5. Insurance, the Archetypal Risk Management Institution, its Opportunities and Vulnerabilities

published on July 13, 2020

Good morning I just got been running to get over here I just got back from World Economic Forum and we talked to a lot of the world's financial leaders and I was thinking what I would tell you about it but then I realized it's all off the record so I'm not supposed to say

Anything to you I was going to talk in debt instead today about about insurance which is one of the major risk management institutions that that it's not always considered part of Finance because people think of finance and

Insurance that's separate should I started debt better I have to turn up now it's up okay so it's all about we talked about basic principles of risk management in the preceding lecture it's all the same for in finance and

Insurance and yet we tend to consider them as separate businesses that's partly I think an accident of history and it's partly a product of regulation because of certain ideas that we'll come to in a few minutes that has kept the

Insurance industry separate from other financial industries but the basic last period we talked about the mean variance risk management problem and about the capital asset pricing model that's fundamental to insurance as well the

Basic idea is pooling of risk and preventing people from being subjected to extreme risks through the concept of risk pooling so I wanted to start today is talking about insurance starting with the concept of insurance of and that I

Wanted to reiterate a theme this course that financial institutions are inventions they're structures that someone had to design and make work right sometimes they don't work right then I wanted to move to a particular

Example of insurance which was until recently the biggest insurance company in the world called the American International Group or AIG and it's particularly important that that we talk about this example because on march 2 we

Have the former CEO of AIG Maurice Hank Greenberg coming to our class so I thought it's appropriate that we use AIG but not only because it was the biggest insurance company in the world but also because he's coming here so and

Then I want to talk about regulation of insurance that the insurance industry has always been subject to government regulation I'll talk about types of insurance your chapter in Fabozzi adele is mostly about types of insurance so I

Think you can mostly get that from the textbook but I wanted to say some things about it and then I was going to conclude with thoughts about insurance and how important it is to our lives and what progress it still has to make so

Insurance it doesn't sound like a very exciting topic does it I don't know I'm going to try to make it more exciting I guess you think of the insurance salesman coming knocking on your door they don't do that so much anymore they

Used to go around door to door and that was a depressing moment when the life insurance salesman came and if you invited this person into your house he would tell you about the probability of dying

How are you how tough it will be on your family that sort of thing but to me I think insurance is to me it's an exciting issue because it's about making our lives work and it's really about preventing horrible

Catastrophes from and it involves mathematical theory that that underlies the concept so to me it's exciting but I don't know if I can convey that but the fundamental concept again is risk pooling the the idea of insurance goes

Back to ancient Rome but only in very limited forms but the idea of risk pooling is is is kind of an obvious one people form organizations partly to risk pool so in ancient Rome a form a common form of insurance was death interns that

Would pay funeral bills and people in the ancient world believed that you had to get a proper burial or your soul would wander forever and that so insurance salespeople associated with guilds or business organizations would

Sell general insurance but they didn't have a very clear idea of the risk pooling concept it must have under under laying there I'm thinking but it wasn't until much later that people began to understand the concept there are

Examples of insurance throughout ancient and medieval times but they're very blurred and sparse I remember reading an insurance supposedly an insurance contract written in Renaissance Italy translated into English but it was

Hardly recognizable to me as an insurance concept contract they didn't have the concepts done it seemed to have a lot of religious language in it which normally we don't think of as something that's part of an insurance

Contract but it seemed like insurance came in in the 1600s at the same time that certain concepts of mathematics were began to be developed nope notably the concept of probability became more widely known in the 1600s according to

One historian the oldest known description of the insurance concept goes to a goes back to a count Oldenburg actually it's an anonymous letter to count Oldenburg written in 1609 and the letter says why don't we start I'm

Paraphrasing at the moment I don't we start a fund in which people pay 1% of the value of their home every year in the fund and then we will use the fund to replace the house if there's a fire and now quoting this anonymous writer

This writer said he had no doubt that it would be fully proved if a calculation were made of the number of houses consumed by fire within a certain space in the course of 30 years that the loss would not amount by a good deal to the

Sum that would be collected in that time okay it was just intuitive he said there can't be that many fires and if we collect that amount of money every year we can pay for all the houses that are

Burned down and so I didn't didn't express any mathematical law but it's the concept of insurance you don't find that before that before 1609 so I guess we don't have any clear statement of insurance before then actually you can

Find a statement approximate statement of the law of large numbers and I'm thinking of Aristotle the philosopher he wrote in this is in ancient times and I'm quoting from D kylo his book Aristotle to

Succeed in many things or many times is difficult for instance to repeat the same throw 10,000 times with the dice would be impossible whereas to make it once or twice is comparatively easy he doesn't have the language of probability

But he knows you can't explore the dice a thousand times and come up with the same number every time now we have a probability theory about it so we know that if you have n events each occurring with a probability of P then the average

Proportion out of the end events that that occur and so you have n trials an event occurring with probability P then the standard deviation of this proportion of events that occur is P times 1 minus P all over n to the

One-half power and that's a theorem from probability theory the standard deviation of the proportion of trials for which the event occurred assuming independence is given by this and so you note that it goes down with n as n

Increases it goes down with I should say the square root of n so that means that if n gets very large if you write a lot of policies and the probability of deviating from the mean by more than one or two standard deviations becomes very

Small which is what Aristotle said but but making insurance work as a as a as a institution to actually protect people against risk is is is rather difficult to achieve and that's because it has two things have to be done right

So let me let me just remind you what are the basic types of insurance this is what Fabozzi talks about there's life insurance that ensures people against early death of course you still die what it really interiors is your family

Against the loss of a breadwinner the father or the mother so you life insurance is suitably given to family especially with young children to protect the children with very important it used to be very important when there

Was a lot more early deaths now very few young people lose their parents so life insurance has receded in importance another example is health insurance this is insurance of course that you get sick and you need medical care then there's

Property and casualty insurance insuring your house or your car and then there's other kinds of though you might call investment oriented products like annuities this is a table in your textbook by Fabozzi which lists these

Categories of insurance but but the any of these insurance types are inventions and I want to specify that we have the idea that an insurance company could be set up that would say insurer houses against fires and we just heard it

Intuitively in this letter to Oldenburg long ago but to make it work and to make it work reliably involves a lot of detail so it's like you know you can think of the idea of making an airplane but to make it really work and to make

It work safely is another matter so first of all insurance needs a contract design that specifies risks and excludes risk that are in propria and issue that moral that insurance companies reach is moral

Hazard something rubbing when they're okay I'll try not to what's doing it's this one okay moral hazard is a expression that appeared in the nineteenth century to refer to the effects of insurance on

People's behavior that are undesirable so the classic example is you take out fire insurance on your house and then you burn it down deliberately in order to collect on the house or another example is you take out life insurance

And then you kill yourself to give the support in your family these are undesirable outcomes and they could be fatal to the whole concept of insurance because if you don't control moral hazard obviously the whole thing is not

Going to work so what they do in an insurance contract is they exclude risks that are particularly vulnerable to moral hazard and so that means they you would exclude certain causes of death that that might look like suicide

You can do other things to control moral hazard than excluding certain causes you can also make sure that you don't insure the house for more than it's worth right if if some1 insures a house there's no and the insurance does not cover the

Full value of the house then there's no incentive to burn it down you might as well just sell the house right no point in burning it down if it still does a little bit of money so that's one of the problems that insurance companies face

And part of the design of the insurance contract has to prevent moral hazard from becoming excessive an analogous thing is selection bias that occurs when John keeps breaking selection bias occurs when the people

Who sign up for your contract know that they are higher risk and so that they then want to what for example health people who know they are have a terminal disease and are about to die they'll all come signing up for your life insurance

Contract that will put immense costs on the insurance company and if they don't control the selection bias they will they will have to charge very high premiums and that that will force other people who don't know they're going to

Die out of the business so so out of buying insurance and so that's a fundamental problem that again something has to be done to define the policy so one thing you can do is exclude in life insurance certain causes of death that

Are likely to be known and you only put on causes of death that people wouldn't be able to predict about themselves okay another aspect of insurance is that you have to have definitions of the very very specific precise definitions of the

Loss and what constitutes proof of the insured loss if you're not clear about that there's going to be ambiguities later which will involve legal wrangling and dissatisfaction we'll see in a minute that these problems are not minor

And they keep coming up that's a constant challenge for the insurance industry then we need third we need a mathematical model of risk pooling well I just wrote one down here but it might be more complicated in some

Circumstances this is assuming independence and that's if you don't assume independence you can do you can make more complicated models net third then fourth you need a collection of mystics on risks and to evaluate I need

To evaluate the quality of those of those statistics so for example in the 1600s the people started collecting mortality tables for the first time there was no data ages at death it began in the 1600s because people were

Building an insurance industry and they needed to know those things then you need a form for the company what is the insurance company who owns it it could be a corporate form there are shareholders who are investing in the

Company and they're taking the risk that some of our policy modeling our handling of moral hazard or selection bias wasn't right some insurance companies are Mutual rather than share the the insurance is run for the benefit of the

Policyholders and they're like a nonprofit in the sense that the founders of the company pay themselves salaries but the benefits go entirely to the policyholders then you need a government design so that the government verifies

All of these things about the insurance company a problem with insurance is that people will pay in for many many years before they ever collect right especially if you're buying life insurance you hope never to collect now

And so you don't know whether it's going to work right that's why you need government regulation you need government insurance regulators that's part of the design of insurer it doesn't work if you don't have the regulator's

Because you wouldn't trust the insurance company so these are problems that that have inhibited of making insurance work I wanted to give you an example let me start I think it makes it more concrete if we start out with talking

About a particular example and I said I was going to talk about it's a very important example not only because it was the biggest insurance company it was also the biggest bailout in the entire subprime crisis we've seen

Now so and it has an interesting story so AIG okay this is still the readers I'm gonna move it to the other side it seems to not do well on my prints I'm left-handed seems to me so AIG it's an interesting story it was founded in 1919

In Shanghai and you wonder why is it called American International Group that's founded in Shanghai it was founded in Shanghai called American Asiatic underwriters and it was founded by Cornelius Van der Starr who is an

American who just decided to go to Asia and start an insurance business Shanghai in 1919 was a world city it was not really under the Chinese government it was something like Hong Kong it it had constituencies representing many

Different countries and so it was a very lively business center it's kind of interesting that the biggest insurance company in the world emerged from Shanghai and also one of the biggest banks in the world

HSBC you know the you know HSBC means they haven't they don't emphasize it anymore it's Hong Kong and Shanghai Bank Corporation so AIG was founded by mr Stahr in 1919 and started doing an insurance business

In China and moved their headquarters to New York just before Chairman Mao took over China and became a kind of a Chinese investment company in the United States Cornelius

Van der Starr ran the company from 1919 until he died in 1968 so he was CEO for 49 years a half-century and that when he just before he died he appointed Hank Greenberg who will visit us as the CEO in 1962 so that was 49 years under star

And then Greenberg took on and then ran the company until 2005 so it was 37 years under Greenberg so two men ran the company for almost a century since 2005 Greenberg is uh is has been succeeded by three CEOs the usual thing

The usual company has turns over CEOs but there's another interesting story that we might ask about Hank Greenberg that he joined the US Army and fought in world war ii and among the people among his jobs then was deliberate dacha which

Was a a concentration camp so in this was not one of the extermination camps it was a concentration camp for Jews and others under the Nazis and the people were starving and dying it's awful and when

At a Council on Foreign Relations meetings Greenberg met with Mahmoud Ahmadinejad who is the president of Iran and Ahmadinejad said something about the Holocaust doubting that it ever happened Greenberg stood up indignantly

And said it happened I saw it I was there so it's kind of interesting to me to think about this there aren't very many people who as this is an aside momentarily the other person I met who you know Geoffrey Hartman is a professor

Here at Yale and literature of he and his wife both Jewish were teenagers during World War two and Hartman escaped by what were they called kinder transport but his wife Rene was in another concentration camp not Dachau it

Was in it was in Bratislava and she was starving to death and it really happened by the way that's awful and I asked her why do you think they were starving you to death and she said we didn't know we thought maybe they

Were keeping us as hostages or something but so anyway we could ask him about about the about that so the what Greenberg would what did these people do both star and Greenberg created a wide variety of risk management products it

Became the largest underwriter of commercial and industrial insurance in the world it became a very large automobile insurer and also a travel insurance company but Greenberg was forced out of the company after 37 years

When Eliot Spitzer who was the Attorney General for the state of New York claimed that there were some irregularities and Greenberg was forced to resign it turns out though that nothing that Spitzer said has held up

And so apparently Greenberg was innocent of any of the allegations the real problem occurred with AIG after Greenberg left so Greenberg left in 2005 and then the company absolutely blew up and it

Absolutely had to be bailed out and the reason they had to be bailed out was it was primarily due almost entirely due to in a failure of the independence assumption I would say that under they their risk modeling namely they the

Company became exposed to real estate risk and the idea that their risk modelers had was that it doesn't matter that we take on risk that home prices might fall because they can never fall everywhere they can fall in one city but

Won't matter to us that's just one city and it all averages out but what actually happened after being very left was the company took huge exposures toward real estate risk and it fell everywhere home prices fell everywhere

Just exactly what they thought couldn't happen so the the company was writing credit default swaps which I told you about those before they were taking the risk they were insuring basically against

Defaults on companies whose credit depended on the real estate market they were also investing directly in real estate security in mortgage-backed securities that depended on the real estate market for their success and when

All this failed at once the AIG was about to fail that meant that the federal government had decided in 2008 to bail out AIG and the total bailout bill well the total amount committed by the US federal government was a

Hundred and eighty two billion it didn't all actually get spent it was 182 billion committed to bail out AIG that's a lot of money I think that's the biggest bailout anywhere at any time so what a lot of people are angry about

This you know part of this bailout came from what we called tarp this is the Troubled Asset Relief Program which was created under the Bush administration and it was the proposal of Treasury Secretary Henry Paulson and it was

Initially run by Paulson but it was not just tarp there was also loans from the Federal Reserve it was a complicated string of things that were done to bail out AIG so why did they do that why did the government bailout this insurance

Company the the the main reason why they did so was their concern about systemic risk it wasn't I'll come back to other kinds of bailouts of insurance companies but the problem was that AIG if it went

Under all kinds of things would go on all kinds of things would go wrong all these insurance policies that it wrote on people's casualties their their the travel insurance their any of these policies would all now be subject to

Failure because people who had these insurance would find that the company that they bought it through was disappearing but it would go on even beyond that lots of other companies investment companies

Banks would fail to or may fail to because they're involved in some kind of business dealings with AIG which would now become part of the AIG bankruptcy if AIG failed anybody who had any business with AIG would be starting to wonder

What's going to mean what's this going to mean to me AIG owes me money era what's going to happen and so there was a worry that it would destroy the whole financial system this was big enough to cause everybody

To pull back and if everybody pulls back then the business world stops it would be like a stampede for the exits everyone here is AIG goes under and so many people do business with AIG they decided it was intolerable and so the

Government came up with the money massively and quickly if you remember the story Henry Paulson who was Treasury secretary first went to Congress asking for a blank check he didn't say to bail out AIG but that's what he'd he got a

Sort of a blank check from Congress because the the story was told Paulson told the store that if we don't do this if we let company he didn't say IG was he actually asked for the tarp money before the AIG bailout but he said if we

Don't do something to prevent a collapse we could have the Great Depression again and so nobody liked to hear that but they believed him and they didn't know what else to do and so they allowed they allowed the tarp money and they allowed

The Federal Reserve and to bail out this company but some people misunderstand what this in fact means though for the shareholders in AIG the AIG shareholders lost almost everything because the government arranged the bailout in such

A way that AIG got practically wiped out the government took preferred shares in the company at a at a very low price in exchange for helping the companies survive and that diluted down the other shareholders in the company into a very

Low status the company lost over 90% of its shareholder value despite this bailout in of in July of 2009 AIG did a 1 to 20 split remember I told you about splits before usually they do it's a reverse split usually the

Stock goes up in a company and the chairs are that which originally sold for $30 a share are now selling for $100 a share and they think well that's too high a price per share so let's do a 3 for 1 split and let's make every share

Into 3 shares that's the usual split story this was going the other way massively they made every 20 shares into 1 share so if you look at the price recently it's been something like the 30 or $40 a share that's what we do on the

Stock exchange we always like to keep it it's an American tradition not so much true in other countries they have different traditions about what is the preferred price about a stock but so AIG lost just the shareholders lost just

About everything right so the public anger about a bailout of AIG is really a little bit inappropriate because they lost almost everything they could have lost everything this company did not fail it was bailed out and it survived

But it lost almost everything I think the real anger is not anger about the shareholders of AIG who lost almost everything the real anger is that the business Partners of AIG didn't lose anything

Notably Goldman Sachs which is a major partner taking the other side of contracts with AIG it didn't lose a penny alright and well why didn't they why did they but of course Goldman Sachs was not being bailed out it was not

Endangered the the government didn't know what to do with AIG because it felt that it was such a big company doing so many things that if we let them fail who knows Goldman Sachs might fail the government didn't know they didn't know

Whether Goldman Sachs might fail because they didn't have the information because the regulator's had not collected such information so they decided the only thing they could do responsibly was to keep AIG alive somehow alive as an

Insurance company maybe they lose almost all of their value but to the shareholders but they keep going so that's what happened and and AIG continues to this day it's survived after the bailout now I wanted to talk

About something else that many of you may not know about insurance companies namely that we do have something like deposit insurance for insurance companies but do you know when you go into a bank there will be a little sign

Saying FDIC insured notice that when you go into a bank they're required to post that banking bank accounts are insured by the Federal Deposit Insurance Corporation up to a limit two hundred and fifty thousand dollars now and the

Reason we do that is we don't want into it's only for relatively small savers because $250,000 is not big time a lot of money we don't want innocent people who walk into a bank and put their money there to lose their money so

You wonder about insurance do we have something like that for insurance yes we do we have state insurance guarantee funds that protect insurance companies the very they're not as although they're the

Oldest insurance guarantee fund is 1941 and that's in New York and this fund was the first but now virtually every state in the United States has these funds the Connecticut got its first insurance guarantee fund in 1972 so these are

Supposed to protect you as an individual if you take out an insurance policy and then your insurance company like AIG blows up so then you wonder well why didn't the insurance guarantee fund handle a ID okay what do you have any

Idea what the answer is why do we need the special bailout well maybe the answer is obvious the insurance guarantee fund like the FDIC is to protect the little guy right FAI ji was way too big for these state insurance

Funds there's a limit to how much insurance how much you can collect from a State Insurance Fund if your insurance company goes under and in New York its $500,000 and in Connecticut it's the same these are two of the most generous

States typically in a state in the United States you only collect $300,000 maximum now that may sound like a lot of money to you but think of it this way suppose you bought a life insurance policy for your family

What would you typically buy ever thought about it well you have two children okay and you're thinking I'm sending them both to you Yale or someplace like that it's going to cost you like five hundred thousand

Dollars right there right just sending them to college so if that's all you get in your in your insurance it's not not enough not big so these are small they don't guarantee you enough there's another thing about at least I know

About the Connecticut insurance guarantee fund and that is that you can't play the trick that you do with the Federal Deposit Insurance Corporation the Federal Deposit Insurance Corporation insures bank

Accounts for 250,000 all right but all you do is you put your money over many different banks so if you've got two and a half million you put it in ten different banks all right the FDIC will insure every one of those

So you can insure a 25 million but Connecticut the Connecticut insurance guarantee fund won't do that they'll limit you to the 500 thousand no matter how many different policies you go as another important difference between

Deposit Insurance and banks and state insurance guaranty funds at least in Connecticut I know Connecticut does not allow a finance an insurance company to advertise that they're insured it's quite the opposite with Deposit

Insurance where the FDIC requires that they post that they're insured so that's why you don't know about why you don't hear about this but there's a fundamental lesson I'm trying to get to with all of this and that is that you

Have to you have to look at the insurance company that you buy insurance from it's still oh it's still a wild world out there in a sense that if you buy insurance from an insurance company and it goes under

Well you're protected up to five hundred thousand but the that not and you're supposed to watch out now we also have state insurance regulators who are supposed to watch out that insurance companies are good but

They won't make good on you so we have a Connecticut insurance Department for example which regulates insurance companies now another interesting thing about insurance that separates it from finance is that insurance is done by the

State government that's regulated and the guarantee funds are state the Federal Deposit Insurance Corporation is a federal to National Insurance Program but the state insurance programs are but the insurance is done entirely by the

States and this makes it difficult to do business as an insurance company because you have to be you have 50 different regulators in the United States the United States is particularly difficult place to do to handle so that that's

Because we had the the mccarran-ferguson Act mccarran-ferguson act in 1945 which specified that insurance regulation is entirely for the state governments and so so in the United States a regulation of insurance is divided up across 50

Different states which is kind of makes it very difficult it's very difficult because that's a lot of different regulators like regulators to deal with one thing that we have is something called the National Association of

Insurance Commissioners which is a it's not a government organization it's a Association without any constitutional or any government definition the NAIC but what it does is it brings representatives from the different state

Governments and they meet together and they decide on model legislation that each government state government could adopt to allow insurance to be standardized across different state governments otherwise we'd have a total

Total chaos in our insurance in our insurance regulation you might be aware that under the dodd-frank Act which is the major legislation that was passed in 2010 the dodd-frank act creates a net a new Federal Insurance office office so

It sounds like the federal government in the United States is getting into insurance but in fact no it's not the federal government doesn't have any real involvement in the insurance industry it's all done it's all regulated at the

State level oh well all the well it does have an involvement in a sense because here's how it's going to work apparently the Federal Insurance office was created to look at systemic risk of insurance because the AIG problem turned out to be

A federal problem because it was so massive the federal government doesn't want a IG bailouts to happen again so the proposal was made by a number of people well why don't we regulate insurance at the national level other

Countries do that why don't we do that so but the American tradition is too strong to leave to make such a major change so what the dodd-frank act did is it created this new office and the Federal Insurance office is going to

Collect information about insurance companies in order to discover which of them are proposing the kind of risk that AIG did a risk that could bring down the whole system so again they're just looking at the problem that I

Highlighted at the beginning that the whole insurance model assumes independence of risks some kind of independence of risk so that pooling occurs but if it's not really independent then pooling isn't going to

Be successful so here's what the Federal Insurance office does what it will do it hasn't done anything yet I suppose it will monitor insurance companies for being posing systemic risk and if it decides that there is a systemic risk

Another AIG brewing then the this office can recommend to another agency called the the federal the financial stability oversight Commission financial stability oversight Commission created by dodd-frank or people call it F sock it

Can recommend that the insurance company be designated as a threat to the systemic to the system of the United States and then it would be if in that extreme case it would be put under the regulation of the Federal Reserve Board

And it would be handled in bankruptcy like along by the Federal Deposit Insurance Corporation so what dodd-frank has done is left the state regulated insurance companies unchanged except as regards

Systemic risks and they have set up a procedure that would get the federal government involved if the Federal Insurance office concludes that a systemic risk is happening and the dodd-frank act says very clearly we will

Not bail out another insurance company the way we did AIG so but we can get back into the details of what might happen in another AIG circumstance but it's not supposed to be the same thing well I wanted to mention that there are

Other countries that have insurance guarantee funds like the insurance guarantee funds that I mentioned in regards to Connecticut in New York but they're newer and they're not as in many cases they're newer and the not as

Effective so I wanted to mention the the country of China they have just created a China insurance protection fund it's like one of our state guaranteed fun but it has a limit the amount that it limited that it were that it will ensure

Is limited to 50,000 yuan or about six thousand dollars so that's much less developed it's five hundred thousand dollars in the United States in China it's at least they've got it now until last until 2008 there wasn't even any

Such insurance guarantee fund so so anyway the the Fabozzi book talks about various kinds of insurance and I was going to say something about them types of insurance the biggest type the biggest category of insurance are

Privately offered is life insurance which in 2009 was almost five trillion dollars health insurance privately offered health insurance is actually smaller than that and property and casualty insurance is only about 13

Trillion nonetheless these are big industries you go through Fabozzi and it will describe the different types of life insurance which is insurance that ensures you for a certain term of time it terminates

After one year but are typically automatically renewable then there's whole life which gives you insurance in over a long time interval and builds cash value over the years and this other type is variable life which has no

Guaranteed cash value but invested in the count for you and and the insurance then it has an uncertain payout so insurance goes back to the 16 surance goes back to the 1600s as I was saying because that was the most important kind

Of insurance the most important risk that people faced was the death of a parent so it's funny of many of these things develop I mentioned that the first multinational corporation and the first Stock Exchange appeared in the

1600s the same time as the first insurance policies appeared the first health insurance policy was foot prints in 94 by Elder Chamberlain and the first US health insurance plan was the Franklin health insurance company of

Massachusetts which we started in 1850 I wanted to talk a little bit about health insurance because it's something that has been an important problem and many countries have adopted national health insurance plans they've not allowed the

Government has come in fundamentally and has actually required insurance for everyone the government has not allowed insurance to proceed along private lines the United States however has had a tradition of more private or free

Enterprise and has tried merely to regulate insurance and not to impose it as a government plan but there have been problems in the United States in that many people do not get insurance because if you leave a private insurance if you

If you if you don't have a government plan on insurance you start to deal with problems of moral hazard or selection bias that encourage many people not to buy insurance if you think that the people who buy health insurance are the

Sick ones and you're not sick you're not going to buy insurance moreover there were other problems of moral hazard with insurance what one problem was if you have a private health insurance plan the doctors have maybe an incentive to milk

The pterence company right they can order too many procedures doctors don't care about you the patient living a long time they just have an incentive to do a lot of procedures so they won't do

Preventative medicine to protect your life well they will if they have moral character but the financial incentives are wrong so the government in the United States has tried repeatedly to do things that would improve this problem

But see this is what I'm getting back in the initial point that designing insurance is a matter of invention we have to figure out some system that incentivizes doctors right that incentivizes people to sign up both sick

People and healthy people all sign up and things are done right so how do we get that I was going to give some milestones in in this one was the HMO Act the government is always getting involved in trying to this is 1973 HMO

Stands for health maintenance organization a health maintenance organization is is a insurance plan that tries to deal with the moral hazard problem doctors are paid salaries they are not paid for procedures so doctors

Are employees of the HMO and they have no incentive to put you give you an operation that you don't need because there have been pain won't go up the HMO Act of 1973 required employers with 25 or more employees to offer their

Employees a federally certified HMO plan okay so one of the one of the first HMOs I'll say this because you know about them was the Yale health plan actually the Yale health plan dates to sa yhp

For Yale health plan 1971 it actually got started before the HMO Act that's because people here at Yale were thinking along the same there was talk then already about the importance of preventive medicine and Charles Taylor

Who was the Yale Provost liked the idea I know it was being talked about in Congress but Yale didn't even wait for the government to require it we did it in advance so the quoting Taylor social

Responsibility of the university extends to the pioneering and the demonstration of improved methods for the provision of health services to population groups so this was the concept is it was a Yale community everyone at Yale belongs or

Has the option of belonging and you're you have a primary care person there who has in it who's in instruction is to preserve your long-term health another milestone was the emergency the emergency medical treatment and active

Labor Act 1986 or EMTALA emergency medical treatment and active Labor Act 1986 what this did see so many people in the United States have no health insurance and it's because of this problem I'm telling you about there were

The moral hazard problem that selection bias problem people say I'm not going to buy it it's too expensive if I'm not sick that defeats the whole concept of you're supposed to buy it whether you're sick or not okay and so that we had so

Many people that didn't have insurance so what would happen when they got hit by a a hair out there they're lying on the street well people would bring them into the hospital and typically hospitals

Would sew them up and take care of them but they often gave really bad service because they weren't getting paid for this person so the what the EMTALA did in 1986 is it requires hospitals to take you in and take care of you anyone

Needing emergency treatment according to EMTALA can go to any hospital with an emergency room and be taken care of so that's the law so we do have national health insurance in that sense this is an example of what's called an unfunded

Mandate the government just says the hospitals have to do it how do they pay for it well that's their problem the government isn't offering them any money to do it so what the hospital's do is they say okay suppose you get hit by a

Bus all right if you can't talk they'll just treat you if you can talk they're in there asking you to sign papers promising to pay pay for it eventually so you go deeply into debt that's one thing that happens so EMTALA I didn't

Really solve the health problem we still have the moral hazard problem the selection bias problem preventing people from signing up so and we still have the you know the HMO Act was supposed to put us all that I spelled maintenance they

Spelled this run the the HMO Act is supposed to get us all into HMOs well you are all in an HMO because you're part of a community that gives it to you but it there's over 40 million uninsured Americans and not even in any insurance

Plan and people who don't have any health insurance miss diagnostic procedures they get diabetes they get high blood sure and so they're not treated until they're flat out and they're in the

Emergency room and that's not the way to handle these conditions so it's really not good what has happened but that brings us to the 2010 healthcare acts that were created by President Obama there's actually two of them I won't

Write their name but so in 2010 2010 the US government passed a landmark a pair of bills that were addressed to solving the selection bias and moral hazard problems and and reduce the number of people who are uninsured dramatically so

This is what the government did its setting up new it hasn't happened yet but the procedures are there to send it up they creating new insurance exchanges that will offer insurance to be purchased by the by the general

Public and they're going to require they're not going to require you to buy the insurance they're going to put a tax penalty on you if you don't in other word on have to buy insurance because you're a student here you've got

Insurance but suppose you're just out there in the world you're not affiliated with any with any insurance plan then you will actually have to pay a penalty of something like $700 a year if you don't

So the idea is you pretty much are going to do it because you don't want to pay the penalty that solves the selection bias problem because of by forcing everyone to sign up insurance companies no longer have the problem that only

Sick people sign up everyone signs up so they can lower their premiums because they're you know it doesn't cost them as much per person when they've got healthy people now so there's a penalty for individuals in not buying insurance and

There's a penalty for companies who do not buy insurance for their employees that's another part of the selection bias problem so we get almost everyone covered by insurance and that will bring the cost down

Moreover insurance companies that are on the new insurance exchanges cannot say no for pre-existing conditions this happens all the time now if you already are sick an insurance company is going to offer you a really high they'll say

Well insure you but well it will demand a really high monthly premium so you say I can't afford that because it doesn't it doesn't work now that won't happen I wanted to conclude with some thoughts about the insurance industry and where

It's going and we've made it seems too painfully slow to me I talked about insurance being invented in the 1600 that's 400 years ago and still we had over 40 million Americans with no health insurance pretty obvious that we should

Have it but we have was making it work and we still have problems that especially in less developed countries so let me mention the another insurable risk which which was be taking here very badly you know

That last year there was a terrible earthquake in Haiti the the loss of life in Haiti and the loss of damages was generally not insured the there were efforts to get more insurance to Caribbean countries in 2007 the

Caribbean catastrophe risk insurance facility was trying to promote insurance for the Caribbean region but it had reached only eight million dollars in insurance as of the Haiti earthquake what what that meant is that most

Buildings were not insured in Haiti and that meant not only that people couldn't collect when the building collapsed but it also meant that the building really collapsed because the there were no insurance companies imposing building

Codes and standards if an insurance company is bearing the risk they will then go in and make sure that the building is constructed right and so the risk is is dealt with properly in contrast a similar catastrophe in the

United States was the Hurricane Katrina which destroyed much of the city of New Orleans but in contrast many or most people in New Orleans had insurance on their house and studies show that the insurance while there were complaints

The insurance actually worked and most people I think well about 200,000 homes were severely damaged and payment was about $40,000 per home still there were problems in New Orleans when when New Orleans came

In which there were two kinds of risk one was wind damage and the other one was flood damage and it turns out I was saying earlier that an insurance policy tries to define the loss very carefully and precisely because it's going to end

Up costing the insurance company billions of dollars they got to get it exactly right but they had different coverage for insurance for wind loss and flood loss now the problem is when you have a hurricane which is it what was

What was the problem that hit your house because it was both wind and flood so there was rankling and there was wrangling over the definition another problem I'm almost done here I wanted to talk about another kind of risk that

Worries us a great deal that that tends not to be covered well by traditional insurance company and that's terrorism risk okay most insurance policies traditionally have excluded acts of war or terrorism from coverage and they feel

That they have to exclude it because those are correlated risks right if if the if there's a war it's going to cause the probability they're not independent probabilities of damage that and so insurance companies have excluded it but

It turns out that these are some of the risk that we worry most about and so what we what we had in the United States was tria which was the terror terrorism risk insurance act in 2000 but started out in 2002 then it's been renewed the

Act requires insurance to offer terrorism insurance but it also agrees that the government will pay some of the amount of losses if there is a major national catastrophe so it becomes a a government a government

Funded or super for it in the case of a huge let's say systemic problem caused by a massive increase in terrorism the government will take up the major losses so that is another important step that we now have insurance against terrorism

It was something that had been excluded because of the systemic problem the last thing I'll mention is catastrophe bonds this is a insurance like in this institution that has been developing slowly a catastrophe bond is a bond that

Is used to finance the management of large risks I'll give you an example the Mexican government in May of 2006 issued bonds totaling 160 billion dollars which need to be repaid only if Mexico does not have an

Earthquake a major earthquake so if you invest in Mexican catastrophe bonds or cat bonds they're called then you are helping Mexico against a systemic big risk if Mexico City is hit by another earthquake like the one that

They had was about 20 years ago it would be a huge cost to Mexico the Mexican government has to it the Mexican government is not big enough to manage such a risk effectively it's better if the risk is spread out over the whole

World so this is an example of a kind of risk management contract that extends the scope of insurance actually making it more financial who these bonds are actually sold and put into portfolios and it doesn't look like insurance

Like a bond that deals with the that deals with the insurance risk in a financial way so these are some other thing I'm about done let me just say the insurance industry manages important risks that matter to our life risk to

Our health to our children to our businesses to our way things that we do and it still suffers from various imperfections that we can see we're just it seems like we're just dealing with some of the problems I mentioned the

These new innovations but there are still problems in the in the insurance industries I could just mention a few of them one of them is that we don't well insure against changes in probabilities so for example recently in the American

South there have been for unknown reasons there's been a growing mold problem the funguses are growing in houses and if if you can damage a housing has to be torn down so the probability of this risk is going up so

Insurance companies are raising their rates reflecting the probability but there was no insurance against raising the rates also hurricane risk seems to be going up right because we've seen because of global warming hurricane risk

Is going up so insurance companies have been raising their insurance premiums for that reason but that that is not a risk that's insured against so if you buy a house down in Florida and then hurricanes get much worse you might not

Be able to afford your insurance policy we also have problems that insurance policies are not indexed to inflation we have life annuities I really discussed those but there are policies that would benefit from

Inflation indexation and so these are still some example I think that the insurance industry is a let me just conclude with this thought it's like any other industry it deals with very important real problems that require

Technology solutions the solutions are difficult and we are slowly moving ahead and improving our ability to deal with these problems but it's a science it's a technology it's got a long ways to go

And I'm predicting that over your career is in the next half century or more we'll see a lot of advances a lot of changes in the insurance industry like the changes I talked about here and these changes will lead to a much better

Lives for all of them so I talking about efficient markets next year which is a favorite topic of mine it's about why you can't beat the market or maybe you can that's what I like it like about

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