The meaning of insurance vs. subsidized insurance

 

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.

Blame the supplier or the dealer or the consumer?

 

Private fractional reserve banks have been labeled the guilty party throughout this financial crisis. There sins are reckless lending and gambling with other peoples money and getting bailed up at the end.

The government is routinely blamed for not providing and implementing a regulatory environment that would disallow such practices. The people face austerity and an increasingly socialist of fascist governments are being constructed in these countries. The central bank is found as a savior and looks on helplessly as the private banking firms take losses, bankrupting individuals who had assets tied up with the loans they granted.

This picture is obfuscated to say the least. The banks unfortunately are placed in a somewhat prisoners dilemma. As the intermediaries in the credit markets, they are rewarded a spread for the successful entrepreneurial activity of placing funds in those assets that provide the highest rates of growth and return for their depositors and shareholders. This of course exists in a non-inflationary system of banking. Banks today are guided by the wise hand of the nations Central Bank who regulates the volume of credit and money at a given time in the economy. Setting reserve requirements it caps the maximum ability of credit expansion, using open market operations it “smoothens” out short term liquidity issues that might arise and effects the term structure of the nations interest rates.

Banks in this environment are forced to play ball with the central bank. The central bank placing minimum reserves forces banks to lend out more than they have stored liquidity in their vaults. If one bank didn’t engage in this sort of practice, other banks would and take a large share of the loanable market, forcing the prudent bank out of business. The bankruptcy of the prudent bank occurs because it can only make a profit by loaning out the funds that it has stored in its vault, charging a safe-keeping fee for the deposits that haven’t left the bank. The other banks make money by amplifying the returns by expanding a greater quantity of credit to the economy and crowding out the prudent bank with favorable loans, lower interest rates, interest only loans and grace period loans. The banks, receiving excess funds from the central bank merrily go about loaning these funds out to the public, essentially pyramiding these funds out. Business is deceived in expanding production due to a appearance in new savings and consumers feel wealthier, as they are able to borrow at increasingly cheaper rates, refinancing mortgages or borrowing against asset appreciation.

To keep the long story short; when it is revealed that the real savings aren’t really real and that the whole expansion is based on resource redistribution and inflation, the game stops, business contracts, unemployment increases and prices should drop. A recession has begun with the populace having to forced to live a life within their means.

So, who is to blame? The banks who want to increase shareholder wealth and market share? The businesses that want to bring a new product to the market as quickly as they can with the lowest possible cost? Or the consumer who can afford a level of existence previously not reached? Well, none of them, really.

The central bank as the source manipulator has brought this recession. The banks, even though they probably know (I’m giving a lot of rope to the banks here) that pyramiding loans would weaken their capital positions and solvency, are forced to comply, because they would be forced out of the market with more expansionary banks. The expansionary banks are safe, as they are always protected from a default from the central bank.

Unfortunately, citizens still blame the mess on greed and incompetence. Greed does occur in this type of environment and so does incompetence, but they are a result from an initial catalyst that brought this on the system in the first place.

Real life austerity

 

What if a family of four suddenly woke up one day and decided not to go to work. (We can assume that these four people are made up of a working father, mother and two elderly adolescents that have recently entered into the workforce.)

After a couple of hours mindlessly walking around the living room, they had an idea to go shopping and live a little, maybe grab a vacation on a cruise ship or even buy a new home. Well, since that they abdicated from their jobs, they will need sustenance to keep them going. They are no longer productive and they need a line of credit (a loan) to finance their extravaganza. This family is now ready to shop till they drop. They will be certainly heralded by the mainstream economic press and university professors of economics as doing the right thing - helping the economy and making sure that a level of demand is out there to support GDP growth.

Just a remainder - The money they received for this activity has been saved from the rest of the population. A baker, shoe manufacturer, a steel worker, teacher, farmer and everybody else, have pooled in their savings and loaned it to the bank. The bank in return to make a profit (spread) will re-loan it out to this family. (We shall a assume a full banking, non fraudulent system to keep things simple).

Now, these funds, given to this family is a form of personal sacrifice coming from rest of society in the form of present goods. The family will take these present goods and promise to make good on the loan in the future. They will of course provide future goods for the individuals that have sacrificed in the present. The passage of time will reflect an interest component. To keep it really simple, we will just use the present versus future value of a good difference as a function of time, not including the various risk components that go into making a loan. As time passes, the family has to rely on a way to return this loan plus interest. But, it can't. It doesn't have the means of commerce anymore, only of frugality. The next logical step would be to refinance the current loan for an even bigger loan. Lets for the sake of fun call these NINJA loans (No income, no job, no asset).

To obtain a new loan, there must be unused present resources in the economy that haven't been consumed to finance this loan. Let's move ahead and say that such funds don't exist. Society has extinguished its savings. What will the family do? It can't repay its debt. It will have to restructure its debt. This means a negotiation between them and its creditors. The family might say that it will return to work and pay a couple of percent on the dollar, forcing them into bankruptcy. The creditors are forced to take a loss. There future standard of living has been diminished as they not only sacrificed so far, but will not receive any compensation for this sacrifice. They will have worked for nothing.

This analogy is the same on a nation wide basis between two countries: One that supplies the funds, and the other one, that consumes the funds. One country makes goods and renders services, while the other consumes those that are imported. The render of the good may even make loans to the consumer country, giving them an ability to consume even more in the present. This, however cannot continue indefinitely. This sort of behavior never can occur in a full banking system in which loanable funds are not created out to nothing. Sooner or later, the creditor doesn't only ask for the interest, but the principal as well. If the consumer driven country can't pay, they are forced to live within their means. They are forced to take harsh austerity reality. A smaller level of consumption, lower wages, more work hours etc. marks an austerity. But don't be fooled that they suffer alone. The creditor nation has to take a loss as they will never be repaid. Society ends up poorer and demoralized.

This story is extremely simple, and profound, as it truly governs the relationships between countries. The next twist is adding a fractional reserve banking system, a disincentive tax system made by the government and special interest groups that compound this problem greatly.