not in danger. The government didn’t know what to do with AIG, because it felt that it was such a big company doing so many things that if we let them fail, who knows, Goldman Sachs might fail. The government didn’t know, they didn’t know whether Goldman Sachs might fail. Because it didn’t have the information, because the regulators had not collected such information. So, they decided the only thing they could do responsibly was to keep AIG alive, somehow alive, as an insurance company. Maybe, they lose almost all of their value to the shareholders, but they keep going. So, that’s what happened. And AIG continues to this day. It survived after the bailout.
5.4 Regulation of the Insurance Industry
Now, I wanted to talk about something else that many of you may not know about insurance companies. Mainly, that we do have something like deposit insurance for insurance companies. You know, when you go into a bank, there will be a little sign saying FDIC Insured? Do you notice that when you go into a bank? They’re required to post that. Bank accounts are insured by the Federal Deposit Insurance Corporation up to a limit, $250,000 now. It’s only for relatively small savers, because $250,000 is not big time, a lot of money. We don’t want innocent people who walk into a bank and put their money there to lose their money. So, you wonder about insurance. Do we have something like that for insurance? Yes we do.
We have state insurance guarantee funds that protect insurance companies. They’re not as old, though. The oldest insurance guarantee fund is 1941, and that’s in New York. And this fund was the first, but now virtually every state in the United States has these funds. Connecticut got its first insurance guarantee fund in 1972. So, these are supposed to protect you, as an individual, if you take out an insurance policy, and then your insurance company, like AIG, blows up. So, then you wonder, well, why didn’t the insurance guarantee fund handle AIG? Any idea where the answer is? Why did we need the special bailout? Well, maybe the answer is obvious. The insurance guarantee fund, like the FDIC, is to protect the little guy, right? AIG was way too big for these state insurance funds. There’s a limit to how much you can collect from a state insurance fund if your insurance company goes under, and in New York it’s $500,000, and in Connecticut it’s the same. These are two of the most generous states. Typically, in a state in the United States, you only collect $300,000 maximum.
That may sound like a lot of money to you, but think of it this way: Suppose you bought a life insurance policy for your family. What would you typically buy? Ever thought about it? Well, you have two children. You’re thinking of sending them both to Yale, or some place like that. It’s going to cost you like $500,000 right there, just sending them to college. So, if that’s all you get in your insurance, it’s not enough, not big. So, these are small, they don’t guarantee you enough. There’s another thing about, at least I know about the Connecticut insurance guarantee fund, and that is that you can’t play the trick that you do with the Federal Deposit Insurance Corporation. The Federal Deposit Insurance Corporation insures bank accounts for 250,000, all right? But all you do is, you put your money over many different banks. So, if you’ve got $2.5 million, you put it in 10 different banks. The FDIC will insure every one of those, so you can insure $2.5 million. But the Connecticut insurance guarantee fund won’t do that, they’ll limit you to $500,000, no matter how many different policies you got.
There’s another important difference between deposit insurance and banks and state insurance guarantee funds, at least in Connecticut. I know Connecticut does not allow an insurance company to advertise that they’re insured. It’s quite the opposite with deposit insurance, where the FDIC requires that they post that they’re insured. So that’s why you don’t hear about this. But there’s a fundamental lesson that I’m trying to get to with all of this, and that is that you have to look at the insurance company that you buy insurance from. It’s still a wild world out there in the sense that if you buy insurance from an insurance company that goes under, well, you’re protected up to $500,000, but beyond that, not. And you’re supposed to watch out. Now, we also have state insurance regulators who are supposed to watch out that insurance companies are good, but they won’t make good on you. So, we have a Connecticut Insurance Department, for example, which regulates insurance companies.
Now, another interesting thing about insurance that separates it from finance is that insurance is done by the state government. It’s regulated and the guarantee funds are state. The Federal Deposit Insurance Corporation is a federal–it’s a national insurance program. But insurance is done entirely by the states. This makes it difficult to do business as an insurance company, because you have 50 different regulators in the United States. The United States is [a] particularly difficult place to handle. That’s because we have the McCarren-Ferguson Act in 1945, which specified that insurance regulation is entirely for the state governments. So, in the United States, regulation of insurance is divided up across 50 different states, which is kind of, makes it very difficult. It’s very difficult, because that’s a lot of different regulators to deal with.
One thing that we have is something called the National Association of Insurance Commissioners. It’s not a government organization, it’s an association without any constitutional or any government definition. The NAIC. But what it does, is it brings representatives from the different state governments and they meet together, and they decide on model legislation that each state government could adopt to allow insurance to be standardized across different state governments. Otherwise, we’d have a total chaos in our insurance regulation.
You might be aware that under the Dodd-Frank Act, which is the major legislation that was passed in 2010, the Dodd-Frank Act creates a new federal insurance office. So, it sounds like the federal government in the United States is getting into insurance. But, in fact, no it’s not. The federal government doesn’t have any real involvement in the insurance industry„ it’s all done, it’s all regulated at the state level. Well, it does have an involvement in a sense, because here’s how it’s going to work apparently. The Federal Insurance Office was created to look at systemic risk of insurance, because the AIG problem turned out to be a federal problem, because it was so massive. The federal government doesn’t want AIG bailouts to happen again. So, the proposal was made by a number of people, well, why don’t we regulate insurance at the national level? Other countries do that, why don’t we do that? But the American tradition is too strong to make such a major change.
So, what the Dodd-Frank Act did, is it created this new office. And the Federal Insurance Office is going to collect information about insurance companies in order to discover which of them are posing the kind of risk that AIG did, a risk that could bring down the whole system. So again, they’re just looking at the problem that I highlighted at the beginning, that the whole insurance model assumes independence of risk, some kind of independence of risk, so that pooling occurs. But if it’s not really independent, then pooling isn’t going to be successful. So, here’s what the Federal Insurance Office does–what it will do, it hasn’t done anything yet, I suppose. It will monitor insurance companies for posing systemic risks. And if it decides that there is a systemic risk, another AIG brewing, then this office can recommend to another agency called the Financial Stability Oversight Commission, created by Dodd-Frank–people call it F-SOC.
It can recommend that the insurance company be designated as a threat to the system of the United States. In that extreme case, it would be put under the regulation of the Federal Reserve Board, and it would be handled in bankruptcy by the Federal Deposit Insurance Corporation. So, what Dodd-Frank has done, is left the state-regulated insurance companies unchanged, except as regards to systemic risks. And they have set up a procedure that would get the federal government involved if the Federal Insurance Office concludes that a systemic risk is happening. And the Dodd-Frank Act says very clearly, we will not bail out another insurance company the way we did AIG. We can get back into the details of what might happen in another AIG circumstance, but it’s not supposed to be the same thing.
Well, I wanted to mention that there are other countries that have insurance guarantee funds like the insurance guarantee funds that I mentioned in regards to Connecticut and New York. In many cases, they’re newer and they’re not as effective. So, I wanted to mention–in the country of China, they have just created the China Insurance Protection Fund. It’s like one of our state guarantee funds, but it has a limit. The amount that it will insure is limited to CNY 50,000, or about $6,000. It’s $500,000 in the United States. At least, they’ve got it now. Until 2008, there wasn’t even any such insurance guarantee fund.
5.5 Specific Branches of the Insurance Industry - Life and Health Insurances
So anyway, the Fabozzi book talks about various kinds of insurance, and I was going to say something about [the] types of insurance. The biggest category of insurance privately offered is life insurance, which in 2009 was almost $5 trillion. Privately offered health insurance is actually smaller than that, and property and casualty insurance is only about $1.3 trillion. Nonetheless, these are big industries. You go through Fabozzi, and it will describe the different types of life insurance. There’s term insurance, which insures you for a certain term of time. It’s terminates after one year, but is typically automatically renewable. Then there’s whole life, which gives you insurance over a long time interval and builds cash value over the years. There’s other types–there’s variable life, which has no guaranteed cash value, but invests in an account for you. And the insurance, then, has an uncertain payout.
Life insurance goes back to the 1600s, as I was saying, because that was the most important kind of insurance. The most important risk that people faced was the death of a parent. I mentioned that the first multinational corporation and the first stock exchange appeared in the 1600s, the same time as the first insurance policies appeared. The first health insurance policy was proposed in 1694 by Elder Chamberlain. And the first U.S. health insurance plan was the Franklin Health Insurance Company of Massachusetts, which started in 1850.
I wanted to talk a little bit about health insurance, because it’s something that has been an important problem. Many countries have adopted national health insurance plans. The government has come in, fundamentally, and has actually required insurance for everyone. The government has not allowed insurance to proceed along private lines. The United States, however, has had a tradition of more private, or free enterprise, and has tried merely to regulate insurance and not to impose it as a government plan. But there have been problems in the United States, in that many people do not get insurance. Because if you don’t have a government plan on insurance, you start to deal with problems of moral hazard or selection bias that encourage many people not to buy insurance. If you think that the people who buy health insurance are the sick ones, and you’re not sick, you’re not going to buy insurance.
Moreover, there were other problems of moral hazard with insurance. One problem was, if you have a private health insurance plan, the doctors have, maybe, an incentive to milk the insurance company, right? They can order too many procedures. Doctors don’t care about you, the patient, living a long time. They just have an incentive to do a lot of procedures, so they won’t do preventative medicine to protect your life–they will, if they have moral character–but the financial incentives are wrong. So, the government in the United States has tried repeatedly to do things that would improve this problem. But see, this is what I’m getting back in the initial point. Designing insurance is a matter of invention. We have to figure out some system that incentivizes doctors right, and incentivizes people to sign up–both sick people and healthy people all sign up–and things are done right. So, how do we get that?
I was going to give some milestones in this. One was the HMO Act. The government is always getting involved and trying to–this is 1973. HMO stands for health maintenance organization. A health maintenance organization is an insurance plan that tries to deal with the moral hazard problem. Doctors are paid salaries, they’re not paid for procedures. So, doctors are employees of the HMO and they have no incentive to give you an operation that you don’t need, because their pay won’t go up. The HMO Act of 1973 required employers with 25 or more employees to offer their employees a federally certified HMO Plan. One of the first HMOs–I’ll say this, because you know about them–was the Yale Health Plan. Actually, the Yale Health Plan dates to–I’ll say YHP for Yale Health Plan–1971. It actually got started before the HMO Act.
That’s because people here at Yale were thinking along the same–there was talk then, already, about the importance of preventive medicine. And Charles Taylor, who was the Yale provost, liked the idea. It was being talked about in Congress, but Yale didn’t even wait for the government to require it, we did it in advance. So, quoting Taylor: “Social responsibility of the university extends to the pioneering and the demonstration of improved methods for the provision of health services to population groups.” The concept is that it was a Yale community. Everyone at Yale belongs–or has the option of belonging–and you have a primary care person there, whose instruction is to preserve your long-term health.
Another milestone was the Emergency Medical Treatment and Active Labor Act in 1986, or EMTALA. See, so many people in the United States have no health insurance, and it’s because of these problems I’m telling you about, the moral hazard problem, the selection bias problem. People say, I’m not going to buy it, it’s too expensive because I’m not sick. That defeats the whole concept. You’re supposed to buy whether you’re sick or not. So, we had so many people that didn’t have insurance, so what would happen when they got hit by a bus, they’re lying on the street? Well, people would bring them into the hospital and, typically, hospitals would sew them up and take care of them. But they often gave really bad service, because they weren’t getting paid for this person. So, what the EMTALA did in 1986, is it requires hospitals to take you in and take care of you. Anyone needing emergency treatment, according to EMTALA, can go to any hospital with an emergency room and be taken care of. So, that’s the law. So, we do have national health insurance in that sense.
This is an example of what’s called an unfunded mandate. The government just says the hospitals have to do it. How do they pay for it? Well, that’s their problem. The government isn’t offering them any money to do it. So, what the hospitals do, is they say, OK. Suppose you get hit by a bus. If you can’t talk, they just treat you. If you can talk, they’re in there asking you to sign papers promising to pay for it eventually. So, you go deeply into debt. That’s one thing that happens. So, EMTALA didn’t really solve the health problem. We still have the selection bias problem preventing people from signing up. The HMO Act was supposed to put us all–did I spell maintenance? I spelled this wrong. The HMO Act was supposed to get us all into HMOs. Well, you are all in an HMO, because you’re part of a community that gives it to you. But there’s over 40 million uninsured Americans, not even on any insurance plan. And people who don’t have any health insurance miss diagnostic procedures, they get diabetes, they get high blood pressure. And so, they’re not treated until they’re flat out and they’re in the emergency room. And that’s not the way to handle these conditions. So, it’s really not good what has happened.
But that brings us to the 2010 health care acts that were created by President Obama. There’s actually two of them, I won’t write their names. So, in 2010, the U.S. government passed a landmark pair of bills that were addressed to solving the selection bias and moral hazard problems and reduce the number of people who are uninsured dramatically. So, this is what the government did. It hasn’t happened yet, but the procedures are there to set it up. They’re creating new insurance exchanges that will offer insurance to be purchased by the general public. And they’re not going to require you to buy the insurance, they’re going to put a tax penalty on you if you don’t. You don’t have to buy insurance, because you’re a student here, and you’ve got insurance.
But suppose you’re just out there in the world, and you’re not affiliated with any insurance plan, then you’ll actually have to pay a penalty of something like $700 year if you don’t. So the idea is, you pretty much are going to do it, because you don’t want to pay the penalty. That solves the selection bias problem, because by forcing everyone to sign up, insurance companies no longer have the problem that only sick people sign up. Everyone signs up, so they can lower their premiums, because it doesn’t cost them as much per person when they’ve got healthy people now. So, there’s a penalty for individuals in not buying insurance, and there’s a penalty for companies who do not buy insurance for their employees. That’s another part of the selection bias problem. So, we get almost everyone covered by insurance, and that will bring the cost down. Moreover, insurance companies that are on the new insurance exchanges cannot say no for pre-existing conditions. This happens all the time now. If you already are sick, an insurance company is going to offer you a really high–they’ll say, we’ll insure you, but we’ll demand a really high monthly premium. So you say, I can’t afford that, because it doesn’t work. Now, that won’t happen.
5.6 Insurance in the Face of Catastrophes
I wanted to conclude with some thoughts about the insurance industry and where it’s going. It seems painfully slow to me. I talked about insurance being invented 1600s, that’s 400 years ago, and still we have over 40 million Americans with no health insurance. Pretty obvious that we should have it, but we have problems making it work. And we still have problems, especially in less developed countries.
Let me mention another insurable risk, which was being taken care of very badly. You know that last year, there was a terrible earthquake in Haiti. The loss of life in Haiti, and the loss of damages, was generally not insured. There were efforts to get more insurance to Caribbean countries. In 2007, the Caribbean Catastrophe Risk Insurance Facility was trying to promote insurance for the Caribbean region, but it had reached only $8 million dollars in insurance as of the Haiti earthquake. What that meant is that most buildings were not insured in Haiti. And that meant not only that people couldn’t collect when the building collapsed, but it also meant that the building really collapsed, because there were no insurance companies imposing building codes and standards. If an insurance company is bearing the risk, they will then go in and make sure that the building is constructed right, and so the risk is dealt with properly.
In contrast, a similar catastrophe in the United States was the Hurricane Katrina, which destroyed much of the city of New Orleans. But in contrast, many, or most people in New Orleans had insurance on their house. And studies show that the insurance–while there were complaints–the insurance actually worked. And most people–I think about 200,000 homes were severely damaged, and payment was about $40,000 per home. Still, there were problems in New Orleans. When New Orleans came, there were two kinds of risk. One was wind damage and the other one was flood damage. I was saying earlier that an insurance policy tries to define the loss very carefully and precisely, because it’s going to end up costing the insurance company billions of dollars, they got to get it exactly right. But they had different coverage for wind loss and flood loss. Now the problem is, when you have a hurricane, which is it? What was the problem that hit your house? Because it was both wind and flood. So, there was wrangling over the definition.
Another problem–I’m almost done here–I just wanted to talk about another kind of risk, that worries us a great deal, that tends not to be covered well by a traditional insurance company. And that’s terrorism risk. Most insurance policies traditionally have excluded acts of war or terrorism from coverage. And they feel that they have to exclude it, because those are correlated risks, right? If there’s a war, it’s going to cause–there are not independent probabilities of damage. And so, insurance companies have excluded it. But it turns out, these are some of the risks that we worry most about.
So, what we had in the United States was TRIA, which was the Terrorism Risk Insurance Act in, well, it started out in 2002, then it’s been renewed. The act requires insurance to offer terrorism insurance, but it also agrees that the government will pay some of the amount of losses if there is a major national catastrophe. So, it becomes a government-funded–in the case of a huge, let’s say, systemic problem caused by a massive increase in terrorism, the government will take up the major losses. So, that is another important step, that we now have insurance against terrorism. It was something that had been excluded because of the systemic problem.
The last thing I’ll mention is catastrophe bonds. This is an insurance-like institution that has been developing slowly. A catastrophe bond is a bond that is used to finance the management of large risks. I’ll give you an example. The Mexican government, in May of 2006, issued bonds totaling $160 billion, which need to be repaid only if Mexico does not have a major earthquake. So, if you invest in Mexican catastrophe bonds, or cat bonds, they’re called, then you are helping Mexico against a systemic, big risk. If Mexico City is hit by another earthquake like the one that they had–it was about 20 years ago–it would be a huge cost to Mexico. The Mexican government is not big enough to manage such a risk effectively. It’s better if the risk is spread out over the whole world.
So, this is an example of a kind of risk management contract that extends the scope of insurance, actually making it more financial. These bonds are actually sold and put into portfolios, and it doesn’t look like insurance. It looks like a bond that deals with the insurance risk in a financial way.
I’m about done, let me just say the insurance industry manages important risks that matter to our life. Risks to our health, to our children, to our businesses, to things that we do. And it still suffers from various imperfections that we can see. It seems like we’re just dealing with some of the problems. I mention these new innovations. But there are still problems in the insurance industries.
I could just mention a few of them. One of them is that we don’t well-insure against changes in probabilities. So for example, recently in the American South, for unknown reasons, there’s been a growing mold problem. The funguses are growing in houses, and it can damage the house and it has to be torn down. So, the probability of this risk is going up. So, insurance companies are raising their rates reflecting the probability, but there was no insurance against raising the rates. Also, hurricane risk seems to be going up, right? Because of global warming, hurricane risk is going up. So, insurance companies have been raising their insurance premiums for that reason. But that is not a risk that’s insured against. So, if you buy a house down in Florida and then hurricanes get much worse, you might not be able to afford your insurance policy. We also have problems that insurance policies are not indexed to inflation. We have life annuities–I haven’t really discussed those, but they’re policies that would benefit from inflation indexation.
So, these are still some examples. I think that the insurance industry is a–let me just conclude with this thought–it’s like any other industry. It deals with very important, real problems that require technological solutions. The solutions are difficult and we are slowly moving ahead and improving our ability to deal with these problems. But it’s a science, it’s a technology, it’s got a long ways to go. And I’m predicting that over your careers, in the next half century or more, we’ll see a lot of advances, a lot of changes, in the insurance industry, like the changes I talked about here. And these changes will lead to much better lives for all of us. So, I’m talking about efficient markets next period [correction: after the guest lecture by David Swensen], which is a favorite topic of mine. It’s about why you can’t beat the market. Or maybe you can. That’s what I like about it.
- Fabozzi, Foundations of Financial Markets, Ch. 6