Insurance – Part 2: Chapter 14

I really do like his analysis of moral hazard and adverse selection in the second half of chapter 14. Really, about the only thing I would like to see discussed more is case probability vs class probability and an explanation of what probability is. Which actually, Sowell doesn’t discuss at all here. 

He does make a gaff when he talks about how government regulation can reduce moral hazard by restricting dangerous activity. So, the government requiring you to wear your seatbelt cuts down on moral hazard, with the logic being that if you have life insurance or health insurance you are less likely to wear your seatbelt. He doesn’t make this argument precisely, but it is precisely in the same vein and logically consistent with the examples he does give.  He actually uses the prohibition of storing flammable liquids in schools. Why does this need to be a government regulation? He discusses earlier the fact that most insurance companies require dead brush to be cut back away from a building before that building is eligible for insurance coverage. Why should seat belts or flammable liquids in schools or bald tires be any different? If it affects the risk, insurance companies can and do adjust their policies and the price of their premiums. For instance, you pay more for home insurance if you don’t have a fire extinguisher and smoke detectors in your home.  

At best, government regulations have no impact. At worst, they are a detriment. The single exception might be in requiring all drivers to carry liability insurance. This is a problem peculiar to socialized roads. In society with private roads, the owner of the road might potentially bare some responsibility for whatever accidents might occur on its roads. The road owner might insure the drivers; perhaps the cost would be built in, in a similar way that the cost of risk is factored into the price of the car rentals of Hertz, as Sowell writes about earlier in the same chapter. It’s unclear what would happen in a free market. 

Otherwise, the regulations do have an adverse effect, as Sowell goes on to illustrate with the banking industry and the FDIC… something that the Canadian banking system apparently does not have, and I’ve written about this elsewhere. You can see my post on Canadian Banks from March 24th.  Their depositors are on the hook if the bank goes under. This creates market forces where depositors are interested in the solvency of their banks in contrast to American depositors whose accounts are insured by the FDIC. They don’t care at all about the solvency of the bank, so the banks are free, and in a sense encouraged, to be reckless in their business practices. If it works out, they make a lot of money. If it doesn’t work out, the depositors don’t care and the government might bail them out anyway. 

He does a fair job in discussing the differing risks of different classes, and explaining why different groups had different insurance rates. Essentially, an 80-year-old buying a life insurance policy will pay significantly more than a 30-year-old woman seeking to buy life insurance. Not many 30-year-old women die, compared to 80-year-old men. So, the risk is higher among one group than the other and is thus reflected in the price.  

And, I’ll also make a note that he did not, and that Mises did, make that insurance is for the unknown and uncontrollable future events. Yes, it is known we will all die, but it is not known when, at least for most. You can control whether or not you go to the doctor for a cold; you cannot control being admitted to the hospital for appendicitis. If you already have cancer, this is not a future event. 

Sowell finishes the chapter strong ripping on FEMA and explaining that it isn’t insurance at all, which sorta feeds into my last point about the unknown. If you build in a low-lying area that gets lots and lots of rain from time to time, you don’t know when the building will flood, but you can bet that it will be ruined by flood in the next 5-10 years. It is uninsurable. 

If you want a good handle on this subject of insurance, risk, and uncertainty, I implore you to take some time and listen to Chapter 6 of “Human Action” on Uncertainty. You might also listen to chapter 5 on time. I think chapters 5 and 6 can stand alone and provide a masterful explanation of the same things Sowell tried to cover in his chapter.