Insurance and Risk Management

Posted by PITHOCRATES - April 2nd, 2012

Economics 101

By collecting a Small Fee from Many Policy Holders Insurance Companies can Afford to Pay for the Large Losses of a Few

Insurance has one purpose.  To protect wealth.  People work hard accruing wealth.  Buying a house.  Cars.  College fund for the kids.  Retirement 401(k)s and IRAs.  It takes a long time to earn the money that lets us have these things.  And they take a constant stream of payments to sustain them.  And we are always at risk of losing them.  Something can interrupt that stream of payments to sustain them.  An accident or illness that prevents us from working.  Burying us in a stack of unexpected bills.  A tree could fall onto the house during a bad storm.  You could total your car while driving to work in a thick fog.  A wife could lose her husband leaving her to raise their children on her own.

These are very real risks that we must manage.  Because we need to protect our wealth.  We buy house and car insurance so we can keep or replace our houses and cars because we can’t afford to buy new ones should we lose the old ones.  We buy life insurance to provide for our families should we die.  We buy health insurance so an accident or disease doesn’t wipe out our savings, college fund and retirement investments.  Because we do do these things we can manage the risks in life.  So that something unexpected and incredibly expensive doesn’t take everything away that we worked so hard for.

Managing our risks allows us to live our lives.  To plan for the future.  A future that has a price tag.  A future that takes a lifetime of accumulating wealth to pay for.  And to protect the wealth that provides for our families and our retirements we buy insurance.  Groups of people join together and pay a small fee for an insurance policy that will protect a very large amount of wealth.  So if we have an unexpected and very expensive event in our lives our insurance will protect our wealth by paying for our losses.  By collecting a small fee from hundreds of thousands of policy holders insurance companies can afford to pay for the large losses of a few.  Allowing life to go on.  As best as it can following these  unexpected events.  So even in the worst of events families can keep their homes.  Keep their kids in their schools.  Protect their kids’ future by keeping their college fund intact.  Replace their property.  Allowing life to go on as close to what it was before the event.  All thanks to insurance.

Bad Insurance Risks have an Advantage over Insurance Companies due to Asymmetric Information and Adverse Selection

Insurance companies provide this valuable service.  But it isn’t easy.  Because insurance isn’t a science.  But statistical analysis.  And risk analysis.  Which is how they determine the cost of their insurance policies.  A critical part for the survival of insurance companies.  So they can continue to provide this valuable service.

Insurance companies are at a disadvantage because of asymmetric information.  Meaning their customers know more about how great a risk they are than the insurance company.  For example, reckless drivers don’t offer that information when someone is quoting a policy for them.  For they want a low price.  Not a high price that reckless drivers normally get charged.  This is a problem mostly with young drivers.  Older drivers have a driving record.  If it’s a safe record they get a low quote.  If the record includes many points and at-fault accidents they will get a high quote.  Young drivers, though, don’t have a driving record yet.  This is where the statistical analysis comes in.  On average young men drive more recklessly than young women.  Based on the statistical evidence.  So they charge young men higher rates than they charge young women.  Problem solved.  But this causes another problem.

Not all young women are good drivers.  But by charging young women lower rates some bad women drivers are getting a rate lower than their risk warrants.  Which means insurance companies will lose money insuring these drivers at rates below their risk level.  In fact, this will attract more high-risk drivers.  Thus increasing an insurance company’s risk exposure.  And as they pay out claims that exceed the premiums they collect they have to raise insurance rates for all women drivers.  Thus discouraging some good drivers from buying insurance because of the higher premiums.  Thus increasing the percentage of high-risk drivers.  Which forces the insurance companies to raise their premiums again to cover these higher losses.  We call this problem adverse selection.  Where pricing plans to manage risk ends up increasing risk.  One way around this is by group coverage.  Like in health insurance.  Where everyone at a company buys insurance in exchange for a lower group rate.  Including the high-risk people.  And the low-risk people.  Thus avoiding adverse selection.

Economic Growth is the Creation of Wealth and our Insurance Protects that Wealth

When is insurance not insurance?  When it is health insurance.  At least as it is today.  It still acts like insurance for the unexpected and catastrophic accident or illness.  But it is anything but insurance for most everything else.  The latest example in the media these days being birth control.  Which is neither an unexpected nor a catastrophic expense.  For there are few expenses that are more expected and more affordable than birth control.  Unlike, say, chemotherapy.  Or trauma care in the emergency room.  Both of which are unexpected.  And very, very expensive.

When insurance pays for everything for everybody it is no longer managing risk.  Insurance companies are no longer collecting a small fee from all policy holders to pay for the large losses of a few.  Instead they’re collecting a large fee from everyone to pay for the costs of everyone.  Or more precisely, they’re collecting a large fee from the employers who provide health insurance to their employees.  So the recipients of all those free health care goodies don’t see their costs.  Which is how they’ve been able to include everything but the kitchen sink in today’s health care insurance policies.  Causing the price of health insurance to soar.  Hurting families.  Businesses.  And the economy as a whole.

A healthy economy allocates scarce resources to where we use them most efficiently.  When we do we create the most goods possible from these scarce resources.  Making society as a whole better off.  By improving the standard of living for society as a whole.  But by turning health insurance into a welfare program it increases the cost of doing business.  Which puts downward pressures on wages.  Preventing real wages from keeping pace with the rise in consumer prices.  Leaving workers with less disposable income.  Which translates into weak economic growth.  And a stagnant or declining standard of living.

Economic growth is the creation of wealth.  And our insurance protects that wealth.  When we convert that insurance into welfare, though, we put our wealth at risk.  By putting greater pressures on that stream of payments to sustain our wealth.  Our future plans.  And our families.

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Prices, Scarcity and Value

Posted by PITHOCRATES - December 12th, 2011

Economics 101

“Economics is the Study of the Use of Scarce Resources which have Alternative Uses”

Agriculture advances gave us food surpluses.  Food surpluses gave us a division of labor.  The division of labor gave us trade.  Money made that trade more efficient.  Religion and the Rule of Law allowed great gatherings of people to live and work together in urban settings.  Free trade let us maximize this economic output and elevated our standard of living.  And free labor sustained economic growth by increasing the number of people making economic exchanges.  Of course, we need something else to facilitate these economic exchanges.  Prices.

British economist Lionel Robbins defined economics as the “study of the use of scarce resources which have alternative uses.”  Resources are the things we buy.  Or they make up the things we buy.  We can use these resources to make many different things.  For example, we can eat corn as a food.  It can be an ingredient in food.  We can make it into a sweetener.  We can use it to make bourbon whiskey.  We can even use it to make fuel to burn in our cars.   So corn has many alternative uses.

Depending on the corn harvest corn can be abundant.  Or scarce.  We can have a lot of it.  Or if there was a drought we may not have so much of it.  For another example of scarcity you can consider a concert.  Whether it is for your favorite band or a Broadway show, ticket prices for that show will vary.  The pair of tickets that are front row center are the most coveted.  And typically end up with a service or a scalper.  Thousands of people may be able to enjoy the show.  But only two can sit front row center.  These two tickets are very scarce.  And if you ever bought a pair of these tickets you know how expensive these tickets can be.

We Agree to Economic Exchanges when both Buyer and Seller Agree on the Value which is Communicated by Price

Those tickets are expensive because they are scarce.  The price of these tickets tells us this.  There are more seats available that are not as good.  And they cost less.  Because there are so many of these ‘cheap’ seats pretty much anyone can buy them.  Unlike the front-row center seats.  The scarcer something is, then, the greater its value.  And the more expensive it is.

Something becomes scarcer when the alternative uses for it grows.  For example, we now use corn to make ethanol to fuel our cars.  Leaving less available for food.  So food prices rise.  Because with this new use for corn the users in the food industry have to compete with each other to buy the smaller amount of remaining corn.  Corn, then, became scarcer when we added another use for it.  And more expensive.

We determine the price we are willing to pay for something based on the value it has to us.  In every economic exchange both buyer and seller assign a value.  Of what the buyer is willing to pay.  And what the seller is willing to accept.  We communicate this information with prices.  And we agree to make the economic exchange when both buyer and seller agree on the value of what they’re exchanging.  By agreeing on a sales price.

‘High’ Prices make sure Scarce Resources that have Alternative Uses are Always Available for those Alternative Uses

In this way prices automatically ration limited resources that have alternative uses.  And directs these limited resources to where their use is valued most.   By automatically flowing to the highest bidder.  This is the hallmark of capitalism.  And why you can walk into any American supermarket and be overwhelmed by the choices available.  But when you interfere with prices you have shortages.  And rationing by government bureaucrats.  Such as the gas lines during the Seventies.  When price controls made gas cheap to buy.  But it was almost impossible to find any to buy.  Because that cheap price for a scarce resource (made scarce by the Arab oil embargo) allowed people to buy it up until there was no more left.  Had we allowed the price to rise we would have bought less gas.  Guaranteeing there would be gas available for those who needed it most.  And who were willing to pay the higher price.

During the height of the Cold War when Soviet defectors came to the United States the American supermarket astonished them.  They never saw anything like it behind the Iron Curtain.  For communism didn’t use prices to manage their resources.  Bureaucrats managed their resources.  Their decisions filled stores with things no one wanted to buy.  And made people stand in line for hours to buy their ration of soap or toilet paper.  Things these defectors could fill a shopping cart with on any day of the week in any American supermarket.  And have money left over to buy so much more.  Thanks to capitalism.

Prices are relative.  Prices that may seem high serve a purpose.  They make sure scarce resources that have alternative uses are always available for those alternative uses.  Yes, the prices may be ‘high’ from time to time.  But these high prices guarantee these scarce resources will always be available to buy.  Unlike a low price.  Which, if too low, it will make a scarce item unavailable.  At any price.  Such as gasoline in the Seventies.

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It’s the Lack of Capitalism in Health Care that Makes it so Expensive and Inaccessible

Posted by PITHOCRATES - November 6th, 2011

Week in Review

Why is health care so expensive in the U.S.?  Apparently it’s because of doctors and insurance companies.  Not the people who set the rules doctors and insurance companies must play by (see Health insurance in America: Obamacare is making health insurers bigger posted 10/29/2011 on The Economist).

Good, cheap health care has long eluded America. Doctors are paid for each service, so they deliver as many as possible, necessary or not. Insurers protect margins by micromanaging claims and hiking premiums.  These perverse incentives are addressed, faintly, by Obamacare. For example, there are pilots to reward hospitals for the quality rather than the quantity of their care. Mostly, however, the reform deals with the symptoms of muddled incentives: high premiums and poor access.

Yes, these are perverse incentives.  But this is what happens when you exclude capitalism from health care.

All of the problems, and I mean ALL of the problems, of health care go back to one fatal flaw in how we pay for health care.  We don’t.  That is, we don’t pay for our own health care.  Others do.  And when the recipient of services rendered doesn’t pay for the services rendered you can’t help but to have these perverse incentives.

When you buy a new fridge you don’t let the salesman sell you the most expensive one with the most features if you can’t afford it.  Because you’re going to say no.  Because you can’t afford it.  Those features are nice.  But they’re not necessary for a happy and healthy life of refrigerating stuff.

But if someone else is paying the bill, guess what?  You’re probably going to get the best.  Because it won’t cost you anymore.

Just like people with good prescription coverage don’t buy generics.  Because it doesn’t cost them any more to buy the name brand.

This is what happens when you don’t pay for what you buy.  This is why health care costs are out of control.  And fixing this problem by making the original problem bigger, having other people pay for your health care, as in Obamacare, won’t do a thing to cut costs or provide more access.  What will happen is what has happened in nations with national health care.  Higher taxes and a rationing of services.  To pay for the out of control rise of costs.  Which, surprise surprise, keep rising.  Even in these countries that have ‘solved’ the problem of out of control costs.

If you want to control costs you have to increase the amount of capitalism in the system.  Not reduce it.  Because this is what capitalism does.  And what bureaucrats can’t do.

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