Insurance Fundamentals
Professor: So today we wanted to talk…the idea was to talk about insurance and it’s a very old idea. In fact, in some sense it even is used by animals, non-human animals. If they share risks, then it’s some kind of insurance maybe. So it’s very basic. And I think you have some idea of really what insurance is, but it involves an insurance company of some kind or a government insurance. Butthe policyholders have a contract with the insurance company to protect them against certain well-defined risks and for that they pay a premium, a regular payment to the insurance company for its standing ready to manage those risks.There is a theory behind insurance and this theory is risk pooling. That, what is a risk for one person is not a risk for society at large if they are independent. Because by the Law of Large Numbers, the number of bad outcomes are fairly predictable.The insurance company pools all these risks, and by the Law of Large Numbers is not really risky in itself. There’s a little mathematical formula for risk pooling which is assuming independence, let’s say it’s a life insurance. If every death is independent of the other, there’s no epidemics or wars that bring a lot of deaths all at once. Then the risk that you face if you’re writing any policies each against one life is, the standard deviation is given by the √p(1-p)/n, where p, is the probability of death. And you can see thatas n gets large, the standard deviation approaches zero.The fraction of policies that result in death becomes practically unknown number. That’s the key idea of insurance.
TA:“ According to the Law of Large Numbers, the average of the results obtained from a large number of trials should be close to the expected value and will tend to become closer as more trials are performed. The Law of Large Numbers is important because it guarantees stable long-term results for the averages of some random events. So, let’s take an example. While a casino may lose money in a single spin of the roulette wheel, its earnings will tend towards a predictable percentage over a large number of spins. That’s how the casino can confidently pay its monthly bills. Another example would be, if we took a six-sided dice and rolled it many times, the average of their values sometimes called the sample mean is likely to be close to 3.5 with the precision increasing as more dice are rolled. ”
Professor: Unfortunately, it’s not so easy to make this idea work in practice, largely because of moral hazardand selection bias. Moral hazard occurs when people knowing they are insured take more risks. So for example, if your house is insured against fire you may say, “I don’t care, I’ll be careless with fire because it’s insured.” So then the risk goes up. Or even worse, if the insurance company insures your house for more than you think you can sell it, you would say, “I’ll just burn it down and pretend it was an accident. And then I’ll get more money than I would have for selling the house.” Selection bias is different. It is that, the insurance company may not be able to see all of the risk parameters that define risk then their customers may see them more. So for example, health insurance tends to attract sick people. So health insurance companies ask for a medical exam, traditionally, to screen out people who know they’re already going to be sick. If they’re not successful in doing that, then the selection bias can harm their business and it can destroy an insurance business because, if people know that they’re going to be sick, then only sick people sign up. The insurance has to be expensive. Healthy people won’t sign up because they don’t want to pay the expense and so the whole thing collapses and doesn’t work. So you have to deal with selection bias the best you can by exams and disclosure and also by mandatory.The government can make it mandatory that insurance companies do not look at the selection. Obamacare is known for that, that health insurance companies are not allowed to take preexisting conditions into account. Let me give you an example of moral hazard and selection bias in insurance. Many people in this world today are living in marginal economies, subsistence farmers. You have a farm in some very underdeveloped part of the world and you depend on the crop every year to feed your family. But unfortunately, the weather throws up those curveballs every now and then. There will be a typhoon or there will be a drought of some sort. So farmers should buy insurance, right? But, how do we do that? One kind of insurance that’s been offered for many centuries, I suppose, is crop insurance. So the farmer buys insurance against the crop failing. That sounds good and workable. There’s a problem with it though. The problem is that it’s subject to manipulation. The farmer can lie about the crop, right? He can say, “I didn’t get much of a yield this year.” He can sneak some of it off and sell it and then try to claim on the insurance. Or the farmer can just get careless. Maybe he’s just not that focused guy, right. He doesn’t do things right. He gets drunk and he doesn’t do the necessary thing. That’s a moral hazard. And then there is selection bias. Farmers who know that they’re living on marginal land will be the ones who will go for the insurance. So, crop insurance has been around but it hasn’t worked that well. This leads to an advance that occurred in the last 20 years or so as pushed by the World Bank, which is an international development institution. How about insuring the weather instead of the crop?Okay, because the farmer can’t cheat on the weather. He can’t make bad weather. We have weather stations. So that sounds like a good idea? Well it’s a new idea. Weather insurance for farmers. And it’s starting to catch on especially in the developing world where it’s extremely important. It can be life or death for some of these farmers. But then, does that sound obvious and workable? Can you think of any problems with weather insurance? You have to define the weather very carefully if you’re going to describe the effect on crops. It turns out that, if you plant seeds on a certain date and they start germinating they’re very vulnerable to drought. After a certain number of days after planting and if the bad weather comes right then, so you have to measure it locally and know exactly when the planting was, details like that to make it work.
Along the lines of moral hazard Jason mentioned, you cited an article that says that we are transforming from financial capitalism into more like philanthropy capitalism, and my question is do you think that the increasing number of philanthropists and NGOs causes people in the developing countries to have less of an incentive to insure these natural disasters? Okay. That’s a complicated question. The reason we want insurance as opposed to gift giving is because insurance is much more logical and priced out so we know exactly what cost and what you can expect. And so for example, flood insurance in this country was created to prevent people from making big mistakes. The big mistake that was being made was that a lot of people were building houses in flood plains and you know sometime in the next 20 years, it’s going to be a big flood. And then these people are apparently counting on. “Well, someone will bail me out.” So in the United States in 1968, Congress passed a National Flood Insurance Act which specified that you had better buy flood insurance and the government will subsidize it but it will be priced appropriately. So go ahead, build your house in a floodplain but you’re going to have a sky high insurance rate. We’re going to price it out. And that’s the idea. So people are forewarned. You better watch out because this is a high risk area and the flood insurance rates will tell you that. So that’s a coherent system. If it’s just philanthropy, then people would always…a lot of people would be building on a flood plain. So, you’ve got to have it priced out and done right.
_128c76ee3a01538b75eea4dcef998671_Lect03_2_Insurance-MilestonesInsurance Milestones
So, in order to make insurance work it takes a lot of developments and it’s not easy and obvious. The concept of insurance, as we pointed out, goes back to ancient Rome but it doesn’t seem to have taken over. It wasn’t managing most risk. It was a narrow scope of risk. If you look at the history of insurance, insurance developed because of specific technical advances like the development of actuarial theory. So it was in the 1600’s that they produced the first life tables. And what they were, it showed the probability of dying at each age. That’s what you need to know if you’re doing a life insurance policy. What is the probability that the insured will die? And they didn’t, nobody had any statistics anywhere in the world on that until the 1600’s. So they started doing life insurance but it didn’t take off well. And fire insurance, it wasn’t widely accepted. The people mistrusted it and didn’t understand it. Even in my family, my grandfather who owned a farm in Michigan, lost their house to a fire and they weren’t insured. So this is part of our family. My family moved into the chicken coop, lived there, because they came home one day, they were on an outing and they came home and the house was gone. It completely burned down when nobody was there. So there are some milestones in insurance history about how we can get things going so that it works. In 1840, Morris Robinson who is the head of the Mutual Life of New York, a mutual insurance company, got the idea that what insurance company really needs is insurance salesman. And these had to be pillars of the community type people. And so they had to be paid very well. So the idea it was, he was going around hiring exemplary men, I assume they were all men in those days, and he had to make a door to door call. It’s unusual you get a man that looked like someone you’d heard of as a pillar of the community coming to your house. Maybe they would do it through your church or somehow get introduced. But you needed salesmen because people resisted the idea of paying for something like insurance which seems abstract and you can easily forget the risks. It turned out that you had to pay these guys a lot. They had to keep coming back and re-affirming. They had to pay another visit to you because you would tend to stop paying on the insurance after some years when you hadn’t had a claim. Then Henry Hyde in the 1880’s discovered having the sales appeal of having insurance with a large cash value. So, if you stop paying your insurance, you lose the cash value. And it’s also a saving vehicle as well.Why combine insurance with savings? Well, because it seems to affect the psychology of the purchase. And Viviana Zelizer, who is a sociologist at Princeton, did a big study of how insurance was marketed in the 19th century. And she said that, talking particularly about life insurance, women were the main beneficiaries of life insurance because men were the breadwinners, are earning an income and they tended to die young in those days. But women seemed to be, according to her studies, objecting to life insurance saying, “No, I don’t want that.” So why would a woman say that in the 19th century? Well, partly because Viviana Zelizer concludes, they were Fundamentalist Christians and they believed in the power of prayer. And they thought, women thought that insurance was some crazy gimmick scheme. And they wanted to trust in the Lord rather than in something that looked like gambling.So one woman said, apparently, “You know, this insurance policy it looks like I’m making a bet that my husband will die.” And she said that will encourage God’s wrath. I should stay out of that because I’m challenging God to take my husband and I should not do that.So they developed a different sales pitch and the new sales pitch was, don’t try to explain probability theory. Don’t try to explain how this business works. You come to the wife and you tell her, “I have a mission, okay. My mission is to help your husband protect you from beyond the grave. If God forbid something horrible were to happen to your husband, you know he would love and protect you if he could. I’m making it possible.” And that, that seemed to work and women went along with it. So these are, these are little inventions, they’re marketing inventions, but they’re important. Now we don’t need life insurance as much because people live longer. Really life insurance is to protect families against the death of a father or mother while young. Advantage of insurance might be that it has an information value that, if like you were saying earlier, if I look up the growing premium on an insurance for insuring some flood on the other side of the country, then, I look at the price. It is going up, then all of a sudden i’m inferring something [inaudible]. Right. The risk in that area without even having visited – Right. So that has other [inaudible]? Yeah. If they didn’t have the insurance then the seller of the property has no incentive to tell you about the flood that we had 20 years ago. You know you can’t see the damage anymore so you might not know, there’s no incentive. But if, if, if you are looking to buy insurance and then you see they want a thousand dollars a month for insurance, what are we talking about here? This is crazy. Why is that? Then, yeah it makes an impression on people. You know, I talk a lot about human psychology and human failures but there is a certain element of rationality and that moment happens when you’re about to sign the papers for your insurance and you say, “Wait a minute. You want me to pay a thousand dollars a month just for the flood insurance add on?” Then it makes you think and most people will make somewhat rational response to that. What do you think about the —.
_80896d098868b83d7ecfa1ae3ab37999_Lect03_3_Insurance-is-a-local-phenomenonInsurance is a Local Phenomenon
Insurance is a complicated thing because it has been regulated for centuries and it’s often regulated at the local level. Inthe United States insurance is a really local phenomenon.The Dodd Frank Act of 2010 created a federal insurance office. But it’s really mainly just a monitoring for risk. There are no national insurance companies, they all have state charters. Also, what protects you if your insurance company goes under? Well, the regulator is supposed to have checked that they’re doing things right. But what if the regulator messes up and you buy insurance? And now there’s some big catastrophe and the insurance company goes bankrupt and can’t pay you. So the state governments have set up insurance guarantee funds.There’s a lot of complexity to this whole business. It’s not so simple and easy. So the first step, it wasn’t until the 20th century that these even setup. It’s like deposit insurance when you have a bank. When you go to the bank, you’ll see FDIC insured, Federal Deposit, Insurance Corporation, but we have similar insurance of the failure of the insurance companies. But not until 1941. There was no insurance guarantee. So, here’s our local insurance guarantee fund, Connecticut Life and Health Insurance Guaranty Association. It was created in 1972, it’s not, that long ago. It’s kind of remarkable, thatbefore 1972 if your insurance company failed in Connecticut you were just out of luck. But now they will ensure your insurance against a maximum death benefit of $50,000. It’s still not big enough because if you as a young person, what is your present value, your lifetime present value? It must be several million dollars. So $500,000 just doesn’t cut it, but at least it’s something. Other countries have insurance. The China Insurance Regulatory Commission has set up a state-owned non-profit called China Insurance Protection Fund that protects people against the failure of an insurance company.But again, they’re limited to 50,000 yuan, which is not much money. So we still live in a world that’s highly, you gotta watch what you get into and check things. One thing I like, this is a course in financial markets, and I like this institutional detail because to me, it’s what makes things work. >> So, when you’re talking about AIG the last lecture and how they take the whole government bailout, what’s preventing them from committing their own moral suspicion of moral dubiousness. If they know hat there’s something like a big catastrophes coming again, they’ll get another bail out because they’re so big. Are there regulations im place? >> Well the financial crisis of 2008 took everyone by surprise. The bailouts weren’t the planned course of action. It just happened. It got so severe so suddenly that the government stepped in. In the US and in other countries to protect the integrity of the whole financial system. Now the issue now is does this set a precedent that insurance companies will say, hey we don’t need reserves because we’ll just get bailed out. Well that’s a concern and it’s been a concern of law makers. Part of the issue though is thatAIG was bailed out but the stock holders did not do well.They didn’t enrich the stock holders. It was a disaster. On top of that I think that our new regulations are stiffer and and are more aware of that crisis, but you are getting at a really important problem that too big failis a natural problem.When you have a complicated interdependent economic system and if one big company like AIG fails, that was the biggest insurance company in the world. Once one company like that fails, the government isn’t wanted to just let it everything fall where it may. There’s a natural tendency to bail out and it’s hard to get past that.We’re making efforts to, but it’s a fundamental problem. The US Government took over securities regulation in the 1930s after the Great Depression. They formed the Securities and Exchange Commission to regulate stocks and bonds from the federal level.They never did that for insurance. In fact the McCarran-Ferguson Act of 1945 delegated insurance regulation to the states. So there’s 50 different state regulators, all different. Now this is chaos, because companies like to operate nationally, but they have 50 different regulators,
one for each state. So there was a non-profit called National Association of Insurance Commissioners, NAIC, which is not government.It’s set up by the insurance industry and they have regular meetings creating suggested laws for insurance. That helps reduce the complexity of the US insurance system, because at least the state governments talk with each other, and standardize their insurance laws somewhat.
_90669b157ff17278f3474f83aed1f0fd_Lect03_4_Health-Insurance
Health Insurance
okay, the first health insurance, apparently was in 1694. The first U.S. health insurance company was Franklin health insurance company of Massachusetts in 1850. There was an important step forward in health, in Health insurance with the health maintenance organization Act of 1973 which required employers with 25 or more employees to offer what’s called an HMO. A health maintenance organization. The idea at that time was that the medical services were generally provided by practitioners, to uninsured people who had to pay when they were sick. The problem was that doctors made more money if people were sick. They would, they didn’t have any incentive to prevent disease. So there were people who complained that we needed to have our health managed by practitioners who had an incentive to keep you healthy to do preventive things. So how do we do that we have to create an organization like the Yale health plan, that keeps you for a lifetime. Let’s say that gives regular checkups to you and encourages you to come and talk to the doctor. The doctor has no incentive because a doctor is paid a salary, has no incentive to urge unnecessary surgery on you or the like. So this is what Yale health plan which was a pioneer. It was one of the first HMO’s. What they do at, I think you’ve been there right. They assigned you a primary, which is the gatekeeper for you. And they encourage you to come in for any minor thing which might reveal a more serious problem. In 1986, the U.S. Congress passed another law called EMTALA law. Emergency Medical Treatment and Active Labor Act which required hospitals and ambulance services to provide care to anyone needing emergency treatment. So basically it was a tax on everybody to provide emergency services. Now, you could probably go to an emergency room before 1986 because there was some, public spirit that hospitals would treat you if you came in. But it became mandatory in 1986. But it’s not the same thing as health insurance. Because they kind of hope that you take your sick people to another hospital’s emergency room not ours, because it comes out of our pocket, if you can’t pay. So it’s not a… it is a not a great system.Then it came, as you’ve heard of theU.S. Patient Protection and Affordable Care Act of 2010 called Obamacare.And it tries to deal with the selection bias problem by forcing everyone to sign up. So there’s a penalty for individuals not buying insurance. A tax penalty. And a penalty for companies not offering insurance for their employees. So they set up health exchanges that try to regularize the competition among insurance companies. It’s a complicated system that the Republicans want to shut down, as soon as possible. But to me,Obamacare reflects some really important issues in insurance namely that the U.S. has had something like 45 million people uninsured. And if they are uninsured then they will go to the emergency room when they are dying but they don’t. It’s not a good system because they don’t get preventive care and they don’t, they only end up In the last stage of collapse at the medical system. So it’s not perfect.
Earlier when you were talking about mandatory health insurance, now that Obamacare is kind of pushing into the direction in the area of health insurance, do you think that’s the Right thing? Right. Well, see. Health insurance has suffered an important shortcoming in the United States. It’s not, hasn’t been offered by the government. It’s private, and it’s often through employers. So suppose you lose your job then you’ve got to go out and buy health insurance. Now the problem is that they will look at you, and if you are sick they’ll say will charge you a very high rate. And so and they also have a selection bias. We talked about this in class that the people who sign up for insurance are the people who know they’re sick and need it. So that means you have to charge very high rates and then people who know they’re healthy will not sign up because they don’t want to pay the high rate. So nobody is insured, or not many people are insured. So the Obama, the Obama Care Act in Congress made it mandatory. You would pay a fine if you don’t sign up for insurance. That was supposed to put everyone back into a pool where everyone is insured and was supposed to bring the rates down. So you have to do something like that this, this is the fundamental problem with insurance. If it’s not a risk it doesn’t work. If people know there that they are at special risk then it’s… it’s not going to work. You can only insure against the unknown, but you can make laws that prevent companies from taking account of, of risk factors so that people can buy insurance and that’s what Obama here did.
_cf27fef98431eb2a71ec266ad98c73a5_Lect03_5_DisastersDisaster
Most people in the world do not have insurance against earthquake risk. Now that seems almost astonishing because the risk is so well quantified and there’s such an incentive to manage the risk. So this is a picture from the Haitian Earthquake of 2010. And you can see the damage it caused and yet most people there were not insured. So the earthquake came in 2010, before the earthquake there was the movement that tried to get Caribbean countries to buy insurance. And so they did so only a little bit. The Caribbean catastrophe risk insurance facility, manage to a create about $8 million of loss insurance. [LAUGH] But the loss is from Haitian earthquake reached into the billions. So why weren’t the Haitians insured? There was an organization trying to get them to do it and they could have bought it. But apparently, there was a resistance a thought that maybe a mistrust of institutions, a tendency to believe in good luck or something like that. Here’s another example. Hurricane Katrina is 2005. Now, this is in the United States where people are much more sophisticated, I would say, or at least attuned to financial solutions. So the city of New Orleans was heavily damaged in the Katrina hurricane. But again if insurance wasn’t perfect there as well. So now this is totally different from Haiti because we have a lot of insurance in the United States.There was in fact losses of $34 billion caused by the hurricane. And these were settled and paid out. But there were problems then, again, the problem was that a lot of the insurance policies were insured against wind damage, but not flood damage. Now, before the fact, when you sign the insurance contract, this might seem like a minor distinction. Because Hurricane Katrina was both wind and flood. But many of them did not have flood insurance. Now why didn’t they? Maybe they couldn’t imagine how can it flood here in New Orleans? They didn’t understand the impact that a hurricane can have. So also maybe because of global warming and greater fears of hurricanes, the insurance companies had been raising their rates on hurricane insurance. So many people in New Orleans had cancelled their insurance because they thought it got too expensive. So there was this substantial failure to compensate people in New Orleans as well. Not as bad as Haiti. You’re saying why should I buy flood insurance if I just say I didn’t do it sorry I’m I’ve made a mistake someone will come and help me. And so I’m going to build the house on a flood plain anyway because I don’t care. Now, that was a problem. When they passed the National Flood Insurance Act in 1968, people didn’t just go and buy it. They were ignoring it. So one thing that, later, Congress, in 1973, passed another act that
made it mandatory to buy. It wasn’t a choice anymore. You had to buy the insurance. If you were building in what was a designated high-risk area. On top of that, the US government has tried to tell you, we are not going to help you that much. If you didn’t buy in areas where it wasn’t mandatory, if you didn’t buy flood insurance, the government will
limit their help to loans. So okay, your house was washed away in a flood. You didn’t buy flood insurance. Well, we’re not going to just forget about you, we are going to lend you the money to build another house. So the government is there but it’s not helping you that much. So they’re trying to create a system with the right incentives and the bottom line is, stop building in flood prone areas. And if you do make the mistake, you will only get minimal help. And you better know that when you build a house. Some people disregard everything. I’m sure it’s still happening, but it’s kept down to a small number. I think this is one of the wonders of modern capitalism that we do as well as we do. And then finally we want to talk about terrorism risks. Insurance policies have in the past generally not focused on terrorism risk. Before 9/11/2001, most insurers did not exclude terrorism risk because they didn’t think that it was even a risk. But after 2001, they started changing their policies to say we don’t cover terrorism. This led to a sense of frustration that this is a big risk that people are suddenly concerned about, and they can’t by insurance against it. For the insurance company, said that this isn’t the way we do business. We don’t insurance against correlated risks like that. There could be a huge terrorist attack, and how do you expect us to pay it out? In this case, this is an example where the government plausibly becomes involved and has been involved in history as well in providing the insurance against the acts of war. Because the insurance companies can’t do it by themselves. So in 2002, the United States Congress passed the TRIA, the Terrorism Risk Insurance Act of 2002, which required insurers to offer terrorism insurance for three years. But the government would pay for it, or at least 90% of it. Because they decided it was too much of a tax on the insurance company, to asked them to bear this risk. And what were they charged for? That’s the thing because they don’t know where it’s going. So the government agreed to pay 90% of the insurance industry losses above a $100 billion. So that act keeps expiring and keeps being renewed again. So by 2015 the act was renewed again until 2020. But you think they should just make it permanent, right? Why is it a temporary thing? It reminds me of bankruptcy law. In the 19th century, if you went bankrupt, let’s go back to 1800. If you couldn’t pay your bills in 1800, they had special prisons for you called debtor’s prisons. But there were repeated financial crises through the 19th century. And, A lot of people went to debtor’s prison who were perfectly innocent. The only crime they’re guilty of is not understanding that they would lose their job in a financial crisis and they couldn’t pay. And their company would say, it’s something like that. It’s not really their fault. It’s not something we want to see punished by jail. So in the 19th century, whenever there was a financial crisis, they passed some special bankruptcy law that had a time duration like this and expired. They thought, well, we’re just dealing with the current crisis. But as time went on, these crises kept coming and eventually, bankruptcy law became a permanent fixture, not just a reaction to a crisis.So that’s probably what should happen to TRIA eventually. There are certain things that are hard to insure. And we require the government to come in to do the job. We’ll come back to that when we talk about public finance later.
1.保險是一種風險共擔(risk pooling)的概念，保險人透過合約付款給保險公司，將風險轉移給保險公司。
2.如果大家面臨之風險是互相獨立的話，一個人的風險不會是整個社會的風險，而透過大數法則(Law of Large Numbers)，當n夠大時，標準差趨近於零（隨機事件大量重複出現，事件出現的頻率，約等於其機率），因此有多少次事件是大概可以算出來的。
3.道德危機與逆選擇是保險中常遇到的問題，須透過充分揭露、測驗與強制等手段來避免。
4.需要避免給予大眾過度的保險而讓他們不好好珍惜與防備。
5.普林斯頓Viviana Zelizer研究發現，在美國早期，女人不願意買保險，主要由於大多家庭經濟來源是源自於男人，而這些女人認為買保險就像在詛咒他們會死一樣，所以演變到後來，介紹保險應該有不同的說法，不應該向他們解釋機率等等，而是以她們丈夫的角度出發。
6.在美國，保險是一件非常在地化的事情，是個州有個州的規範，且一開始保險公司是沒有保險基金的，也就是如果保險公司倒了，只能說是大眾自己雖了。
7.而是到後來20世界才開始逐漸出現，包括中國也有保險保護基金等。
8.美國後來有一個非政府組織NAIC，就是為了提供政府建議，讓各地保險相關法規可以更統一一些。
9.美國在1973年實施了HMO，要求有超過25位員工的雇主提供醫療組織，但當時遇到的問題是，醫生沒有照顧好他們的誘因，因為他們要生病醫生才可賺錢的。
10.美國在1986年實施了EMTALA要求醫院提供緊急醫療照護，如果付不出來是由納稅人買單，而因此很多醫院未必願意收急救病患。
11.2010年的歐巴馬健保就是強制大家要保險，或強制公司要幫員工保險，否則會罰款。其實保險在美國一直是很缺乏的東西，因為他多是私人的，且多透過雇主。