Basic Economics

by Thomas Sowell

  If, over a period of ten years, you pay a total of $9,000 in premiums for insurance to cover some property and then suffer $10,000 in property damages that the insurance company must pay for, it might seem that the insurance company has lost money. If, however, your $9,000 in premium payments have been invested and have grown to $12,000 by the time you require reimbursement for property damage, then the insurance company has come out $2,000 ahead. According to The Economist magazine, “premiums alone are rarely enough to cover claims and expenses,” and in the United States “this has been true of property/casualty insurers for the past 25 years.”{498} In 2004, automobile and property insurers in the United States made a profit from the actual insurance underwriting itself for the first time since 1978.{499}

  While it might seem that an insurance company could just keep the profit from its investments for itself, in reality competition forces the price of insurance down, as it forces other prices down, to a level that will cover costs and provide a rate of return sufficient to compensate investors, without attracting additional competing investment. In an economy where investors are always on the lookout for higher profits, an inflated rate of profit in the insurance industry would tend to cause new insurance companies to be created, in order to share in this bonanza. There are already many competitors in the insurance industry, none of them dominant. Among American property and casualty insurance companies in 2010 the four largest, put together, collected just 28 percent of the premiums, while the next 46 largest insurance companies collected 52 percent. {500}

  The role of competition in forcing prices and profits into line can be seen in the decline of the price of term life insurance after an Internet website began to list all the insurance companies providing this service and their respective prices. Other changes in circumstances are also reflected in changing prices, as a result of competition. For example, when the large baby boomer generation became middle-aged, their declining automobile accident rates as they moved into the safest age brackets were reflected in the ending of the sharply rising automobile insurance rates in previous years. Crackdowns on automobile insurance frauds also helped.

  With insurance, as with advertising, the costs paid do not simply add to the price of products sold by a business that is insured. With advertising, as noted in Chapter 6, the increased sales that it produces can allow a business and its customers to benefit from economies of scale that produce lower prices. In the case of insurance, the risk that it insures against would have to be covered in the price of the product sold if there were no insurance. Since the whole point of buying insurance is to reduce risk, the cost of the insurance has to be less than the cost of the uninsured risk. Therefore the cost of producing the insured product is less than the cost of producing the product without insurance, so that the price tends to be lower than it would be if the risk had to be guarded against by charging higher prices.

  “Moral Hazard” and “Adverse Selection”

  While insurance generally reduces risks as it transfers them, there are also risks created by the insurance itself. Someone who is insured may then engage in more risky behavior than if he or she were not insured. An insured motorist may park a car in a neighborhood where the risk of theft or vandalism would be too great to risk parking an uninsured vehicle. Jewelry that is insured may not be as carefully kept under lock and key as if it were uninsured. Such increased risk as a result of having insurance is known as “moral hazard.”

  Such changes in behavior, as a result of having insurance, make it more difficult to calculate the right premium to charge. If one out of every 10,000 automobiles suffers $1,000 worth of damage from vandalism annually, then it might seem as if charging each of the 10,000 motorists ten cents more to cover damage from vandalism would be sufficient. However, if insured motorists become sufficiently careless that one out of every 5,000 cars now suffers the same damage from vandalism, then the premium would need to be twice as large to cover the costs. In other words, statistics showing how motorists currently behave and what damages they currently incur may under-estimate what damages they will incur after they are insured. That is what makes “moral hazard” a hazard to the insurance companies and a source of higher premiums to those who buy insurance.

  For similar reasons, knowing what percentage of the population comes down with a given illness can also be misleading as to how much it would cost to sell insurance to pay for treatment of that illness. If one out of every 100,000 people comes down with disease X and the average cost of treating that disease is $10,000, it might seem that adding insurance coverage for disease X to a policy would cost the insurance company only an additional ten cents per policy. But what if some people are more likely to get that disease than others—and those people know it?

  What if people who work in and around water are more likely to come down with this disease than people who work in dry, air-conditioned offices? Then fishermen, lifeguards and sailors are more likely to buy this insurance coverage than are secretaries, executives, or computer programmers. People living in Hawaii would be more likely to buy insurance coverage for this disease than people living in Arizona. This is known as “adverse selection” because statistics on the incidence of disease X in the population at large may seriously under-estimate its incidence among the kinds of people who are likely to buy insurance coverage for a disease that is more likely to strike people living or working near water.

  Although determining costs and probabilities for various kinds of insurance involve complex statistical calculations of risk, this can never be reduced to a pure science because of such unpredictable things as changes in behavior caused by the insurance itself as well as differences among people who choose or do not choose to be insured against a given risk.

  Government Regulation

  Government regulation can either increase or decrease the risks faced by insurance companies and their customers. The power of government can be used to forbid some dangerous behavior, such as storing flammable liquids in schools or driving on tires with thin treads. This limits “moral hazard”—that is, how much additional risky behavior and its consequent damage may occur among people who are insured. Forcing everyone to have a given kind of insurance coverage, such as automobile insurance for all drivers, likewise eliminates the “adverse selection” problem. But government regulation of the insurance industry does not always bring net benefits, however, because there are other kinds of government regulation which increase risks and costs.

  During the Great Depression of the 1930s, for example, the federal government forced all banks to buy insurance that would reimburse depositors if their bank went bankrupt. There was no reason why banks could not have bought such insurance voluntarily before, but those banks which followed sufficiently cautious policies, and which had a sufficient diversification of their assets that setbacks in some particular sector of the economy would not ruin them, found such insurance not worth paying for.

  Despite the thousands of banks that went out of business during the Great Depression, the vast majority of these were small banks with no branch offices.{501} That is, their loans and their depositors were typically from a given geographic location, so that their risks were concentrated, rather than diversified. None of the largest and most diversified banks failed.

  Forcing all banks and savings & loan associations to have deposit insurance eliminated the problem of adverse selection—but it increased the problem of moral hazard. That is, insured financial institutions could attract depositors who no longer worried about whether those institutions’ policies were prudent or reckless, because deposits were insured up to a given amount, even if the bank or savings & loan association went bankrupt. In other words, those who managed these institutions no longer had to worry about depositors pulling their money out when the managements made risky investments. The net result was more risky behavior—“moral hazard”—which led to losses of more than half a trillion dollars by savings & loan associations during the 1980s.{502}

&
nbsp; Government regulation can also adversely affect insurance companies and their customers when insurance principles conflict with political principles. For example, arguments are often made—and laws passed accordingly—that it is “unfair” that a safe young driver is charged a higher premium because other young drivers have higher accident rates,{xxii} or that young male drivers are charged more than female drivers the same age for similar reasons, or that people with similar driving records are charged different premiums according to where they live. A City Attorney in Oakland, California, called a press conference in which he asked: “Why should a young man in the Fruitvale pay 30 percent more for insurance” than someone living in another community. “How can this be fair?” he demanded.{503}

  Implicit in such political arguments is the notion that it is wrong for people to be penalized for things that are not their fault. But insurance is about risk—not fault—and risks are greater when you live where your car is more likely to be stolen, vandalized, or wrecked in a collision with local drag racers. Fraudulent insurance claims also differ from one location to another, with insurance premiums being higher in places where such fraud is more prevalent. Thus the same insurance coverage for the same car can vary from city to city and even from one part of the same city to another.

  The same automobile insurance coverage that costs $5,162 in Detroit costs $3,225 in Los Angeles and $948 in Green Bay.{504} The same insurance coverage for the same car costs more in Brooklyn than in Manhattan because Brooklyn has been one of the hotspots for insurance fraud.{505}

  These are all risks that differ from one place to another with a given driver. Forcing insurance companies to charge the same premiums to groups of people with different risks means that premiums must rise over all, with safer groups subsidizing those who are either more dangerous in themselves or who live where they are vulnerable to more dangerous other people or where insurance fraud rings operate. In the case of automobile insurance, this also means that more unsafe drivers can afford to be on the road, so that their victims pay the highest and most unnecessary price of all in injuries and deaths.

  Concern for politically defined “fairness” over risk also led to a 95-to-nothing vote in the United States Senate in 2003 for a bill banning insurance companies from “discriminating” against people whose genetic tests show them to have a higher risk of certain diseases.{506} It is certainly not these people’s fault that their genes happen to be what they are, but insurance premiums are based on risk, not fault. Laws forbidding risks to be reflected in insurance premiums and coverage mean that premiums in general must rise, not only to cover higher uncertainties when knowledge of certain risks is banned, but also to cover the cost of increased litigation from policy-holders who claim discrimination, whether or not such claims turn out to be true.

  Such political thinking is not peculiar to the United States. Charging different premiums by sex is banned in France, and efforts have been made to extend this ban to other countries in the European Union.{507} In a free market, premiums paid for insurance or annuities would reflect the fact that men have more car accidents and women live longer. Therefore men would pay more for car insurance and life insurance in general, while women would pay more for an annuity providing the same annual income as an annuity for men, since that amount would usually have to be paid for more years for a woman.

  Unisex insurance and annuities would cost more total money than insuring the sexes separately and charging them different amounts for given insurance or annuities. That is because, with one sex subsidizing the other, an insurance company’s profit-and-loss situation would be very different if more women than expected bought annuities or more men than expected bought life insurance. Since those who buy insurance or annuities choose which companies to buy from, no given company can know in advance how many women or men will buy their insurance or annuities, even though their own profit or loss depends on which sex buys what. In other words, there would be more financial risk to selling unisex insurance policies and annuities, and this additional risk would have to be covered by charging higher prices for both products.

  GOVERNMENT "INSURANCE"

  Government programs that deal with risk are often analogized to insurance, or may even be officially called “insurance” without in fact being insurance. For example, the National Flood Insurance Program in the United States insures homes in places too risky for a real insurance company, and charges premiums far below what would be necessary to cover the costs, so that taxpayers cover the remainder. In addition, the Federal Emergency Management Agency (FEMA) helps victims of floods, hurricanes and other natural disasters to recover and rebuild. Far from being confined to helping people struck by unpredictable disasters, FEMA also helps affluent resort communities built in areas known in advance to face high levels of danger.

  As a former mayor of one such community—Emerald Isle, North Carolina—put it: “Emerald Isle basically uses FEMA as an insurance policy.” Shielded by heavily subsidized financial protection, many vulnerable coastal communities have been built along the North Carolina shore. As the Washington Post reported:

  In the past two decades, beach towns have undergone an unprecedented building boom, transforming sleepy fishing villages into modern resorts. Land values have doubled and tripled, with oceanfront lots selling for $1 million or more. Quaint shore cottages have been replaced by hulking rentals with 10 bedrooms, game rooms, elevators, whirlpool bathtubs and pools.{508}

  All this has been made possible by the availability of government money to replace all this vulnerable and expensive real estate, built on a shore often struck by hurricanes. After one such hurricane, FEMA bought “an estimated $15 million worth of sand” to replace sand washed away from the beach in the storm, according to the Washington Post.{509}

  Unlike real insurance, such programs as FEMA and the National Flood Insurance Program do not reduce the over-all risks. Often people rebuild homes and businesses in the well-known paths of hurricanes and floods, often to the applause of the media for their “courage.” But the financial risks created are not paid by those who create them, as with insurance, but are instead paid by the taxpayers. What this means is that the government makes it less expensive for people to live in risky places—and more costly to society as a whole, when people distribute themselves in more risky patterns than they would do if they had to bear the costs themselves, either in higher insurance premiums or in financial losses and anxieties.

  Television reporter John Stossel’s experience was typical:

  In 1980, I built a beach house. A wonderful one. Four bedrooms—every room with a view of the Atlantic Ocean.

  It was an absurd place to build. It was on the edge of the ocean. All that stood between my house and ruin was a hundred feet of sand. My father told me, “Don’t do it, it’s too risky. No one should build so close to an ocean.”

  But I built anyway.

  Why? As my eager-for-the-business architect said, “Why not? If the ocean destroys your house, the government will pay for a new one.”{510}

  Four years later, the ocean surged in and ruined the first floor of Mr. Stossel’s house—and the government replaced it. Then, a decade after that, the ocean came in again—and this time it wiped out the whole house. The government then paid for the entire house and its contents. John Stossel described the premiums he paid for coverage under the National Flood Insurance Program as “dirt cheap,” while the same coverage from a private insurance company would undoubtedly have been “prohibitively expensive.” But this is not a program for low-income people. It covers mansions in Malibu and vacation homes owned by wealthy families in Hyannis and Kennebunkport.{511} The National Flood Insurance Program is in fact the largest property insurer in the country.

  More than 25,000 properties have received flood insurance payments from the federal government on more than four different occasions each. One property in Houston was flooded 16 times, requiring more than $800,000 worth of repairs—several times the value of
the property itself. It was one of more than 4,500 properties whose insurance payments exceeded the value of the property during the period from 1978 to 2006.{512}

  There is an almost irresistible political inclination to provide disaster relief to people struck by earthquakes, wildfires, tornadoes and other natural disasters, as well as providing money to rebuild. The tragic pictures on television over-ride any consideration of what the situation was when they decided to live where disaster victims did. The cost of rebuilding New Orleans after Hurricane Katrina struck has been estimated to be enough to pay every New Orleans family of four $800,000, which they could use to relocate to some safer place if they wished.{513} But no such offer is likely to be made, either in New Orleans or in other places subject to predictable and recurrent natural disasters ranging from wildfires to hurricanes.

  Even when there is no current natural disaster, just the prospect of such a disaster often evokes calls for government subsidies, as in a New York Times editorial:

  With premiums rising relentlessly and insurers cutting hundreds of thousands of homeowner policies from the Gulf of Mexico up the East Coast to Florida and Long Island, there is a real danger that millions might soon be unable to purchase insurance. That’s a compelling argument for government help.{514}

  Such arguments proceed as if the only real issue is covering the cost of damage, rather than reducing the risk of damage in the first place by not locating in dangerous places. Private insurance provides incentives to relocate by charging higher premiums for dangerous locations. But government-imposed price controls on insurance companies have had predictable results, as the same editorial noted—“private insurers have jacked up premiums as much as they can and, when barred from raising prices, dropped coverage of riskier homes.”{515}