I decided to write on this particular subject because it is pivotal to understand the difference between risk and uncertainty in the economy in the economy. We shall keep it simple and focus on two insurable events. One is insurance concerning the aspects of life and death (life insurance) and insurance regarding natural disasters.
Life insurance can be classified as a form of savings and as a form of speculation. Insurance in its pure form is speculation. In the the case of life, it’s a safety net that allows individuals to hedge against certain unforeseeable events in the future. This safety net is activated in the case of death (the insurance policy in its most purest form). The funds are then distributed to the beneficiary of the policy (the family or relatives); depending on the clauses in the insurance contract.
The individual that pays for this protection is concerned for his and his family’s well being decides to make a monthly commitment of a certain amount of funds for a number of years to the insurance company and if it unlikely event were to occur, the insurer is obligated to pay out a certain amount to the beneficiary. In sorts, for those that understand the derivatives market, the premium that is paid is nothing but going long a put option on his well being. If he dies at a certain period of the insurance contract, his well being is valued as zero and his exercise price is determined at the beginning of the contract. Simple.
The insurance process usually involves determining the probability of his death or at what point during the contract he will activate the policy. This includes falling on actuary tables, the age at which the the consumer of the policy binds himself to the contract, his life style and etc. This is of great importance for the insurance company to know these risks, because the price of the premium is determined by these variables. The total expected premiums can be discounted to the present value at a certain discount rate to determine the acceptable level of the asset side in the balance sheet. When the event occurs, the insurance company will have enough assets to liquidate to pay of the policy with interest as well as maintaining a capital level to satisfy internal growth.
What happens when this premium is subsidized? That is, the inherent uncertainty is borne by someone else. Usually the government steps in and pays part of this premium. The first thing to notice is that this new paid in premium doesn’t reflect the true state of economic affairs. The government first of all, has to take this funds from the economy, or borrow funds to subsidize the insurer. The second step: The demand wasn’t there before the government intervention. The subsidized premium lowers the relative price of the premium payment (the absolute payment is made, but the rate of return has to drop to compensate the higher premium price). The insurer, with these additional funds has the ability of purchasing more assets than he initially could and the assets that he purchases drives the return of these assets down. The insurer is carrying an overvalued asset side of the balance sheet and and liabilities don’t reflect the true cost of capital. This can go on for a number of years, as long as the government subsidizes a certain class of savers and speculators to the detriment of the individuals that don’t take out life insurance and it also helps the companies whose financial paper is purchased, driving down the cost of capital for these key industries.
We shall comment on only what happens when the subsidy stops. When the subsidy stops, the insurance company sees that it is grossly underfunded. The new premiums that enter the system are much lower than they ought to be concerning the interest generated by the assets of the insurance company. The consumers are willing to insure themselves, but the interest rate that is desired has to be greater to offset the fall in premiums. The interest generated by the assets is insufficient for this. That is, if the base premium is low, a higher interest rate is required. If the insurance company doesn’t change the structure of its asset side it will have a average weighted return of the asset side of lets say 6%, but the liabilities have a 8% discount rate. The insurance company will have to sell its assets because the present values of the asset side is lower than the liability side. If it doesn’t change its asset structure, it will experience losses.
The insurance taken out for natural disasters has a similar twist to it. Consider the following: Which is more expensive: An insurance policy against tornado damage in tornado alley or an insurance policy against tornado damage in Alaska? Well the answer is obvious.
What happens when the government subsidizes tornado insurance in tornado alley? The cost of manufacturing homes and the maintenance of such is lower than it should be. The number of houses built greatly dwarfs the number that should have been built. Any reserve funds (rainy day funds) are severely underfunded in case of a tornado. The insurance company purchases assets that don’t generate the interest income necessary in case of a tornado. When the tornado hits, the insurer has to take a massive loss because the insurer physically can’t make up the massive number of payments now activated due to this disaster. The paid-in premiums are too low (if there is a government guarantee) and the assets are underfunded.
Just as AIG in the US sold default insurance on government bonds, raking in hefty premiums but without any buffer to support them if a default occurred; a default on mortgages written by AIG took this insurance giant down.
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