no third solution

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On Social Insurance Programs

May 1st, 2007

Any form of “social insurance,” whether it be flood insurance, universal health care, etc., represents what can only be properly described as a forced transference of risk from those unwilling and/or unable to retain or share that risk, to those who otherwise are willing to either retain or avoid that risk. The simplest case to make, perhaps is catastrophe insurance, which type of insurance is said to be privately uninsurable in general, because the potential losses accruing cannot be forecast accurately. That is to say, that in any given year, we may have a long-run average loss from floods, or hurricanes. Or we may have mega-catastrophes like Hurricane Katrina. Or we may have relatively few hurricanes, like 2006 saw. The expected losses cannot be calculated within a meaningful margin, because the variance is too great, or the sample is too small or not representative, or both.

Do you think you could buy a term-life policy, if not for the general accuracy of mortality tables? Of course, you could not. Term-life insurance works because in any given year, the actual mortality rates are very close to the expected long-run mortality rates. But we have no such accurate means of predicting losses due to floods, hurricanes, earthquakes, etc. A single flood may wipe out every insured property – or it may barely scathe any of them.

Moreover, there are areas which we know with some (or great) certainty, are prone to flooding. These areas can undoubtedly be avoided by anyone unwilling to bear the risk personally, or the risk can be shared mutually among those who do choose to live in those locales. By retaining the risk, we understand that any individual who builds a house on a flood plain, may be subject to a financial loss up-to-and-including the full amount of his capital assets located there. If you own a $300,000 condo on the Mississippi Delta, and a flood wipes out your building, you’ve lost $300K. But attempting to share the risk via mutual is slightly problematic, as a mutual insurer is subject to the same sample and forecasting problems described in brief, above. Even a mutual insurer is not immune to the chance that each insured may very well be called upon to bear the full burden, that is, risk will not necessarily be shared under a mutual and the individuals suffering losses will be called upon to bear the full burden thereof. I’m not sure either is more advantageous than the other.

But this is not, contrary to popular belief, justification for “social insurance” or government-provided flood insurance. It is actually strong evidence that one ought not live in such an area if he is incapable of retaining the full amount of risk to which he is subject.

So, should anybody live in areas prone to flooding? Should any businesses operate facilities there?

Actually, these situations can easily be accommodated. Because in the absence of social insurance, we can surmise that the property values and land rents in those areas would be significantly lower than they are at present. This would allow a greater number of individuals (or firms) to retain the full amount of risk, because the potential for monetary loss would be markedly lower.

Social insurance programs necessarily (and simultaneously) stimulate a morale hazard, by reducing the actual exposure of those most prone to the particular risk being “insured.” But such programs, like most government programs, have the propensity to be self-perpetuating. The more people who move to such areas as a result of the morale hazard, the more disastrous the claims – as a result of inflated property valuation – and concurrently, the more urgent the need for the continuance of such programs.

I can find no justification for social insurance, so-called, which forces those wise enough to avoid a risk altogether, to bear its burden for the certain benefit of others.

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no third solution

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