OK, good morning. I've been running to
get over here. I just got back from The
World Economic Forum. 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 instead
today about insurance, which is one of the major risk
management institutions that is not always considered part
of finance, because people think of finance and insurance
as separate. [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER: We
talked about basic principles of risk management in the
preceding lecture. It's all the same for finance
and insurance. 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. 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
risks and preventing people from being subjected to extreme
risks through the concept of risk pooling. So, what I wanted to start
today is talking about insurance, starting with the
concept of insurance. And then, I wanted to reiterate
a theme of 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 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 -- well not only because it was the
biggest insurance company in the world, but also because
he's coming here. 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 et al. 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'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 tough it will be on your family, that
sort of thing. But, to me, I think insurance is
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 underlies the concept. To me, it's exciting,
but I don't know if I can convey that. The fundamental concept,
again, is risk pooling. The idea of insurance goes back
to ancient Rome, but only in very limited forms. But the
idea of risk pooling is kind of an obvious one. People form organizations
partly to risk-pool. So, in ancient Rome, a common
form of insurance was death insurance that would
pay funeral bills. People in the ancient world
believed that you had to get a proper burial, or your soul
would wander forever. So, insurance salespeople
associated with guilds or business organizations would
sell funeral insurance. But they didn't have a very
clear idea of the risk pooling concept. It must have underlain
their 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 contract. They didn't have the
concepts down. 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 seems like insurance came
in in the 1600s, at the same time that certain concepts
of mathematics began to be developed. 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
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
-- why don't we start a fund, in which people pay 1% of the
value of their home every year into 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." OK? It's 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. So, he 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 an
approximate statement of the law of large numbers -- and I'm thinking of Aristotle,
the philosopher. This is in ancient times,
and I'm quoting from De Caelo, 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 throw the dice 1,000 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 the probability of p, then the
average proportion out of the n events that occur -- I'm sorry, we have n trials,
an event occuring 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 1/2 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, then the
probability of deviating from the mean by more than one or
two standard deviations becomes very small, which
is what Aristotle said. But making insurance work as
an institution, to actually protect people against
risk, is rather difficult to achieve. And that's because things
have to be done right. So, let me just remind
you, what are the basic types of insurance? This is what Fabozzi
et al. talks about. There's life insurance
that insures people against early death. Of course, you still die. What it really insures, is your
family against the loss of a bread winner, the
father or the mother. So, life insurance is suitably
given to families, especially with young children, to
protect the children. 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 what you might call investment-oriented products,
like annuities. This is a table in your textbook
by Fabozzi et al., which lists these categories
of insurance. But 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, insure
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. 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
risks that are inappropriate. An issue that insurance
companies reach is moral hazard. [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER: Moral
hazard is an expression that appeared in the 19th
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
support 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 you would
exclude certain causes of death 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 someone insures a house,
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 you'll still lose 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 analagous thing is
selection bias. That occurs when -- chalk keeps breaking -- selection bias occurs when the
people who sign up for your contract know that they
are higher risk. For example, health. People who know they 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 have to charge very high premiums.
And that will force other people, who don't know
they're going to die, out of buying insurance. And so, that's the fundamental
problem. 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. Another aspect of insurance is
that you have to have 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. It's a constant challenge for
the insurance industry. 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. If you don't assume
independence, you can make more complicated models. Then, fourth, you need a
collection of statistics on risks, and you need to evaluate
the quality of those statistics. So for example, in the 1600s,
people started collecting mortality tables for
the first time. There was no data on
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, or handling of moral
hazard, or selection bias wasn't right. Some insurance companies are
mutual, rather than share. 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 policy
holders. Then, you need a government
design so that the government verifies all of these things
about the insurance company. The 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. 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. And that's part of the
design of insurance. It doesn't work if you don't
have the regulators, because you wouldn't trust the
insurance company. So, these are problems that
have inhibited making insurance work. I wanted to give
you an example. I think it makes it more
concrete if we start off with talking about a particular
example. And I said I was going to talk
about AIG, which is a very important example, not only
because it was the biggest insurance company. It was also the biggest
bailout in the entire financial crisis
we've seen now. And it has an interesting
story. [SIDE CONVERSATION] PROFESSOR ROBERT SHILLER:
So AIG, it's an interesting story. It was founded in 1919
in Shanghai. And you wonder, why is it called
American International Group if it's founded
in Shanghai? It was founded in Shanghai,
called American Asiatic Underwriters. And it was founded by Cornelius
Vander Starr, who was 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 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 what HSBC means? They don't emphasize
it anymore. It's Hong Kong and Shanghai
Banking Corporation. So, AIG was founded by Mr. Starr
in 1919, and started doing an insurance business
in China. And moved their headquarters
to New York just before Chairman Mao took
over at China. And then, it became kind of a
Chinese investment company in the United States. Cornelius Vander Starr ran the
company from 1919 until he died in 1968. So, he was CEO for 49 years,
a half-century. And then, just before he died,
he appointed Hank Greenberg, who will visit us, as
the CEO in 1962. So, that was 49 years under
Starr, and then Greenberg took on, and then ran the
company until 2005. So, it was 37 under Greenberg. So, two men ran the company
for almost a century. Since 2005, Greenberg has been
succeeded by three CEOs, the usual thing. The usual company
turns over CEOs. There's another interesting
story that we might ask about Hank Greenberg. He joined the U.S. Army and
fought in World War II. And among his jobs, then, was to
liberate Dachau, which was a concentration camp. This is not one of the
extermination camps, it was a concentration camp for Jews and
others under the Nazis. And people were starving and
dying, it was awful. At a Council on Foreign
Relations meeting, 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. It's kind of interesting to
me to think about this. This is an aside, momentarily. The other person
I've met who -- do you know Geoffrey Hartman,
who's a professor here at Yale in literature? He and his wife, both Jewish,
were teenagers during World War II. And Hartman escaped by what they
called Kindertransport. But his wife, Renee, was in
another concentration camp. Not Dachau, it was
in Bratislava. And she was starving to death. And it really happened,
by the way. It'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. So anyway, we could ask
him about that. What did these people do? Both Starr 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, 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. The reason they had to be bailed
out was, it was almost entirely due to a failure
of the independence assumption, I would say. That under their risk
modeling, namely -- 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
it won't matter to us. That's just one city, and
it all averages out. But what actually happened after
Greenberg 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 company was writing
credit default swaps -- I told you about those before --
they were taking the risk. They were insuring, basically,
against defaults of companies whose credit depended on
the real estate market. They were also investing
directly in real estate securities, in mortgage-backed
securities that depended on the real estate market
for their success. And when all this failed at
once, AIG was about to fail. That meant that the federal
government decided, in 2008, to bail out AIG. And the total bailout bill,
well, the total amount committed by the U.S. federal
government was $182 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. A lot of people are
angry about this. 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 a proposal
of Treasury Secretary Henry Paulson. 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 bail out
this insurance company? The main reason why they did
so was their concern about systemic risk. I'll come back to other
kinds of bailouts of insurance companies. The problem was that AIG -- if it went under, all kinds
of things would go wrong. All kinds of things
would go wrong. All these insurance policies
that it wrote on people's casualties, their travel
insurance, any of these policies, would all now
be subject to failure. Because people who had these
insurances 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 too, or may fail too,
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
this going to mean to me? AIG owes me money, 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 hears, 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 did. He got sort of a blank check
from Congress, because Paulson told the story that if we don't
do this, if we let the company -- he didn't say AIG, 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. Nobody liked to hear that, but
they believed him, and they didn't know what else to do. And so, they allowed the TARP
money, and they allowed the Federal Reserve to bail
out this company. 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 very low price in exchange for
helping the company 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 July of 2009, AIG did
a 1-to-20 split. Remember, I told you about
splits before? That's a reverse split. Usually, the stock goes up in
a company and the shares, 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 three-for-one split,
and let's make every share into three shares. That's the usual split story. This is going the other
way massively. They made every 20 shares
into one share. So, if you look at the price
recently, it's been something like $30 to $40 dollars
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. So, AIG lost -- the shareholders lost just
about everything. So, the public anger about a
bailout of AIG is really a little bit inappropriate,
because they lost almost everything. They could've 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 was a major partner taking the other
side of contracts with AIG. It didn't lose a penny,
all right? But, of course, Goldman Sachs
was not being bailed out. It was not in danger. 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 it didn't have the
information, because the regulators 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 to the shareholders, but
they keep going. So, that's what happened. And AIG continues to this day. It survived after the bailout. Now, I wanted to talk about
something else that many of you may not know about
insurance companies. Mainly, that we do have
something like deposit insurance for insurance
companies. You know, when you go into a
bank, there will be a little sign saying FDIC Insured? Do you notice that when
you go into a bank? They're required to post that. Bank accounts are insured by the
Federal Deposit Insurance Corporation to a limit,
$250,000 now. 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. They're not as old, though. The oldest insurance guarantee
fund is from 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. 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 AIG? Any idea where the answer is? Why did 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? AIG was way too big for these
state insurance funds. There's a limit to how much you
can collect from a state insurance fund if your insurance
company goes under, and in New York it's
$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. 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. You're thinking of sending them
both to Yale, or some place like that. It's going to cost you like
$500,000 right there, just sending them to college. So, if that's all you get in
your insurance, it's 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 $2.5 million,
you put it in 10 different banks. The FDIC will insure every one
of those, so you can insure $2.5 million. But the Connecticut insurance
guarantee fund won't do that, they'll limit you to $500,000,
no matter how many different policies you got. There's another important
difference between deposit insurance and banks and state
insurance guarantee funds, at least in Connecticut. I know Connecticut does not
allow 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
hear about this. But there's a fundamental lesson
that I'm trying to get to with all of this, and that
is that you have to look at the insurance company that
you buy insurance from. It's still a wild world out
there in the sense that if you buy insurance from an insurance
company that goes under, well, you're protected
up to $500,000, but beyond 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. It's regulated and the guarantee
funds are state. The Federal Deposit Insurance
Corporation is a federal -- it's a national insurance
program. But insurance is done entirely
by the state. This makes it difficult to do
business as an insurance company, because you have 50
different regulators in the United States. The United States is
a particularly difficult place to handle. That's because we have the
McCarren-Ferguson Act in 1945, which specifies that insurance
regulation is entirely for the state governments. So, in the United States
regulation of insurance is divided up across 50 different
states, which makes it very difficult. It's very difficult, because
that's a lot of different regulators to deal with. One thing that we have is
something called the National Association of Insurance
Commissioners. It's not a government
organization, it's an 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 state government could adopt to
allow insurance to be standardized across different
state governments. Otherwise, we'd have total
chaos 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 new
federal insurance 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 regulated at the state level. 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 AIG 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? But the American tradition is
too strong 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 risk,
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 posing systemic risks. And if it decides that there
is a systemic risk, another AIG brewing, then this office
can recommend to another agency called the Financial
Stability Oversight Commission, created
by Dodd-Frank -- people call it F-SOC. It can recommend that the
insurance company be designated as a threat to the
system of the United States. In that extreme case, it would
be put under the regulation of the Federal Reserve Board, and
it would be handled in bankruptcy by the Federal
Deposit Insurance Corporation. So, what Dodd-Frank has done,
it left the state-regulated insurance companies unchanged,
except as regards to 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. 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 and New York. In many cases, they're newer and
they're not as effective. So, I wanted to mention -- in the country of China, they
have just created the China Insurance Protection Fund. It's like one of our state
guarantee funds, but it has a limit. The amount that it will insure
is limited to CNY 50,000, or about $6,000. It's $500,000 in the
United States. At least, they've got it now. Until 2008, there wasn't
even any such insurance guarantee fund. So anyway, the Fabozzi et al. book talks about various kinds
of insurance, and I was going to say something about the
types of insurance. The biggest category of
insurance privately offered is life insurance, which in 2009
was almost $5 trillion. Privately offered health
insurance is actually smaller than that, and property and
casualty insurance is only about $1.3 trillion. Nonetheless, these are
big industries. You go through Fabozzi et al.,
and it will describe the different types of
life insurance. There's term insurance, which
insures you for a certain term of time. It's terminates after one
year, but is typically automatically renewable. Then there's whole life, which
gives you insurance over a long time interval and builds
cash value over the years. There's other types -- there's
variable life, which has no guaranteed cash value, but
invests in an account for you. And the insurance, then, has
an uncertain payout. Life insurance 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. 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 proposed in 1694 by Elder Chamberlain. And the first U.S. health
insurance plan was the Franklin Health Insurance
Company of Massachusetts, which started in 1850. I want to talk a little bit
about health insurance, because it's something that has
been an important problem. Many countries have
adopted national health insurance plans. The government has come in,
fundamentally, and has actually required insurance
for everyone. The government has not allowed
insurance to precede 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 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. One problem was, if you have a
private health insurance plan, the doctors have, maybe, an
incentive to milk the insurance 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 -- 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. Designing insurance is a
matter of invention. We have to figure out some
system that incentivizes doctors right, and 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 this. One was the HMO Act. The government is always
getting involved and trying to -- this is 1973. HMO stands for health
maintenance organization. A health maintenance
organization is an insurance plan that tries to deal with
the moral hazard problem. Doctors are paid salaries,
they're not paid for procedures. So, doctors are employees of
the HMO and they have no incentive to give you an
operation that you don't need, because their pay 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. 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 -- I'll say 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 already
about the importance of preventive medicine. And Charles Taylor,
who was the Yale provost, liked the idea. 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, 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." The concept is that it was a Yale community. Everyone at Yale belongs -- or
has the option of belonging -- and you have a primary care
person there, whose instruction is to preserve
your long-term health. Another milestone was the
Emergency Medical Treatment and Active Labor Act
in 1986, or EMTALA. See, so many people in the
United States have no health insurance, and it's because of
this problem I'm telling you about, the moral hazard
problem, the selection bias problem. People say, I'm not going to
buy it, it's too expensive because I'm not sick. That defeats the
whole concept. You're supposed to buy whether
you're sick or not. So, we had so many people that
didn't have insurance, so what would happen when they got
hit by a bus, 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, 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 hospitals
do, is they say, OK. Suppose you get hit by a bus. If you can't talk, they
just treat you. If you can talk, they're in
there asking you to sign papers promising to pay
for it eventually. So, you go deeply into debt. That's one thing that happens. So, EMTALA didn't really solve
the health problem. We still have the selection bias
problem preventing people from signing up. The HMO Act was supposed to
put us all -- did I spell maintenance right? I spelled this wrong. The HMO Act was 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 there's over 40 million
uninsured Americans, not even on any insurance plan. And people who don't have any
health insurance miss diagnostic procedures, they get
diabetes, they get high blood pressure. 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
health care acts that were created by President Obama. There's actually two of them,
I won't write their names. So, in 2010, the U.S. government
passed a landmark pair of bills that were
addressed to solving the selection bias and moral hazard
problems and reducing the number of people who are
uninsured dramatically. So, this is what the
government did. It hasn't happened yet,
but the procedures are there to set it up. They're creating new insurance
exchanges that will offer insurance to be purchased
by the general public. And 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. You don't have to buy insurance,
because you're a student here, and you've
got insurance. But suppose you're just out
there in the world, not affiliated with any insurance
plan, then you'll actually have to pay a penalty
of something like $700 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 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 it doesn't cost them as much
per person when they've got healthy people now. So, there's a penalty for
individuals that are 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, we'll insure you,
but we'll demand a really high monthly premium. So you say, I can't afford that,
because 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. It seems painfully slow to me. I talked about insurance being
invented 1600s, that's 400 years ago, and still we have
over 40 million Americans with no health insurance. Pretty obvious that we should
have it, but we have problems making it work. And we still have problems,
especially in less developed countries. Let me mention another insurable
risk, which was being taken care
of very badly. You know that last year,
there was a terrible earthquake in Haiti. The loss of life in Haiti, and
the loss of damages, was generally not insured. 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
$8 million dollars in insurance as of the
Haiti earthquake. 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
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
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 about 200,000 homes
were severely damaged, and payment was about $40,000
per home. Still, there were problems
in New Orleans. When New Orleans came, there
were two kinds of risk. One was wind damage and the
other one was flood damage. 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 wind loss and flood loss. Now the problem is, when you
have a hurricane, which is it? What was the problem that
hit your house? Because it was both
wind and flood. So, there was wrangling
over the definition. Another problem -- I'm almost done here -- I just wanted to talk about
another kind of risk, that worries us a great deal, that
tends not to be covered well by a traditional insurance
company. And that's terrorism risk. 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 there's a war, it's
going to cause -- there are not independent
probabilities of damage. And so, insurance companies
have excluded it. But it turns out, these are
some of the risks that we worry most about. So, what we had in the United
States was TRIA, which was the Terrorism Risk Insurance
Act in 2002. It started out in 2002,
but 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
government-funded -- 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 an insurance-like
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, which need to be
repaid only if Mexico does not have 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 -- it was
about 20 years ago -- it would be a huge
cost to Mexico. 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. These bonds are actually sold
and put into portfolios, and it doesn't look like
insurance. It looks like a bond that deals
with the insurance risk in a financial way. I'm about done, let me just
say that the insurance industry manages important risks
that matter to our life. Risks to our health, to our
children, to our businesses, to things that we do. And it still suffers
from various imperfections that we can see. It seems like we're just dealing
with some of the problems. I mention these
new innovations. But there are still problems 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, for unknown reasons, there's been
a growing mold problem. The funguses are growing in
houses, and it can damage the house and it 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 of global warming,
hurricane risk is going up. So, insurance companies have
been raising their insurance premiums for that reason. But 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 haven't really discussed
those, but they're policies that would benefit from
inflation indexation. So, these are still
some examples. 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 technological 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 careers, 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 much better lives for all of us. So, I'm talking about efficient
markets next time [correction: after the guest
lecture by David Swensen], 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 about it.
