Archive for March, 2003

91305779

March 24, 2003

Insuring the uninsurable

Bit of an unplanned hiatus there, as I find myself quite literally too exhausted to write anything for a week … sorry.
Historical note: this excuse was true when I wrote it; then my broadband crash intervened and since then I haven’t got round to posting this. etc etc.

Anyway, I’m sorry to inflict another rambling go-nowhere post on my long-suffering readers (recent arrivals: suck it in), but before we get going on the application of the principles of insurance to a few important economic topics, I think I need to set out a couple more concepts. Don’t worry, we’ll be having fun with these soon.

The general topic of these notes is that of how the world deals with uninsurable risks, the point being that risks don’t go away just because they’re large, non-accidental or actuarially ill-behaved.

(By the way, at this point, I’d like to correct what looks like a mistake in the post below, which was pointed out to me in comments. I’ve been using the term “nonergodic” in lots of previous posts to describe certain properties of economic systems which operate on the basis of positive feedback, and which for that reason don’t have the property of having well-defined expectations. Because this topic has been on my mind while I’ve been working through Paul Davidson’s excellent book “Money, Financial Markets and the Real World”, I’ve been overusing it somewhat. Specifically, I seem to have misused it below in a way which implies that nonergodicity of the underlying system is one of the most important ways in which a phenomenon can be actuarially ill-behaved. This is not really right; in general, the problem with actuarially ill-behaved processes is that the underlying risk factor is non-stationary. Non-stationary processes are by definition nonergodic in a fairly weak technical sense, but they can often be modelled (to take a simple example, by conditioning on a linear time trend) in a way which leaves residuals which follow an ergodic process. The problem with respect to actuarially ill-behaved series is usually that the non-stationarity of the underlying process is quite important and the risk event is uncommon, meaning that the sampling distribution of risk events doesn’t converge on the underlying process anything like quick enough to build a model you can have any confidence in; in other words, it’s a problem of sampling theory which could in principle be solved by having an infinitely large risk pool, rather than a problem of “deep” nonergodicity, under which there is no model at all under which the sampling space represents the underlying process.)

But anyway, there are a lot of uninsurable risks out there, and we need to live with them. The following methods are all ways of making financial sense of an uncertain future (“making financial sense of an uncertain future” is the motto of the UK’s Faculty and Institute of Actuaries, if you care), and they are in general important because they tell us a bit about the different ways in which economic agents behave when faced with what Frank Knight called “uncertainty” as opposed to “risk” (the distinction here being that “risk” is what you face if your economic welfare depends on a random variable for which your expectation has a well-defined probability measure and “uncertainty” being the case in which you just generally don’t know what�s going to happen — a distinction which might have been made in terms of ergodic and nonergodic systems if the history of probability had been a bit different). As a result, given that the official editorial position of D2D is that the economic world is full of actuarially ill-behaved (because nonergodic) processes, the concepts that we find in close observation of the disreputable end of the insurance industry probably have a lot to do with a lot of otherwise inexplicable human behaviour in everyday economic life. On with the show … I’ve italicized and/or bolded most of the terms of art, but not in any particularly systematic way.

The first way in which the world deals with uninsurable risks is to use insurance. Sounds paradoxical but isn’t really. Basically, there are two ways in which insurance companies cover uninsurable risks. In the first place they are often prepared to write speculative insurance (remember that in the post below we remarked that speculative risks were uninsurable), either because they can hedge that speculative risk by dealing in an open market (oh God, I fear that I will have to write yet a third “concepts” post on the difference between insurance and hedging before we can go on to bloody anything interesting.). The basic idea here is that if you’re a big and well-capitalised insurance company, you can take a gamble on something that’s more or less uninsurable, but if you think that the actual risk of paying out is small, you’ll probably make money. Thus, insurance against alien abduction, etc, which isn’t based on sound actuarial principles, but which is just basically a fancy form of bookmaking (note that when you see a bookmaker offering an outrageous bet on whether Elvis will be found alive, etc, they will usually be laying the risk off with an insurance company. On a related note, if your firm wants to spice up your annual golf tournament by offering a $1,000,000 prize for anyone scoring a hole-in-one, these guys will do you insurance against someone scoring it, and given the number of such tournaments held in the world, this risk is surprisingly diversified and actuarially well-behaved).

The other way in which insurance companies write insurance on uninsurable risks is by accident. This happens all the time and there’s nothing much that anyone can do about it. All manner of risks which look on the face of them to be decent insurance propositions can turn out on deeper analysis to be large (like asbestos), or not really accidental (like medical negligence) or actuarially ill-behaved (like insurance against terrorist attack), and mistakes are bound to be made by overworked actuary’s departments when under pressure from hard-charging underwriters. It’s also possible to write a lot more insurance on a particular risk factor than you believe yourself to be writing if you happen to have mispriced a given category of insurance, something which also happens all the time, but which probably deserves a section of its own in a future post.

Any road up, if you can’t get an insurance company to take on your risk at what you consider to be a reasonable rate of premium, you have two choices;
Self-insurance. This is where you set aside an amount of capital roughly equal to what you think your risk will cost to sort out. You then go about your business, taking the investment income on the capital you’ve set aside and (we shall assume) spending it on sweets, and then one day when the catastrophe occurs, you�ve got the cash set aside to pay for it. Note that setting aside the capital for self-insurance isn’t really a cost to you, because the investment is still yours and you get the income from it despite the fact that the assets are also being used to support the insurance of risks (this “double-gearing” was one of the attractions of being a Lloyd’s name, back in the day, which gives you a clue that there is some economic sense in which there is a cost after all). But in order to self-insure, you’ve got to have the capital lying around in the bank. Which is why under Marxist economics, insurance premium is not a cost of doing business; it’s part of the return on “surplus-value” in the same way in which coupon payments to a rentier are, and for this reason, insurance premiums weren’t a tax-deductible expense in Russia for a long time. But I digress. The other way of dealing with an uninsurable risk that happens to take up residence in your house is …

Non-insurance. This is the same as self-insurance, except that you don’t put the money aside in a dedicated fund, either because you can’t or because you don’t want to. When the shit heads fanward, you just suck it in and pay for the clean-up bill out of your current income. This makes sense for small risks, particularly which the insurance industry regards as uninsurable for reasons of moral hazard; for example, unless you have a bizarrely generous motor insurance policy, you yourself are currently following a non-insurance strategy for small bumps and dents, through the excess on your policy. For large uninsurable risks, however, non-insurance shades into …

Socialisation. I’m using this as a catch-all term for the time-honoured procedure of taking your risk event and chucking it onto an arbitrary group of people who basically don’t know anything about it, don’t want it, but who have the attractive property of being able to pay for it when you can’t. The two most common groups of people to hit up for an uninsured risk event are 1) your creditors (including your employees), through declaring bankruptcy and 2) the government, if you can make a decent political or moral case for not being allowed to actually die or be forced into penury through an unfortunate event.

Anyway, that’s my taxonomy and I’m sticking to it. Sorry for the lack of interesting applications of these principles to interesting economic cases, but bear with me … we’re on a journey here. Applications of these categories to such cases as health insurance, unemployment insurance and retirement insurance (which can be analysed as “insurance against living too long for your savings”) are for the moment left as exercises for the reader, out of a probably forlorn hope of having the only comments board on the whole internet used for purposes other than calling people bastards for having views on Israel which differ from one’s own.

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91302257

March 24, 2003

On the road again

Sorry for the lack of updates … this is not due to procrastination or lack of ideas, just the fact that the surf’s up, the fish are biting and that means that, with apologies to John Masefield

I must down to the sea again, to the lonely sea and the sky
For if I stop in Throgmorton Street, they’ll lynch me by and by.

All of which is not only complete doggerel, but actually plagiarised from a New Statesman joke contest in the 1970s, of which my parents used to own an anthology. Sorry, I was miles away there.

  • The French are not exactly innocent of this “freedom fries” nonsense, by the way, unless you believe that they have lobsters in Brittany
  • Without wanting to get all armchair general about this, it seems pretty obvious to me why the Iraqi troops appear to have been pretending to surrender and then continuing to fight. Strikes me that it’s just a matter of tactics; if you’re worried that some of your army might be surrendering anyway, then if the loyal ones occasionally wave a white flag between attacks, then even a surrendering unit will still hold up the enemy because they have to be careful to make sure they’ve really surrendered. It’s the exploitation of a social convention for private gain and it’s horrendously irresponsible, just as it was when the Serbs used to paint red crosses on their supply vehicles and we used to put spies among the weapons inspectors. It is hard to conclude other than that the rules of war are going to hell pretty quickly.
    Update: No, what the hell, I’ll say what I think on this one, in the knowledge that a lot of readers aren’t going to like it. In all honesty, if I were a commander in the Gulf right now, I would ignore all shades of the Basra Road, put to one side remarks about the Mark of Cain, and white flag or no, I’d keep shelling any Iraqi position until the smoke stopped rising, on the basis that if the reluctant Iraqi conscripts really want to desert, they can always achieve this by simply running away. It simply isn’t safe to do otherwise and I certainly won’t be condemning UK and US troops for any breaches of the Geneva Convention which are forced on them by an Iraqi tactic of using fake surrenders. This is what is known as “supporting the troops” by the way; attempting to genuinely sympathise with the horrible situation they find themselves in trying to stay alive while executing as many orders as possible, and it is not at all inconsistent with condemning the policies which put them in harm’s way, or recommending that they be brought home as soon as possible. D2D also does not condone the practice of fragging officers in any but truly extraordinary circumstances.

  • Big up to everyone who reads this blog and who knows me from my central banking days (yo Alan). Check out this number from the Bank of England Quarterly Bulletin, written by Tony Yates, who has the official D2D seal of approval as a Top Bloke. Both for the simple reason that he happens to be one, and because he has put together an article on monetary policy as interest rates approach the zero bound which is distinguished in my eyes by having a quite serious discussion in it of Silvio Gesell’s views on the desirability of a tax on hoarding cash balances. Since this was a central tenet of the Social Credit school and thence a key economic idea of Ezra Pound, there is clearly some sort of synchronicity at work here. I haven’t had a chance to read the whole article yet, but if Tony thinks that there’s something to Social Credit (he even namechecks the Alberta SC gang), then maybe we ought to dig old Ezra up after all.
  • More to come …

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March 14, 2003

Starvation cheap

Oh good, I find myself with a few spare minutes, to discuss the other big interest of this blog; the political and economic analysis of works of literature. I want to stress at this point that despite appearances, this post has nothing to do with any contemporary event; I just want to have a swipe at Rudyard Kipling for writing:

Yes, makin’ mock o’ uniforms that guard you while you sleep
Is cheaper than them uniforms, an’ they’re starvation cheap;

, a line from his poem “Tommy”, much quoted by people who don’t like it when anyone suggests that the armed forces might be the undereducated, often ill-behaved proleterians that they actually are rather than the noble, disciplined warriors that belligerent sentimentalist civilians would like them to be. I don’t suppose it’s particularly relevant to the sentiments expressed in the poem, but the historical fact of the matter is that Kipling is bullshitting particularly hard in this couplet.

The poem “Tommy” was written in 1892. At that point, the last time when the British Army had been used in any capacity which might be regarded as “guarding the civilian population of the British Isles while they slept” was at Waterloo, some fifty years before Kipling was born. The British fought a lot of wars in the nineteenth century, but they were in general wars of agression fought against people less well-armed or well-fed than themselves, in pursuit of anything worth stealing for the gloary of the Empire, or in an attempt to protect the profits of privately owned British corporations. Furthermore, between Waterloo and the writing of that poem, the British Army had massacred demonstrators with a cavalry charge in 1819 in Manchester, brutalised the Irish peasantry in 1832 and fired on unarmed protestors against road tithes in Wales in 1844, among other instances of domestic political repression. It is for this reason that the British Army was unpopular among the civilian working class during the nineteenth century, as well as for the unruly, drunken and antisocial behaviour of bored British youths which to this day makes groups of soldiers unwelcome in many licensed premises. Kipling was wrong to have suggested that the British Army was doing anything to protect the British population, and Orwell was wrong in his essay on Kipling to attribute the unpopularity of British soldiers to a “mindless pacifism”. The rest of Orwell’s Kipling essay is very good, though, and I think I shall stop there.

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March 14, 2003

A Quick One, While He’s Away

Recent lack of activity here has been a result of my fucking cable service not working, again. Sorry. Anyway, for that reason, this is a rather quick hit-and-run post, because I’m using a computer other than my own.

  • I hereby claim dibs on being the first person on the entire Internet to adopt the currently wildly fashionable political position of being a Balking Hawk; someone who would basically be in favour of war in Iraq, but who has been pushed onto the anti side because they don’t trust the Bush administration not to fuck it up. Unless you know different, this post from October of 2002, sets out exactly this view as the official foreign policy of D-Squared Digest. Thank you all very much. If there are any other major political issues upon which you need advice in formulating a suitably ineffectual and fence-sitting viewpoint, my rates are reasonable.
  • On a similar note, I have been troubled greatly over the last few days by the following thought; although it is obvious that the USA has an incredible advantage over Iraq in terms of men and materiel, you have to admit that if you were picking a team of leaders to lose this war, you wouldn’t be able to do much better than Bush, Cheney and Rumsfeld. Ignorance – check; Hubris – check; Ability to alienate allies – check; Tendency to ignore unfavourable information – check. It’s like having Saddam Hussein’s fucking fantasy football team in the top job.

    Fortunately, however, being sensible, I don’t regard the fact that I came up with an idea as being a good reason in and of itself to discuss it as if it were a realistic possibility. Nine tenths of good generalship is battle selection, and to take an opponent over which you have already rather more than twice the “full Monty” (the five to one advantage in men and materiel which Field Marshall Viscount Montgomery regarded as ensuring victory), and then insist that they get rid of their remaining weapons before you attack them, is about as good combat selection as you can get.

  • And a correspondent passes on to me the following comments on the subject of Social Credit. I said I’d post them without editorial comment and so I will. If anyone else has any extended comments they’d like to see posted on the front page, it’s not too difficult to track down my email. I must say I’m feeling quite uncomfortable with the promise of “no editorial comments” when posting ideas I disagree with, but then that’s probably a good thing. So I’ll just mention that my correspondent is not connected to the Alberta Social Credit Party.

I’m following up the social credit discussion. I’m not claiming to be an expert on the subject. I am a legal scholar by trade, and generally tread into the economics field with caution. I have however found social credit theory to be an interesting diversion of late. If I can get around to it I’ll provide you with a more detailed response. I think the following points might put social credit theory into its proper context:

(a) Intellectually it is an off-shoot of the Veblenian rather than the Marxian critique of capitalism. More precisely it is closely connected to the guild socialism of the early Labour movement as laid out in the works of Alfred Orage and others. Nowadays it has some support within the environmental movement, but is largely forgotten. This may be because it is a nutty idea, but is rather, I think, because of the emergence in the aftermath of 1917 of the view that a centralised state economy was the only alternative to capitalism. Unfortunately this divide continues to poision most contemporary political and economic discourses. History shows us that it is quite possible that good ideas can be lost for generations – Aristotle’s works were lost to Western Europe for most of the Dark Ages!

(b)You are correct to say that Douglas’ starting point was that new money should not be created as debt by private interests. He turned the capitalised money (debt) concept on its head and said that money should only be created as credit for the community as a whole. He saw two basic forms of money creation: (i) Consumers’ credit – the allocation of money to consumers in the form of a “national dividend” on the strength of the universal claim to a share in the common cultural heritance and knowledge base of society (a very Veblenian notion) and; (ii) Proucers’ credit – a system of money creation based on the concept of a “just price”. Instead of selling at a cost that factored past production, debt finance and profit, producers would sell at a price calculated in accordance with the “A + B theorem”. A + B theorem is based on a critique of the circular flow equilibrium model, because of its failure to account for the effect of time in economic production. You may know more about this than me.

(c) Social credit theory does not demand the nationalisation of banks. It proposes two basic financial institutions – (i) Producer’s banks – they can issue financial credit in line with the creation of real credit created by industry, (ii) Clearing house – a national system that statutorily endorses the Producer Banks’ credit. It is also a facility for the government to fund the national dividend and other public expenditure programmes.

I have no doubt provided a misleading and certainly an incomplete account of social credit. It is of course premised on a decentralised model of social ownership of the means of production. I’m not competent to assess whether it really offers a viable model, and I can see it having major problems in the context of international trade. I do however believe that an economic model that doesn’t demand permanent economic growth and that directs resources towards the production of useful rather than harmful things will become a pressing need as the 21st Century progresses. It could be a start?

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March 5, 2003

Insurable and Uninsurable Risks

This is a post which isn’t really going to go anywhere, for which apologies in advance. But it’s just that I wanted to comment on this post on Mark Kleiman’s site, on the subject of the position of insurance companies with respect to health problems caused by alcohol. But as I was drafting an email to Mark, I realised that I was going wildly off onto tangents, and it really needed to be a post of my own. Then I had a few more thoughts about the generalisation of the problem of insurable and uninsurable risks, and how it could be used to make a few arguments I’ve been wanting to make anyway with respect to economic reasoning. And then this one came up on Brad DeLong’s site about the equity premium puzzle, which is all about the importance of unisurable shocks if you believe John Quiggin, so it was obviously important to include that, and by now we’re looking at a ten thousand word essay which is always a bit daunting to contemplate …. If you’re wondering how unplanned month-long hiatuses happen, by the way, that’s how they happen. So anyway, I think the best thing to do is to use this post to set out the core concepts of uninsurable risk, and then draw on it in two or three (or, realistically, somewhere between one and none) future posts on the substantial issues.

Basically, “insurability” and its opposite “uninsurability” are vague terms, defined by resemblance to the paradigm case of an insurable risk. A paradigmatically insurable risk is one which is accidental, small and actuarially well-behaved. Taking them in order:

Accidental: This is the category under which the well-known problems of “moral hazard” and “adverse selection” fall. If you’re insuring against an utterly random occurrence (paradigmatically, the weather), then you have no better information than the insurer about the likelihood that the insured event will occur in your case. Because of this, the insurer can quote a price for your risk without worrying about the possibility that he is dealing with someone who is trying to rip him off. As we move along the continuum of accidentalness, we reach motor insurance (where there is an asymmetry of information because you have better information than the insurer about whether you’re a crap driver or not), then professional negligence insurance (where the fact that you’re insured might mean that you take less care than you otherwise would), and finally we reach the provision of fire insurance to a small minority of proprietors of garment warehouses.

(By the way, a good way of testing whether you’re dealing with a sharp economist or not is to ask him whether fire insurance is a cyclical or countercyclical business. If he isn’t sharp, he’ll say that it’s neither; fires aren’t correlated to the business cycle. If he’s a bit more streetwise, he’ll realise that it’s a trick question and that the prevalence of fires in insured premises is actually quite strongly correlated to the degree of recession.)

There are things you can do as an insurer to try to make sure that you’re only exposed to the “accidental” component of the risks that you cover. You can use loss adjustment and claims investigation to cut down on fraud. You can put a hefty excess on your policies to deal with the adverse selection and moral hazard effects. Et cetera, et cetera. But it’s a real problem, and a quick glance at the two-and-eight that medical professional negligence has got into is enough to, is enough to make the hardiest of underwriters spend a while thinking about how much they like earthquakes.

Small: An easy one to understand; it’s not possible to write insurance against some kinds of events because the amount of the potential claim is too big a financial risk for the insurer. This is not a problem which can be solved by pricing the risk, by the way; remember the Alfred Hitchcock argument I used in the discussion of genetic testing. Just as Hitchcock’s hypothetical film about the Titanic could still be suspenseful because people wouldn’t know when it was going to sink, most of the variance of an insurance company’s profit and loss is related to the timing of claims rather than their size. For any realistic level of premium, if the insured event happens a couple of months after the policy is taken out you’re going to make a loss, and if that loss is big, you’re bust.

Note that “small” in this context refers to the risk rather than the event itself. Big hurricanes and earthquakes lead to big losses for the insurance industry, and it’s only through the careful use of reinsurance that it’s possible to manage these risks down to an insurable level. But the insurance industry is not just exposed to the risk of big things happening; things can be just as bad if a lot of small things happen at the same time. For example, if you were an insurer underwriting employers’ liability insurance in the 1950s, you’d probably think you were looking at a pretty insurable class of risks; each individual policy you were writing was pretty small relative to the whole. You wouldn’t have known that every single one of those policies was on a factory fitted with brown asbestos … and you certainly wouldn’t have written a policy for the general risk of asbestos if you’d known what you were doing. Small risks can become big in this way if they have long “tails”; if the liability extends out into the future. Another example of a risk of this sort was the guaranteed annuity issue that toppled the Equitable Life in the UK (basically, they’d implicitly written insurance against falling interest rates to a lot of policyholders). Each individual risk was small, but they were all related to a common factor, so the outcome was that Equitable was writing a much bigger single risk than would have been prudent given its capital base.

Actuarially well-behaved: Basically the requirement that it be possible for an actuary to say, with a degree of confidence which reflects his professional status, that he has determined both a premium at which the insurer can expect to write this business profitably in the long run and an amount of capital to be held against the insurance written which will provide reasonable confidence that the insurer will be able to meet claims. A risk which is paradigmatically “actuarially well-behaved” is one where there is a lot of data on past experiences of claims and where that data has the property that it can be fitted to a (possibly multivariate) probability distribution, and that this probability distribution remains stable over time. If you’re lucky enough to be writing insurance on deaths from horse kicks (the data which Poisson was investigating when he discovered the distribution that bears his name), then because you know that these events have a Poisson distribution over time, and you’ve got enough data to fit the parameters of that distribution (mean and moments), which will give you a clear picture of exactly what your risk of ruin is, at any given level of premium. If you’re dealing with subjects on which there is a patchy or inadequate dataset, then there is often a few statistical tricks you can pull (or educated guesses you can make) to quasi-fit a distribution of losses. Even for some kinds of nonergodic data (basically, those described by power laws), you can find actuaries who will go out on a limb and price a policy, even in the absence of a well-defined measure of central tendency and dispersion. But for some things (for example, the success or failure of a business and other “speculative” risks), the actuarial ill-behaviour of the data is bad enough to make it more or less impossible to write insurance.

More to come in this direction … in the meantime, an interesting factoid, backing up a few claims I made in the earlier “genetic discrimination” post (I was arguing that since timing is a much more important source of risk than probability, genetic discrimination in insurance premia would not have the effects many pundits have prophesied for it). Even given what we know about the relative importance of smoking habits, heredity, lifestyle and all the other questions you’re asked on forms, 95% of all UK life assurance policies are written on standard terms.