Category Archives: Public Policy

A Federal Guarantee that is Sure to Go Broke

See the (November 2014) Wall Street Journal article entitled “A Federal Guarantee Is Sure to Go Broke” and related article from November 2015 entitled “Moody’s Predicts PBGC Premiums Will Become Unaffordable“.

Think of PBGC as essentially the FDIC of private pensions. Thus, the analysis the flowchart shown at the bottom of my “On the economics of financial guarantees” blog post concerning how FDIC guarantees bank deposits applies here; in the diagram from that posting, simply replace “FDIC” in the diagram with “PBGC”, and in place of “Bank” and “Depositors”, substitute “Company offering private pension to Workers” and “Workers”.

Quoting from the above referenced WSJ article:

How is the PBGC insurance program doing on its 40th anniversary? Well, it is dead broke. Its net worth is negative $62 billion as of the end of September. That is even more broke than it was a year ago, when its net worth was negative $36 billion… The PBGC has total assets of $90 billion but total liabilities of $152 billion. So its assets are a mere 59% of its liabilities. Put another way, its capital-to-asset ratio is negative 69%.

Why does the government have such a pathetic record at guaranteeing other people’s debts? It isn’t that Washington wasn’t warned. “My son, if you have become surety for your neighbor, have given your pledge for a stranger, you are snared in the utterance of your lips,” reads Proverbs 6: 1-2.

Federal Financial Guarantees: Problems and Solutions

Besides insuring bank and thrift deposits, the federal government guarantees a number of other financial transactions, including farm credits, home mortgages, student loans, small business loans, pensions, and export credits (to name a few).

In order to better understand the problems faced by federal financial guarantee programs, consider the conditions which give rise to a well-functioning private insurance market. In private markets, insurers segregate policyholders with similar exposures to risk into separate risk classifications, or pools. As long as the risks of the policyholders are not significantly correlated (that is, all policyholders do not suffer a loss at the same time), pooling reduces the risk of the average loss through the operation of a statistical principle known as the “law of large numbers”. Consequently, an insurer can cover its costs by charging a premium that is roughly proportional to the average loss. Such a premium is said to be actuarially fair.

By limiting membership in a risk pool to policyholders with similar risk exposures, the tendency of higher risk individuals to seek membership in the pool (commonly referred to as adverse selection) is controlled. This makes participation in a risk pool financially attractive to its members. Although an individual with a high chance of loss must consequently pay a higher premium than someone with a low chance of loss, both will insure if they are averse to risk and premiums are actuarially fair. By charging risk-sensitive premiums and limiting coverage through policy provisions such as deductibles, the tendency of individuals to seek greater exposure to risk once they have become insured (commonly referred to as moral hazard) is also controlled.

In contrast, federal financial guarantees often exaggerate the problems of adverse selection and moral hazard. Premiums are typically based upon the average loss of a risk pool whose members’ risk exposures may vary greatly. This makes participation financially unattractive for low risk members who end up subsidizing high risk members if they remain in the pool. In order to prevent low risk members from leaving, the government’s typical response has been to make participation mandatory. However, various avenues exist by which low risk members can leave “mandatory” risk pools. For example, prior to the reorganization of the Federal Savings and Loan Insurance Corporation (FSLIC) as part of the Federal Deposit Insurance Corporation (FDIC) during the savings and loan crisis of the 1980s and 1990s, a number of low risk thrifts became commercial banks. This change in corporate structure enabled these firms to switch insurance coverage to the FDIC, which at the time charged substantially lower premiums than did the FSLIC. Similarly, terminations of overfunded defined benefit pension plans enable firms to redeploy excess pension assets as well as drop out of the pension insurance pool operated by the Pension Benefit Guarantee Corporation (PBGC).

Although financial restructuring makes it possible to leave mandatory insurance pools, the costs of leaving may be sufficiently high for some low risk firms that they will remain. Unfortunately, the only way risk-insensitive insurance can possibly become a “good deal” for remaining members is by increasing exposure to risk; for example, by increasing the riskiness of investments or financial leverage. Furthermore, this problem is even more severe for high risk members of the pool, especially if they are financially distressed. The owners of these firms are entitled to all of the benefits of risky activities, while the insurance mechanism (in conjunction with limited liability if the firm is incorporated) minimizes the extent to which they must bear costs. Consequently, it is tempting to “go for broke” by making very risky investments which have substantial downside risk as well as potential for upside gain. The costs of this largely insurance-induced moral hazard problem can be staggering, both for the firm and the economy as a whole.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms which engender lower adverse selection and moral hazard costs. Policymakers would do well to consider how private insurers, who cannot rely upon taxpayer-financed bailouts, resolve these problems. The most common private market solution typically involves some combination of risk-sensitive premiums and economically meaningful limits on coverage. Federal financial guarantee programs should be similarly designed so that excessively risky behavior is penalized rather than rewarded.

Insurance death spiral in the news…

It turns out that the so-called “insurance death spiral” which we modeled in class this past Tuesday (see page 21 of the Moral Hazard and Adverse Selection lecture note for a verbal description and the Dynamic Adverse Selection Spreadsheet for a numerical illustration of the problem) is very much in the news these days; e.g., see the editorial entitled Salvaging Private Health Insurance in today’s Wall Street Journal and yesterday’s page 1 WSJ article entitled In Start to Unwinding the Health Law, Trump to Ease Insurance Rules.  Quoting from today’s WSJ editorial,

“ObamaCare’s defenders are calling all of this “sabotage” and warning about “adverse selection,” in which a more robust individual market will siphon off the healthy customers that prop up ObamaCare’s exchanges. They predict a death spiral of higher premiums for the sick or elderly left on the exchanges.”

Sound familiar?  As we discussed in class last Tuesday, since the implementation of combined premium schemes effectively force good risks to pay too much whereas bad risks pay too little, the good risks opt out.  When this occurs,  expected cost of claims (and correspondingly higher premiums) are in store for those who remain in the risk pool.

Case studies of how (poorly designed) insurance creates moral hazard

During last week’s class meetings, we discussed how contract designs and pricing strategies can “fix” the moral hazard that insurance might otherwise create. Insurance is “good” to the extent that it enables firms and individuals to manage the risks that they face. However, we also saw insurance has a potential “dark side.” The dark side is that too much insurance and/or incorrectly priced insurance can create moral hazard by insulating firms and individuals from the financial consequences of their decision-making. Thus, in real world insurance markets, we commonly observe partial rather than full insurance coverage. Partial insurance ensures that policyholders still have incentives to mitigate risk. Furthermore, real world insurance markets are characterized by pricing strategies such as loss-sensitive premiums (commonly referred to as “experience rated” premiums), as well as premiums that are contingent upon the extent to which policyholders invest in safety.

In competitively structured private insurance markets, we expect that the market price for insurance will (on average) be greater than or equal to its actuarially fair value. Under normal circumstances, one does not to observe negative premium loadings in the real world. Negative premium loadings are incompatible with the survival of a private insurance market since this would imply that insurers are not able to cover capital costs and would, therefore, have incentives not to supply such a market.

Which brings us to the National Flood Insurance Program (NFIP). The NFIP is a federal government insurance program managed by the Federal Emergency Management Agency (AKA “FEMA”). According to Cato senior fellow Doug Bandow’s blog posting entitled “Congress against Budget Reform: Voting to Hike Subsidies for People Who Build in Flood Plains”,

“…the federal government keeps insurance premiums low for people who choose to build where they otherwise wouldn’t. The Congressional Research Service figured that the government charges about one-third of the market rate for flood insurance. The second cost is environmental: Washington essentially pays participants to build on environmentally-fragile lands that tend to flood.”

Thus, the NFIP provides us with a fascinating case study concerning how subsidized flood insurance exacerbates moral hazard (i.e., makes moral hazard even worse) rather than mitigates moral hazard. It does this by encouraging property owners to take risks (in this case, building on environmentally fragile lands that tend to flood) that they otherwise might not take if they had to pay the full expected cost of these risks.

There are many other examples of moral hazard created by insurance subsidies. Consider the case of crop insurance provided to farmers by the U.S. Department of Agriculture. According to this Bloomberg article, the effective premium loading on federally provided crop insurance is more than -60%, thus putting crop insurance on a similar footing to flood insurance (in terms of its cost compared to its actuarially fair value). Once again, incorrect pricing encourages moral hazard. As the Bloomberg article notes,

“…subsidies give farmers an incentive to buy “Cadillac” policies that over-insure their holdings and drive up costs. Some policies protect as much as 85 percent of a farm’s average yield.”

Just as mis-priced flood insurance effectively encourages property owners to build in flood plains, mis-priced crop insurance incentivizes farmers to cultivate acreage that may or may not even be fertile.

I could go on (probably for several hundred more pages – there are innumerable egregious examples that I could cite), but I think I will stop for now…

How government policy exacerbates hurricanes like Harvey

Here’s the (very timely) cover story of the latest issue of The Economist. Quoting from the article, “Underpricing (of flood insurance) encourages the building of new houses and discourages existing owners from renovating or moving out. According to the Federal Emergency Management Agency, houses that repeatedly flood account for 1% of NFIP’s properties but 25-30% of its claims. Five states, Texas among them, have more than 10,000 such households and, nationwide, their number has been going up by around 5,000 each year. Insurance is meant to provide a signal about risk; in this case, it stifles it.”

As if global warming were not enough of a threat, poor planning and unwise subsidies make floods worse.

On the Economics of Price Gouging

This is an oldie (from 2007) but goody – on the economics of price gouging in the wake of a hurricane. The principles discussed are timeless and well worth pondering!

Mike Munger of Duke University recounts the harrowing (and fascinating) experience of being in the path of a hurricane and the economic forces that were set in motion as a result. One of the most important is the import of urgent supplies when thousands of people are without electricity. Should prices be allowed to rise freely or should the government restrict prices? Listen in as Munger and EconTalk host Russ Roberts discuss the human side of economics after a catastrophe.

Harvey’s Test: Businesses Struggle With Flawed Insurance as Floods Multiply

This WSJ article provides a fairly comprehensive look at the financial implications for #Harvey for small business. What’s particularly disconcerting is that NFIP is already for all intents and purposes technically insolvent (current debt to the US Treasury stands at around $25 billion) and Congress is supposed to reauthorize funding for the program’s next five years by September 30. On the lighter side of things, it’s fun to see a couple of academic colleagues’ names in print in this article; specifically, Erwann Michel-Kerjan of the Organization for Economic Cooperation and Development Board on Financial Management of Catastrophes and Ben Collier, who is a faculty member at Temple University’s Fox School of Business.

Hurricane will strain a National Flood Insurance Program out of step with needs of small businesses in era of extreme weather.

Catastrophe Bonds Fall as Hurricane Harvey Bears Down on Texas

Good article from Bloomberg on how catastrophe (AKA “cat”) bonds are a unique asset class for investors and how such bonds disrupt traditional reinsurance markets.  For a broader perspective of these topics, also see the August 2016 WSJ article entitled “The Insurance Industry Has Been Turned Upside Down by Catastrophe Bonds” and my blog posting entitled “Cat Bonds“.

Cat bonds represent a form of securitization in which risk is transferred to investors rather than insurers or reinsurers. Typically, an insurer or reinsurer will issue a cat bond to investors such as life insurers, hedge funds and pension funds. The bonds are structured similarly to traditional bonds, with an important exception: if a pre-specified event such as a hurricane occurs prior to the maturity of the bonds, then investors risk losing accrued interest and/or the principal value of the bonds. This is why these bonds are falling in price – investors expect that the payment triggers tied to storms like #Harvey will reduce the payments received by holders of these bonds.

Bonds tied to weather risks tumbled the most in seven months as Hurricane Harvey advances on Texas’s Gulf Coast.

Place Your Bets: When Will the U.S. Hit the Debt Ceiling?

This is an excellent article on how asset prices impound political risks, and the role of so-called “prediction markets” in assessing political event probabilities (in this case, the likelihood of the U.S. defaulting on its debt).

Prediction markets add a crowdsourced opinion to the chaos of Washington.