Insurance, the Archetypal Risk Management Institution, its Opportunities and Vulnerabilities: Lecture 5: Financial Markets (2011), Robert Shiller

Shiller thinks insurance is one of the most central and important elements of finance. He ends by prognosticating that major deficiencies in current insurance protections will be improved over the next 50 years to help make our lives better. Is insurance really so profoundly important for our future welfare?

The lecture details the purpose and problems of insurance so that you can almost feel empowered to start helping to fix the identified issues. How would you reform the insurance industry to help it mitigate the kinds of risks that we all face? Or do you think as Buckminster Fuller did that insurance is a non wealth-producing invention?

5. Insurance, the Archetypal Risk Management Institution, its Opportunities and Vulnerabilities

Finance & insurance tend to be considered separate, yet both use the same principles of risk management. History and regulatory issues have created the separation. Insurance is basically about pooling risk to mitigate against extreme risks. Death insurance dates to the Roman empire as a means of covering funeral expenses. Before the 1600s the concept of insurance was infused with religious ideas and didn't have the modern basis in probabilities and risk management. One historian claims the oldest known description of a insurance concept (for home replacement due to fire) was in an anonymous letter to Count Oldenburg in 1609. Wikipedia observes that insurance was used to protect traders in early China and Babylon (c. 2000 BCE).

Aristotle's book "De Caelo" said "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."

If n independent events occur with probability p, then the standard deviation σ = (p(1-p)/n)^(1/2).

This means, as Aristotle said, that with independent events as n increases the variation from the mean decreases with the square root of n and hence it becomes increasingly unlikely that the variance will differ by more than a few standard deviations from the mean.

Basic types of insurance:
- life insurance: insures against early death
- heath insurance: insures against the costs of medical care when you are sick
- property and casualty insurance: insures a house or car from accidents
- annuities: investment oriented insurance

Details of insurance contracts:
- specify the risks and exclude "inappropriate" risks
- moral hazard: (identified in the 19th century): refers to the effects of insurance on people's behavior that are undesirable (classic example: take out fire insurance then burn down your house to collect): "bad" incentivization in policies
* insurance contracts may exclude risks that are particularly vulnerable to moral hazard (e.g., suicide)
* Alternatively, policies may not insure for the full value of replacement
- Another concern in insurance contracts is selection bias: when the people who want the insurance are high risk (people with terminal illness who sign up for health & life insurance). If the insurer does not control these risks, then premiums will need to be higher to keep them solvent or profitable.
- Requires a precise definition of the loss and how proof of the insured loss is established to minimize legal disputes.
- Requires a mathematical model of risk pooling (such as the σ model above). For example, it might not be reasonable to assume independence.
- Requires evaluation of the quality of the statistics on the risk to be insured against.

There are different forms of insurance companies. Shareholder owned insurance companies have investors. Mutual insurance companies are owned by the policy-holders. They function a bit like a non-profit in that the managers of the company are paid salaries, but profits disperse to the policy-holders.

Regulation of the insurance industry is important because policy-holders pay for many, many years before they might collect. Without regulation there is the risk that the company will renege on its obligations just when a loss is incurred. Regulation provides the insurance industry with a tool to convince policy-holders that they are trustworthy. It protects honest insurance companies from bad ones who might sour the reputation of the industry.

AIG was founded by American Cornelius Vander Starr (1892-1968) in 1919 in Shanghai as American Asiatic Underwriters (AAU). Starr ran the company for 49 years until his death in 1968. He appointed Hank Greenberg as his successor in 1968. The company went public in 1969. Greenberg ran the company for 37 years until 2005. AIG became the largest underwriter of commercial and industrial insurance in the world (also selling automobile & travelers insurance). Greenberg was forced out in 2005 under suspicion in a NYS attorney general investigation that eventually dropped all criminal complaints. In 2008 and 2009, the US government committed \$182 billion to help AIG through the financial crisis that began in 2007. "I think that's the biggest bailout anywhere, at any time". TARP (Troubled Asset Relief Program) was created to deal with the systemic risk that a failure such as the one at AIG could affect so many other industries which could then fail too. The government took preferred shares in AIG at a low price which diluted the value of other shareholders who were largely "wiped out". In July of 2009, there was a 1:20 split turning every 20 shares of AIG into 1 share.

Shiller argues that AIG's failure can be attributed to a failure in the independence assumption. AIG's real estate risk modeling assumed that home prices would not fall everywhere at once but in 2007 that is exactly what happened. In particular, AIG was providing credit default swaps (the buyer pays the seller until default: so the seller is the insurer) to protect companies against default from real-estate risks. Other AIG investments in mortgage-backed securities also suffered.

State Guaranty Funds are administered by US states to protect policy-holders in case their insurance company defaults on benefit payments or becomes insolvent. The first one was established in NY in 1941. In most states there is a \$300,000 limit on benefits (generous states like NY and CT have a \$500,000 limit). Shiller argues that these limitations are inadequate as life insurance policies might be there to protect kids to go to college which can cost \$500,000. Moreover, unlike FDIC insurance the limit is across all policies that a person may hold. In CT, insurance companies are not allowed to advertise that they are insured by the system. Wikipedia has very little information about State Guaranty Funds (https://en.wikipedia.org/wiki/National_Conference_of_Insurance_Guaranty_Funds). I found useful resources on the site of the The National Conference of Insurance Guaranty Funds (NCIGF) at http://www.ncigf.org. The importance of the issue can be seen from the statistics: "From 2011 through 2013, 28 property and casualty companies went into liquidation." (http://www.ncigf.org/media/files/Trends_Winter_2014.pdf). This system has paid billions in claims on insolvent insurance companies. Would you buy insurance if the risk that your insurance company might fail just as you need it most were substantial?

Insurance regulation is done in the US at the state level. So any national insurance company will need to deal with 50 different state regulators. This is due to the McCarran–Ferguson Act of 1945 which specifies that regulation of insurance companies is entirely the responsibility of the states. The National Association of Insurance Commissioners (NAIC) is a non-profit that helps promote standards of insurance regulation to help address the difficulties in the US insurance regulation structure.

The Dodd-Frank Act of 2010 creates a Federal Insurance Office to look at systemic risks (such as the one that AIG posed to the entire economy in 2008) to help prevent further large bailouts of insurance companies. If the Office finds a systemic risk, it can recommend to the Financial Stability Oversight Council (FSOC) that the insurance company be designated as a threat to the US economy so it can be regulated by the Federal Reserve Board.

In 2008 China created the China Insurance Protection Fund which works like the State Guaranty Fund to protect policy-holders up to 50,000 yuan (\$6,000).

Life insurance is the most popular type of insurance (\$5 trillion in 2009). Health insurance is somewhat smaller and property and casualty insurance (\$1.3 trillion in 2009). Term life insurance insures for a limited period of time. Whole life covers one's total lifespan (can build cash value). Variable life has no guaranteed cash value but provides an investment account. Because the most important risk our forebears faced was the death of a parent, life insurance dates to the 1600s.

"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." Unlike many other industrialized countries that require health insurance coverage, in the US there has been a tradition of private health insurance. This creates a selection bias problem where people who are healthy will not buy the insurance which defeats the risk pooling at the heart of the concept of insurance. Private health insurance is also subject to moral hazards such as doctors with a financial incentive to order more procedures to milk the insurance companies. As always the challenge with insurance is to balance the undesirable incentives of moral hazards and selection bias to produce policies that help people and keep insurance companies solvent.

HMO (Health Maintenance Organization) Act of 1973 tries to address the incentive problem with doctors by giving them salaries (they are employees of the HMO with the goal of preserving your long-term health) instead of by reimbursement for procedures. The act requires employers with 25 employees to offer them a federally certified HMO Plan. EMTALA (Emergency Medical Treatment and Active Labor Act) in 1986 required hospitals to treat anyone requiring emergency services. It is an unfunded mandate: there is no provision for paying for the required services.

Then Shiller outlines the new 2010 health insurance legislation passed by Obama. There will be (actually much of this has now been implemented) new insurance exchanges which people need to join to avoid a \$700 tax penalty. This should solve the selection bias problem: even uninsured have an incentive to purchase health insurance.

With 40 million Americans uninsured for health care (before the Obama plan) and major deficiencies in less developed countries (the Haiti earthquake was largely uninsured), insurance has still not achieved the promise that Shiller thinks it ought to have. Starting in 2007, the Caribbean Catastrophe Risk Insurance Facility promoted insurance in the region. But by the Jan 2010 earthquake in Haiti only \$8 million in insurance had been purchased. So not only did the earthquake affect a mostly uninsured population, but the insurance industry was in no position to insist upon structurally robust building techniques. So more buildings were damaged than in a heavily insured region like Los Angeles or San Francisco. In New Orleans after Hurricane Katrina, 200,000 homes were severely damaged, and payment was about \$40,000 per home: insurance worked.

Most insurance policies exclude acts of war or terrorism from claims. TRIA the Terrorism Risk Insurance Act in 2002 provided a government supported reinsurance facility to enable more policies to cover damage from terrorism. Catastrophe (CAT) bonds can help finance large risks. If you purchase such bonds, you will be paid only if the specified catastrophe does not happen. This turns an insurance problem into a financial instrument. Mexico is using them to hedge against earthquake risks which they would otherwise be unable to respond to effectively.

"[T]he 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." One problem is changes in probabilities such as an increasing problem with mold in the American South. There is no insurance against insurance companies raising the rates on changes to the actuarial statistics. The risk of global warming increasing the risk of hurricane which is increasing premiums is not something that we can at present insure against. Insurance policies are not indexed to inflation.

"[T]he insurance industry ... 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 ... And these changes will lead to much better lives for all of us."
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