Fraud, Folly or Probability

As the government continues to pump money into AIG, the foundering insurance giant which found itself at the center of the real estate and financial crashes, I've seen increasing numbers of commentators demand to know why no one is calling for the jailing of AIG executives on charges of fraud. How, the argument goes, was their selling of financial insurance products any different from the sort of fraud Maddoff carried out? They sold insurance policies they couldn't cover! They took money and gave nothing in return!

I think this tends to underline that people don't actually understand insurance and how it works very well. This is doubly concerning in that insurance has become increasingly central to people's ideas of economic security in the last few decades. Indeed, we've reached a point where lacking health insurance is itself considered a health problem, regardless of whether this actually results in someone failing to receive needed treatement.

What is insurance? Basically, insurance is a way of extending your savings for unlikely but high cost eventualities. For example, if I were to die this year, it would place a very heavy burden (in the form of lost earnings) on my family, such that it would be very difficult for me to save enough money to be prepared for the possibility. However, for a few hundred dollars a year, I can buy life insurance that would, if I should die in the next ten years, pay out a lump sum equivalent to 5-10 years of my current earnings.

The insurance company can afford to offer this to me because they believe they have an accurate model of how likely a healthy 30-year-old man is to die before 40. However, if a horrific plague were to strike the US, killing 10% of the population, and I was among its victems, could I console myself on my deathbed with the knowledge the insurance company would be taking care of my family?

No. Their models do not account for the possibility that 10% of the healthy, adult population would die in a single year. They would undoubtedly go bankrupt and my family would get little or nothing.

This is something we don't normally think of in regards to insurance, because insurance companies have good enough models that it would take something very unexpected to make them unable to meet their obligations. Still, because insurance companies base their prices on what they believe to be the probability of having to pay out, if something unforseen by their models occurs, they may well find themselves on the rocks. One should always understand insurance to come with a "all other things being equal" sort of proviso.

But shouldn't AIG have been able to forecast the possibility of a global real estate downturn and take that into account in their pricing? To my knowledge, there's never been a real estate downturn of the scale of the current one on such a wide scale. Sure, plenty of people were predicting the housing market would go down. That was one of my own reasons for getting out of California back in 2003 -- but those who bought a house there when I left would have seen 50% appreciation over the next four years before things went south. And even though many people were going around saying, "It has to go down," there was no historical precident for such a widespread downturn. In the past, it looked like so long as the economy and population were growing, real estate would continue going up.

Now, if you'd asked me in 2006 to insure mortgages against real estate values going down (and the resulting mortgage defaults), I would have refused. And some cautious companies doubtless did. But since there was a decent historical/statistical case to be made that they wouldn't go down, it's not exactly a surprise that someone agreed to meet the need.

Shouldn't there have been regulations in place to prevent people from offering insurance products that they wouldn't actually be able to pay out on in an emergency? Well, here we run into the probability problem again. Is it in fact likely that something will occur which will bankrupt an insurance firm? There's no reason to believe that regulators will be all that much better at understanding what could happen in the future than insurance actuaries are.

In the end, we probably just need to accept that sometimes bad and unexpected things happen. We can do our best to prevent them, but the funny thing about unexpected events is that it's hard to know they'll happen until they do.

So no, I don't think there was necessarily fraud involved here. Though there was an excessive faith in our ability to forecast the future. We'd do well to avoid such excessive faith in analytics in the future, and yet most of the suggestions for "fixing the problem" simply involve having government regulatores forecast the future instead of private insurance writers. I rather doubt that ends us up in a better place.