The Clandestine Risk Free Lunch Subsidy
Most likely it was the combination of location and the propensity for sailors (and shipowners) to gossip that made Edward Lloyd's London coffeehouse a natural choice as a forum for insurance brokerage. Strong and regular information flows were, of course, a critical function to evaluating and then pricing risk, and therefore properly funding risk pools used to diversify the hazards of seafaring ventures. As far as that went, ready access to loss and casualty data, and the slow accumulation of a book of same, is "what it was all about." Kill risk pricing information, and insurance is (eventually) doomed. It simply ceases to be insurance.
A brief and basic insurance digression seems in order:
Consider the plight of a ship owner with a single vessel and a substantial portion of his net worth (or all of it) tied up therein. While the risk of loss on a given voyage might be around 33%, and his tolerance for "risk" might permit that gamble, his tolerance for wild net worth swings (or "variance") is extremely low. With respect only to loss at sea, despite the only moderate risk of loss, he faces significant variance: Successful voyage: 0% loss. Lost vessel: 100% loss.
100 ship owners in similar circumstances, however, might consider a number of strategies to reduce the crushing variance in loss/return figures. They may:
Split consignments such that a single vessel actually carries the cargo of a number of shipowners.
In this way, the loss of a given vessel is not deleterious to a single owner. Obviously, this approach has some drawbacks. First, it requires either that owners split their interests in very expensive vessels as well as split cargo, to avoid the crushing loss of the ship itself falling on a single head. Second, it requires a great deal of coordination with respect to cargo destinations and delivery schedules.1
Agree to split the costs of any losses to any of their vessels evenly across the group.
As with consignment splitting, this does nothing to reduce the actual risk of loss (assuming it holds at, say, 33%) but it does quite a bit to prevent those losses from crushing a single owner. Loss variance is pulled down such that each owner can expect to endure close to the average loss to the group (33%), rather than either a 100% or 0% loss. This, of course, begins to look more and more like insurance. The only missing modern element is a third party (rather than a group of shipowners) to take on risk.
It is often forgotten that Lloyd's wasn't a conventional insurance firm, but rather a group of entities or syndicates that would bid to underwrite against loss for a given venture. Early on members might only assume partial loss risk on a single ship, meaning several members had to contract to cover the vessel fully.
It is easy to see that with the explosive growth in the market for shipping, the fairly exclusive membership quickly lacked the resources to underwrite the amount of risk floating about (if you will excuse the pun). In response, Lloyd's would attach new members to the society. Initially, it did so at simply ruinous prices to the members given that the members were taking on risk about which they likely knew very little in exchange for a relatively modest annuity. The absolutely tremendous asymmetry of information here made such arrangements highly profitable for the core group within a Lloyd's syndicate and for hundreds of years looked about as sure a bet as you could make. In some instances members or "names" bore unlimited liability exposure to the risk being underwritten (and in a time when bankruptcy meant debtor's prison).
But risk is a tricky thing to price even if you have excellent information, and the costs of assuming it are not always evenly distributed over time. In addition, when, over a thrilling game of chance and some sherry at White's, Lord Stuffybramble casually mentions that Lloyd's sends him a check for 70,000 pounds a year just for the right to print his name on a few documents, not only is Fleet Prison the last thought on one's mind, but the matter actually sounds like quite a deal- especially when properly marketed as an exclusive club of high society.
This seems an appropriate time to point out that the key elements that frame the classical definition of "insurance" are: the presence of some probability of loss (risk) and the ability to transfer it (typically for a fee or premium) to an entity or entities with capital (one hopes) across which it can then be diversified.
It will be seen that shipping fits nicely into this model, given that (when careful not to underwrite 12 policies for voyages all departing the same day for the same port) the correlation of shipping losses is likely to be quite weak. True, one might imagine a global storm saturating two oceans with such widespread shipping devastation as to boggle the mind, but this brings us beyond the realm of the "slightly silly" and into the "here be dragons" plot of the Sea of the Wildly Irrational- and thus on to October, 2009, and Nancy Pelosi:
"Think of this," House Speaker Nancy Pelosi said. "You've survived domestic violence, and now you are discriminated [against] in the insurance market because you have a pre-existing medical condition. Well, that will all be gone."
The ban would be part of a broader prohibition against the use of pre-existing conditions to deny care, a component of all the reform bills now under consideration.2
Several things should make themselves apparent in this unfortunate bit of blather.
First, using any derivation of the phrase "to insure a pre-existing condition" does severe violence to any passable definition of "insurance." Any number of Kafkaesque scenes leap to mind. Perhaps:
"How can I help you, good sir?"
"I should like to have you bid on insuring my forthcoming East India voyage."
"Excellent, size and type of vessel?"
"She's a 1475-ton East Indiaman of 60 guns. Her keel was laid not three years ago in the Blackwell yards."
"Outstanding, sir! Quite a vessel indeed! And the vessel's present location?"
"Well, actually, that's not entirely clear."
"Well, she was last seen being boarded after exchanging several broadsides with a French ship of the line. I suppose one might say she was listing to port... just slightly... while ablaze. The rigging seemed to be holding up quite well, however, at least given the circumstances."
True, it is very sad to see an East Indiaman fall prey to villainous French scum, and perhaps equally easy to permit our sympathy to wish the shipowner's sorrows consoled. This does not in any way answer the question: "How, exactly, is it the duty of the insurer to subsidize this loss?" And, make no mistake, this is pure subsidy. Not "insurance."
It takes but little reflection to see that, should the Queen mandate such policies, they would quickly be adopted by only those owners freshly from the coffeehouse with the news of French ships of the line. What then?
Why, of course, the Queen would have to mandate every ship carry "insurance" to make sure premiums would cover the huge losses to be assumed.
One can easily see why such a policy might be appealing in times of war, but, obviously, this is little more than a "tax" to subsidize favored parties against the vile and malodorous French. (A fiscal policy that, on reflection and in other circumstances, finem respice would wholeheartedly endorse).
But then there is this turn of phrase:
You've survived domestic violence, and now you are discriminated [against] in the insurance market....
Scaremongering and sympathetic victim rhetoric delivered with all the subtlety of a 60 gun broadside aside, it actually takes very little wattage to understand that discrimination is the very purpose of insurance. In fact, insurers employ legions of experts toiling away to practice the most base sort of discrimination every day. They are called "underwriters."
To the extent that a victim of domestic battery is likely to find himself battered again (and my weak understanding of such studies indicates that this is so), the probability of his medical costs increasing is also higher. So too, the costs of insuring a listing East Indiaman in the hands of vicious and cheese-smelling French seamen, last seen in the form of a plume of black smoke, receding slowly on the distant horizon. The important connection here is that both are, to one degree or another, foreseeable and quantifiable. They are data about risk. Plain and simple. True, we may argue matters of degree with respect to the delta in probability of loss in these two scenarios. True, we may dislike the reality that victims of domestic violence are likely to have higher medical bills, but it is exceedingly dangerous to permit painful truths to become a rationale for removing pricing data from risk analysis. I may not like the fact that there are different health insurance prices for women than for men. You won't hear me complaining, however, when my much higher use of medical devices is covered without my provider declaring bankruptcy first.
It will be seen that mandating myopic risk pricing for political reasons is nothing more than a rank subsidy. That this is well understood by rank subsidy proponents can be divined with almost no effort by even the most opaque intellect only a few words later in the same passage:
The ban would be part of a broader prohibition against the use of pre-existing conditions to deny care....
Of course, it takes quite a leap to convert "the use of pre-existing conditions to deny third party payment for care" to "the use of pre-existing conditions to deny care." One must assume not just some sort of right to health care, but also the right to have it paid for by a third party to even arguably complete the chain required by this line of thinking. It bears noticing that this text is from CNN's author, and not Mrs. Pelosi. (Be this difference, distinction or neither is left as a question for the reader).
That insurance companies seem to be in the middle of this latest assault on the Oxford English Dictionary is not an accident. The reality is that the United States is quickly running out of sources of capital with which to sate its many, perverse and redistributive lusts. Sutton's law ("That's where the money is.") makes it fairly easy to speculate where the Regulatori might turn next. The mere fact that an industry that struggles to secure even low double digit profit margins has somehow become an example of corporate greed and excess of such magnitude that a bit of "social justice" is suddenly in order says more about the ability of the political class to fraudulently frame the dialog than it does about the greed of insurance companies.
"Equal access," is another term commonly leveled at the heart of insurance firms. Denying coverage (at least cheap coverage) based on defined risk groups has, through some exceptionally adroit bit of verbal judo, become an affront to the fundamental right of "equal access to health care." Alarmingly, no one has managed to retort effectively with the obvious truth that this is actually an affront to "equal access to third party payment for health care," nor ask for citations to authority for my right to have you pay for 25 years of fertility efforts starting on my 45th birthday. ("How dare you deny me the right to have a child!")
Habitual reimbursement for regular, recurring costs is not insurance, people.
Perhaps it is the realization that a wholesale and transparent attempt to socialize all these costs through direct government subsidy would never fly in the United States, but the "go-to" method to clandestinely provide one's constituents with free money seems to have become the forced mispricing of risk under the guise of "fairness." Or justice. Or revenge. Or something.
From the perspective of the legislator or executive, mispricing risk presents a much more optimal means of outright redistribution because the costs of such shifts are buried under a number of layers of opacity and to the extent state or government guarantees are involved they socialize the eventual cost across the tax base, and because these costs tend to emerge only some time after the offending government officials have left office for lucrative positions in the insurance industry.
While asserting "The taxpayers should hand $20,000 to everyone who can't get [cheap insurance|easy credit for their first home|a 5% down payment together]" isn't likely to get many people elected, mispricing risk with government guarantees that "don't cost anything because they will never have to be paid anyhow" seems to have proved much more effective. That is, until the bailouts, and even then it is even money that the political class can deflect the blame for a complex disaster with opaque causes onto some unpopular political class or another.
The ruling political class is entirely aware they are doing this as well. Notice, for example, the fundamental paradox demonstrated (quite earnestly) by proponents of "affordable housing policy" and immediately visible in that this particular political class can be seen to bristle hostilely should anyone have the temerity to suggest that subsidizing mortgage lending played a role in the recent mortgage bubble implosion, while in the same breath calling for expanding the balance sheets of the GSEs to reinflate the mortgage bubble until the economy can recover. By the same token, suggesting that artificially depressing mortgage rates (read: mispricing risk) either directly, by imposing tax benefits, by lowering reserve requirements for qualified MBS securities, or by causing the Treasury to assume (implicitly or explicitly) the risk of default is somehow a subsidy immediately causes howls of protest.
Despite all my jurisprudential research, I have been unable to locate a statutory basis for the right to cheap insurance. Even if one existed, continuing to bail out insurance markets that have long since been forcibly decoupled from any meaningful measure of risk by legislative price fixing and regulation is simply subsidizing the cost of building new house on a twenty year floodplain every couple of decades for people dim witted enough to keep building there. Of course, regular readers will be aware that this is a topic of particular interest on finem respice.
The important realization for the present is that plans to deploy national catastrophe "insurance" (effectively to benefit Florida), national health care insurance (with price fixing), and any other of the many "insurance" mandates floating around are simply rank subsidies about to be paid for by an already insolvent insurer. Not only is every taxpayer in the United States being compelled to assume the role of a Lloyd's Name along with the attendant and wonderful effects of unlimited liability, but the underwriters arms are being twisted to make absolutely certain premiums will never, ever, ever cover the bill.
- 1. Apparently a student of the East India Company and Lloyd's, Pablo Escobar pioneered the use of cargo splitting by narcotraffickers to diversify the risk of cocaine shipment loss across various cartel members.
- 2. Silverleib, Alan, "Democrats Vow to Ban Domestic Violence as 'Pre-Existing Condition,'" CNN (October 6, 2009).