Like commodity speculators, insurance companies deal with inherent and I inescapable risks. Insurance both transfers and reduces those risks. In exchange for the premium paid by its policy-holder, the insurance company assumes the risk of compensating for losses caused by automobile accidents, houses catching fire, and numerous other misfortunes which befall human beings. There are more than 41,000 insurance carriers in the United States alone. That includes more than 11,000 life insurance companies, whose total assets exceed 3 trillion dollars.

In addition to transferring risks, an insurance company seeks to reduce them. For example, it charges lower prices to safe drivers and refuses to insure some homes until brush and other flammable materials near a house are removed. People working in hazardous occupations are charged higher premiums. In a variety of ways, it segments the population and charges different prices to people with different risks. That way it reduces its own over-all risks and, in the process, sends a signal to people working in dangerous jobs or living in dangerous neighborhoods, conveying to them the costs created by their chosen behavior or location.

The most common kind of insurance-life insurance-compensates for a misfortune that cannot be prevented. Everyone must die but the risk involved is in the time of death. If everyone were known in advance to die at age 70, there would be no point in life insurance, because there would be no risk involved. Each individual's financial affairs could be arranged in advance to take that predictable death into account. Paying premiums to an insurance company would make no sense, because the total amount to which those premiums grew over the years would have to add up to an amount no less than the compensation to be received by one's surviving beneficiaries. A life insurance company would, in effect, become an issuer of bonds redeemable on fixed dates. Buying life insurance at age 30 would be the same as buying a 40-year bond and buying life insurance at age 40 would be the same as buying a 30-year bond.

What makes life insurance different from a bond is that neither the individual insured nor the insurance company knows when that particular individual will die. The financial risks to others that accompany the death of a family breadwinner or business partner are transferred to the insurance company, for a price. Those risks are also reduced because the average death rate among millions of policy-holders is far more predictable than the death of any given individual. As with other forms of insurance, risks are not simply transferred from one party to another, but reduced in the process.

Where a given party has a large enough sample of risks, there may be no benefit from buying an insurance policy. The Hertz car rental agency, for example, owns 50 many automobiles that its risks are sufficiently spread that it need not pay an insurance company to assume those risks. It can use the same statistical methods used by insurance companies to determine the financial costs of its risk and incorporate that cost into what it charges people who rent cars. There is no point transferring a risk that is not reduced in the process, because the insurer must charge as much as the risk would cost the insured-plus enough more to pay the administrative costs of doing business and still leave a profit to the insurer. Self-insurance is therefore a viable option for those with a large enough sample of risks.

Insurance companies do not simply save the premiums they receive and later pay them out when the time comes. More than half of current premiums are paid out in current claims-61 percent for Allstate Insurance Company and 83 percent for State Farm Mutual Insurance, for example.

Insurance companies can then invest what is left over after paying claims and other costs of doing business. Because of these investments, the insurance companies will have more money available than if they had let the money gather dust in a vault. About two-thirds of life insurance companies' income comes from the premiums paid by their policy-holders and about one-fourth from earnings on their investments. Obviously, the money invested has to be put into relatively safe investments-government securities and conservative real estate loans, for example, rather than commodity speculation.

Because insurance companies compete with one another for customers, the price of premiums is reduced by these investments, since the premiums paid in do not have to add up to the total amount that will be paid out to the policy-holders. The fact that the money taken in over the years grows because of the returns on the investments financed by insurance companies means that there can be more money at the end than was paid in by the policy-holders over the years.

While it might seem that an insurance company could just keep the profit from these investments for itself, in reality competition forces the price of insurance down, as it forces other prices down, to a level that will cover costs and provide a rate of return sufficient to compensate investors without attracting additional competing investment. In an economy where investors are always on the lookout for higher profits, an inflated rate of profit in the Insurance industry would tend to cause new insurance companies to be created, in order to share in this bonanza. Sometimes this process can overshoot the mark, as periods of unusually high profits are followed by periods of unusually low profits, due to the additional competition that is attracted.

Insurance principles often conflict with political principles. For example, arguments are often made-and laws passed accordingly-that it is "unfair" that a safe young driver is charged a higher premium because other young drivers have higher accident rates or that young male drivers are charged more than female drivers the same age for similar reasons, or that people with similar driving records are charged different premiums according to where they live. A City Attorney in Oakland, California, called a press conference in which he asked: "Why should a young man in the Fruitvale pay 30 percent more for insurance" than someone living in another community.

"How can this be fair?" he demanded.

Running through such political arguments is the notion that it is wrong for people to be penalized for things that are not their fault. But insurance is about risk-and risks are greater when you live where your car is more likely to be stolen, vandalized, or wrecked in a collision with local drag racers. These are all risks that differ from one place to another. Forcing insurance companies to charge the same premiums to groups of people with different risks means that premiums must rise over all, with safer groups subsidizing those who are either more dangerous in themselves or who live where they are vulnerable to more dangerous other people. In the case of automobile insurance, this means that more unsafe drivers can afford to be on the road, so that their victims pay the highest and most unnecessary price of all in injuries and deaths.

Government programs that deal with risk are often analogized to insurance, or may even be officially called "insurance" without in fact being insurance. For example, federal disaster relief in the United States helps victims of floods, hurricanes and other natural disasters to recover and rebuild. But, unlike insurance, it does not reduce the over-all risks. Often people rebuild homes and businesses in the well-known paths of hurricanes and floods, often to the applause of the media for their "courage." But the financial risks created are not paid by those who create them, as with insurance, but are instead paid by the taxpayers.

In short, there is now more risk than if there were no disaster relief available and more risk than if private insurance companies were charging these people premiums which cover the full cost of their risky behavior. Sometimes the government subsidizes insurance for earthquakes or other disasters for which private insurance would be "prohibitively expensive." What that (2) Although fatality rates from motor vehicle deaths are highest for drivers age 16 to 19, the declining fatality rates with age end at around age 50 and then rise again, with drivers aged 80 to 84 having nearly as high a fatality rate from motor vehicle deaths as teenagers. means is that the government makes it less expensive for people to live in risky places-and more costly to the society as a whole, when people distribute themselves in more risky patterns than they would do if they had to bear the costs themselves, either in higher insurance premiums or in financial losses and anxieties.

There is an almost politically irresistible inclination to help people struck by earthquakes, wildfires, tornadoes and other natural disasters. The tragic pictures on television over-ride any consideration of what the situation was when they decided to live where they did. But government-subsidized insurance is, in effect, disaster relief provided for them beforehand, and is therefore a factor in people's choices of where to live and what risks to take with other people's money.

Competition among insurance companies involves not only price but service. When flood, hurricanes or other disasters strike an area, insurance company A cannot afford to be slower than insurance company B in getting money to their policy-holders. Imagine a policy-holder whose home has been destroyed by a flood or hurricane, and who is still waiting for his insurance agent to show up, while his neighbor's insurance agent arrives on the scene within hours to advance a few thousand dollars immediately, so that the family can afford to go find shelter somewhere. Not only will the customer of the tardy insurance company be likely to change companies afterward, so will people all across the country, if word gets out as to who provides prompt service and who drags their feet. For the tardy insurance company, that can translate into losing billions of dollars worth of business.

The lengths to which some insurance companies go to avoid being later than competing insurance companies was indicated by a New York Times story:

Prepared for the worst, some insurers had cars equipped with global positioning systems to help navigate neighborhoods with downed street signs and missing landmarks, and many claims adjusters carried computer-produced maps identifying the precise location of every customer.

The kind of market competition which forces such extraordinary efforts is of course lacking in government emergency programs, which have no competitors. They may be analogized to insurance but do not have the same incentives or results. Political incentives can even delay getting aid to victims of natural disasters. When there were thousands of deaths in the wake of a huge cyclone that struck India in 1999, it was reported in that country's press that the government was unwilling to call on international agencies for help, for fear that this would be seen as admitting the inadequacies of India's own government. The net result was that many villages remained without either aid or information, two weeks after the disaster.

Insurance companies often sell annuities as well as insurance, using similar principles to payoff the living in installments, instead of paying survivors in a lump sum. Here too, government programs may be analogized to the activities of insurance companies, without in fact having either the same incentives or the same results. The most fundamental difference between private annuities and government pensions is that the former create real wealth by investing premiums, in order to be able to pay pensions later on, while the latter simply use current premiums from the working population to pay current pensions to the retired population.

What this means is that a private annuity invests the premiums that come in-creating homes, factories, or other tangible assets whose earnings will later enable the annuities to be paid to those whose money was used to create these assets. Government pension plans, such as Social Security in the United States, simply spend the premiums as they are received. Much of this money is used to pay pensions to current retirees, but the rest can be used to finance other government activities, ranging from fighting wars to paying for Congressional junkets. There is no wealth created to be used in the future to pay the pensions of those who are currently paying into the system.

The illusion of investment is maintained by giving the Social Security trust fund government bonds in exchange for the money that is taken from it and spent on current government programs. But these bonds represent no tangible assets. They are simply promises to pay money collected from future taxpayers. The country as a whole is not one dollar richer because these bonds were printed, so there is no analogy with private investments that create tangible wealth. If there were no such bonds, then future taxpayers would have to make up the difference when future premiums are insufficient to pay pensions to future retirees. That is exactly the same as what will have to happen when there are bonds. Accounting procedures may make it seem that there is an investment when the Social Security system holds government bonds but the economic reality is that neither the government nor anyone else can spend and save the same money.

What has enabled Social Security-and similar government pension plans in other countries-to postpone the day of reckoning is that a relatively small generation in the 1930s was followed by a much larger "baby boom" generation, earning much higher incomes and therefore paying large premiums, from which pensions could easily be paid to the retirees from the previous generation. Not only could the promises made to the 1930s generation be kept, additional benefits could be voted for them, with obvious political advantages to those awarding these additional benefits.

With the passage of time, however, a declining birthrate and an increasing life expectancy reduced the ratio of people paying into the system to people receiving money from the system. Unlike a private annuity, where each generation creates the wealth that will later pay its own pensions, government pensions pay the pensions of the retired generation from the premiums paid by the currently working generation. That is why private annuities are not jeopardized by changing demographics but government pension plans are.

Government pension plans enable current politicians to make promises which future governments will be expected to keep. These are virtually ideal political conditions for producing generous pension laws and future financial crises resulting from them. Nor are such incentives and results confined to the United States. Countries of the European Union likewise face huge financial liabilities as the size of their retired population continues to grow, not only absolutely but also relative to the size of the working populations whose taxes are paying their pensions. In Brazil, government pensions are already paying out more money than they are taking in, with the deficits being especially large in the pensions for unionized government workers. In other words, the looming financial crisis which American and European governments are dreading and trying to forestall has already struck in Brazil, whose government pensions have been described as "the most generous in the world." According to The Economist:

Civil servants do not merely retire on full salary; they get, in effect, a pay rise because they stop paying contributions into the system. Most women retire at around 50 and men soon afterwards. A Soldier's widow inherits his pension, and bequeaths it to her daughters.

. Given that Brazil's civil servants are an organized and unionized special interest group, such generosity is understandable politically. The question is Whether the voting public in Brazil and elsewhere will understand the economic consequences well enough to be able to avoid the financial crises to which such unfunded generosity can lead-in the name of "social insurance." Such awareness is beginning to dawn on people in some countries. In New Zealand, for example, a poll found that 70 percent of New Zealanders under the age of 40 believe that the pensions they have been promised will not be there for them when they retire.

In one way or another, the day of reckoning seems to be approaching in many countries for programs described as "social insurance" but which were in fact never insurance at all.

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