Tuesday, September 1, 2009

Government Re-Insurance

The FDIC appears close to insolvency. This comes on the heels of the insolvency of Fannie Mae + Freddie Mac, and with that of the PBGC, Medicare, Social Security and, many suspect, the FHA, looming on the horizon. There are, of course, no shortages of private sector bankruptcies in the current disrupted economy, but there are good structural reasons to question whether a democratic government can be expected to well manage an insurance program.

The fundamental problem is the asymmetric interest and information involved in such a program. Groups paying premiums have will lobby as hard as they can to reduce their payments far below any risk adjusted fair value. Tax payers, less likely to be aware of the down-the-line costs-to-them politically reduced premiums are likely to bring, will not exert meaningful countervailing pressure. Political decision makers will grease the squeaky wheel.

The general hybrid regime we have of nominally private sector insurance, heavily regulated and implicitly backstopped by the government works reasonably well. Structurally, it creates an interest group able to check political power of premium payers and markets within which risk can be, more or less, priced.

On the other hand, the complexity of the hybrid econo-system reduces cost transparency and accountability. For example, if medical insurance companies were regulatory required to take on previously uninsured sick people at the same price they take on healthy people, insurers would raise rates on everyone. Customers would have general difficulty attributing cause, especially as there would be politicians and affiliated media arguing that the rate increases were due to private "waste" or "greed". A hybrid insurance system, whether or not it effectively produces a public good, is also vulnerable politically to the charge of "socialized risk, private profit." Given a byzantine regulatory framework precludes a reasonably competitive market, its easy to imagine insurers take more than market profit.

In short, the current hybrid system has the advantage of a market for price discovery, but suffers from having too many chefs in the kitchen.

The difficulty with a purely private approach for key forms of insurance is removing the implicit government backstop. If, for example, a life insurer of any reasonable size failed, the politics would tend towards a bailout for beneficiaries. Its hard to imagine how a insurance market could well function without any insurers of reasonable size.

The least bad approach might be "publically provided, privately priced". To take a "Public Option" as an example, such a system could work roughly along the following lines: The Insuring Agency sets its policies as far as what it pays for what and what premiums it charges. The Agency issues "re-insurance" securities with a moderate duration, perhaps three years. In the event the Agency ran out of premium money, holders would pay in the notional value of their securities before a government bailout. In exchange they are paid a fixed monthly rate.

It would not be to difficult to construct a reasonable feedback mechanism. For example requiring the agency sell a certain amount of new "re-insurance" securities in an annual all-or-nothing auction within a set price band. An auction failure -- indicating a lack of market confidence in the Agency's solvency over the three year window -- would trigger mandated steps -- reducing benefits, raising premiums, federal cash infusion -- to restore fiscal health established by a successful auction.

There is, of course, devil in these details. As a general principal, it is hard to imagine our Government creating a market that serves a purpose other than funneling taxpayer dollars to Government/Sachs. More concretely, it is easy to imagine that the Government will motivate the heavily regulated large players to dampen any negative market signals.

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