Because most philosophies that frown on reproduction don't survive.

Monday, March 23, 2009

Fraud, Folly or Probability

As the government continues to pump money into AIG, the foundering insurance giant which found itself at the center of the real estate and financial crashes, I've seen increasing numbers of commentators demand to know why no one is calling for the jailing of AIG executives on charges of fraud. How, the argument goes, was their selling of financial insurance products any different from the sort of fraud Maddoff carried out? They sold insurance policies they couldn't cover! They took money and gave nothing in return!

I think this tends to underline that people don't actually understand insurance and how it works very well. This is doubly concerning in that insurance has become increasingly central to people's ideas of economic security in the last few decades. Indeed, we've reached a point where lacking health insurance is itself considered a health problem, regardless of whether this actually results in someone failing to receive needed treatement.

What is insurance? Basically, insurance is a way of extending your savings for unlikely but high cost eventualities. For example, if I were to die this year, it would place a very heavy burden (in the form of lost earnings) on my family, such that it would be very difficult for me to save enough money to be prepared for the possibility. However, for a few hundred dollars a year, I can buy life insurance that would, if I should die in the next ten years, pay out a lump sum equivalent to 5-10 years of my current earnings.

The insurance company can afford to offer this to me because they believe they have an accurate model of how likely a healthy 30-year-old man is to die before 40. However, if a horrific plague were to strike the US, killing 10% of the population, and I was among its victems, could I console myself on my deathbed with the knowledge the insurance company would be taking care of my family?

No. Their models do not account for the possibility that 10% of the healthy, adult population would die in a single year. They would undoubtedly go bankrupt and my family would get little or nothing.

This is something we don't normally think of in regards to insurance, because insurance companies have good enough models that it would take something very unexpected to make them unable to meet their obligations. Still, because insurance companies base their prices on what they believe to be the probability of having to pay out, if something unforseen by their models occurs, they may well find themselves on the rocks. One should always understand insurance to come with a "all other things being equal" sort of proviso.

But shouldn't AIG have been able to forecast the possibility of a global real estate downturn and take that into account in their pricing? To my knowledge, there's never been a real estate downturn of the scale of the current one on such a wide scale. Sure, plenty of people were predicting the housing market would go down. That was one of my own reasons for getting out of California back in 2003 -- but those who bought a house there when I left would have seen 50% appreciation over the next four years before things went south. And even though many people were going around saying, "It has to go down," there was no historical precident for such a widespread downturn. In the past, it looked like so long as the economy and population were growing, real estate would continue going up.

Now, if you'd asked me in 2006 to insure mortgages against real estate values going down (and the resulting mortgage defaults), I would have refused. And some cautious companies doubtless did. But since there was a decent historical/statistical case to be made that they wouldn't go down, it's not exactly a surprise that someone agreed to meet the need.

Shouldn't there have been regulations in place to prevent people from offering insurance products that they wouldn't actually be able to pay out on in an emergency? Well, here we run into the probability problem again. Is it in fact likely that something will occur which will bankrupt an insurance firm? There's no reason to believe that regulators will be all that much better at understanding what could happen in the future than insurance actuaries are.

In the end, we probably just need to accept that sometimes bad and unexpected things happen. We can do our best to prevent them, but the funny thing about unexpected events is that it's hard to know they'll happen until they do.

So no, I don't think there was necessarily fraud involved here. Though there was an excessive faith in our ability to forecast the future. We'd do well to avoid such excessive faith in analytics in the future, and yet most of the suggestions for "fixing the problem" simply involve having government regulatores forecast the future instead of private insurance writers. I rather doubt that ends us up in a better place.


Jokah Macpherson said...

I'm not as familiar as I should be with the whole AIG story but it seems to me that financial insurance covers a very systematic risk where everyone is likely to need payout at the same time. It would be more like flood insurance for coastal Florida than life insurance in a stable society in that regard.

Darwin said...

My knowledge of financial instruments is not what it would have to be to pontificate with total confidence on the question (I deal with forecasting analytics, which is the sense in which this interests me) but from what I've read the credit default swaps that AIG was mainly dealing in were essentially a guaranteed payout if a debtor (either a company with bonds or a package of bundled consumer loans) defaulted in return for a payment based on the likelihood of the debt defaulting.

So there is potentially a systemic risk if lots of the companies covered start defaulting all at once. But based on historicals I think people had themselves pretty well convinced that there was a limit to how many companies would default at one time, and that they could always make up some of the money to cover the CDSs by shorting companies on the verge of default.

Clearly, they were wrong on this. But based on the last 30-40 years I don't think it was necessarily easy to prove in an analytic sense that they weren't sustainable obligations. You end up with that classic business argument with the one side saying, "Based on all historicals available, we can afford to offer this product at this price and make money on it," while the other is saying, "The data may say that, but something might happen on a scale that's never happened within your historical range. We should hold back."

In cases like that, it's far too often the "let's make money" folks who get listened to and the cautious ones who don't.

Again, I do think it was foolish, but I'm not sure it was provably so, certainly not at the level of fraud.

(And ironically, the idea was that instruments like credit default swaps would _reduce_ systemic risk by lessening the pain of a single major company defaulting on its debt.)

Jokah Macpherson said...

Thanks for the thorough response. I skimmed the first paragraph the first time around and agree that it falls more into the "not a very good idea" category than the "fraud" category.

TS said...

Loved the line "we've reached a point where lacking health insurance is itself considered a health problem", but what I'm thinking is how the health care market has become skewed by insurance since prices seem no longer aimed at the consumers of health care but the big pockets of the insurers. (like $2,000 for having a mole removed - I exaggerate to make a point.) It makes us dependent on insurance in a way that I don't think insurance was originally designed. Prices become artificially inflated.

Perhaps it's also part of the reason that college tuition has gone up so fast - subsidies from outside the system (in the form of state aid, grants and to some extent even student loans) - has inflated the price people would really be willing to pay had they had to pay out of pocket.

In both cases in response to rising costs, instead of making the system leaner or more efficient, insurance and government subsidies have allowed an unsustainable status quo. Health care & education cannot grow faster than the rate of inflation indefinitely.