Insurance Misunderstood

In 2005, Liverpool reached the finals of the Champions League (European Cup) for the first time in 21 years. Liverpool was clearly underdog to the stylish AC Milan. Big underdog. A lot was riding on that one match - Liverpool was 5th in the league that year, which meant they would not qualify for the competition the next season if they didn't win. Their captain, Steven Gerrard, would probably have gone to Chelski if that happened. These were terrible prospects for a Liverpool supporter like myself.

Should I Bet on My Team?

The question was: Should a Liverpool supporter bet on Liverpool or AC Milan? (do answer or make a guess before you read on).

Suppose I was risk-averse and that I placed a bet with AC Milan. If AC Milan won, I would be compensated monetarily instead by winning the bet. If Liverpool won, the amount I placed on the bet would be lost, but it would hardly matter since the joy of seeing my team win would be great. Effectively, placing a bet against my favourite team Liverpool (and on AC Milan) became an insurance policy for me. On the other hand, placing a bet on Liverpool would have exposed me to more risk since I could potentially suffer the double agony of losing both game and bet.

What appears counter-intuitive to the lay person becomes perfectly rational for a trained economist - betting against your favourite team is the route to greater happiness! It sometimes comes as a surprise to me how few people understand this principle. Even when I pose this question to a class of economics undergraduates, 80 per cent would get it wrong despite hours of lectures and classes on insurance.

History would show that I didn't win my bet on AC Milan in 2005, but did it imply that I "lost"?

The Outcome You Do Not Want

The simple example provides an important lesson - always bet on the outcome you do not want for insurance. You buy a car insurance so that you can receive compensation when you get into an accident. If you "win" the bet with the car insurance company, you would have been involved in an accident already - clearly an outcome you do not want! When you "win", you have in fact already lost.

Therefore, my bet on AC Milan was actually one I would rather not win. Likewise, I would rather pay for healthcare insurance and never have to claim it. When it comes to insurance, it is not a good thing in general to "win" against the house (insurance provider)! The notion that we should buy insurance and try to win against the house is simply preposterous.

Purchasing an insurance guards the individual against downsides. For the risk-averse individual, the insurance offers a peace of mind which improves his welfare regardless whether the payout is claimed or not. A car insurance gives me the peace of mind to drive on the roads - knowing that my financial losses are covered. I buy because I am risk-averse. Whether I get a payout or not in the end - surprise surprise - is actually a moot point.

All Can Be Better Off

Let me turn to the longevity insurance proposed by the government (my writeup here). Many bloggers believe that if an individual does not live till 85 to get the payout, he would have "lost" the bet against the house and be worse off as a result of having paid the premium all those years. I hope by now the reader can see that this is an unsound understanding of insurance. Insurance is not a zero-sum game, one does not lose just because he is not getting the payout.

The idea of an insurance policy is that with a small payment, an individual can guard himself against desperate outcomes, thereby offering a peace of mind if he is risk-averse. The longevity insurance allows people to smooth consumption over their natural lives and not worry about money running out at 85. When risk-averse people pool their risks together, it is possible that everyone gains regardless of who gets the payout in the end.

To sum up, don't worry about kicking the bucket at 84. Living till 85 and collecting the payout does not mean you have "won" either. If you are desperate for $250 at age 85, it means your money has already run dry - hardly an outcome you want.

A Right Step Towards Risk Pooling

A couple of months ago, I suggested here (not wholly originally) that the major problem of the CPF system was not that returns were low, but the lack of risk-pooling to guard against "longevity risk".

First on the issue of returns. Based on the sketchy information that has been brought to the public in the two days since N-Day rally, CPF returns would indeed be boosted by giving members a higher "expected" rate that would fluctuate according to market conditions. Obviously, higher expected returns would be accompanied by some risk. The interesting question is - if an individual is more risk averse, can he opt for a fixed 4% interest instead?

The bolder proposal being discussed is the "longevity insurance" - citizens contributing towards a national pot, from which senior citizens aged 85 and above would be paid from. The idea of this is simple enough but it represents a key shift for it is the first time a form of national insurance for retirement (either cross sectionally or inter-generationally) is introduced. When my mother-in-law (a youngish 52) heard the proposal as it rolled out at the 10 o'clock news, her first reaction was, "Why should I be paying for others above 85". As Singaporeans are brought up with the idea that CPF account belongs to the individual, it may be difficult to accept that setting aside a small fraction into a common pot for insurance is in fact beneficial to every one.

From an economic point of view, the proposed policy is indeed a right step forward - and a very smart one in fact. First, the scheme is likely to be mandatory. Otherwise, since an individual is most aware of his own health status, only those who think they can outlive 85 will participate in the scheme (averse selection) making it less sustainable. Some critics however argue that mandatory participation would in fact disadvantage the poor since they have a lower life expectancy and the scheme would be actuarially unfair to them. But my sense is that this problem is small compared to old age destitution when retirement funds run out.

Second, notice that the pay out age of 85 is also set above the average life expectancy. Suppose a worker stops working at 65, he would have to live on his own retirement funds for another 20 years before he could dip his finger into the common pot. In other words, the worker would still have to save up for his own retirement (of 20 years at least) before the insurance element kicks in.

In economic parlance, the 20 years is the "excess" - like how we often have to pay for the first $500 of damage when we file a car insurance claim. The purpose of this "excess" is to reduce the moral hazard problem that always occurs with insurance. Because he still have to worry about 20 years of his retirement, the worker still has strong incentives to build up his personal retirement account even though he is insured past 85.

As expected, the loss of control of a portion of retirement fund has given rise to some unease ("coerced annuity"). Rather than seeing it as coercion, a better way would be to understand the true nature of this proposal, which is essentially a social safety net for the advanced old. But the nature of having a social safety net is as such - there must be contributions by all to support and sustain this safety net. In principle therefore, building in some element of risk-pooling into our CPF system is the right step forward. The proposal also cleverly reduces the moral hazard problem. The government should be given some credit for creative thinking.

Market Hazards

Like Lucky, I have spent most of my last three weeks tracking the subprime crisis, the market and my portfolio. Blogging comes second to watching my housing and retirement funds. Perhaps I would write something about the economics of it some other day when things are calmer. When the market is in this mood, there is really not much point in talking about fundamentals. Even as I tried to offload stocks over the past weeks to stem the losses, my portfolio kept shrinking. I am not losing sleep yet, but it doesn't feel good.

This morning, the STI fell below 3000 points, a decline of nearly 5 per cent at one point. I searched and asked around for the 'trigger' - what new information came into market to trigger this morning's selloff. Apparently, there was none. One analyst said that the market was very frightened, but it was not entirely sure what it was frightened off. A friend of mine working in the finance industry told me that we were in the "tail chasing dog" territory. The sharp fall was trying to find a reason to justify itself !

Indeed, as I look at the balance sheets of some of the blue chip companies, their profits, the cash they hold, there simply isn't any credit or liquidity crunch of any sort. But I remember a quote, "The market can stay irrational longer than you can stay solvent." Nevertheless, the market cannot stay irrational forever. Looking at the valuations of some of these companies, it would be irrational of me not to put money in. So even though my trading screen was flushed with a sea of red, with trembling hands and a pounding heart, I clicked some buy buttons this afternoon.

[Latest: STI rallied from nearly 180 down to close with negative 20. US Fed has cut lending rate to banks.]

As the day closes, it appears that world markets might have just dodged a bullet today. But be warned, there would surely be more bullets to come. Like Lucky says, we are going through an interesting but terrifying time. My personal take is that one should never aim to eliminate all financial risks and forego all potential returns. Having a clear head about personal finances, staying invested and learning to cope with risks would be a better strategy.

Learning to Tie the Policy Hands

In this post, I argue, using the current red-hot property sector as an example, how too much policy discretion over the economic cycle may actually compromise long-term objectives. Some "tying of hands" or credible commitment on the part of policy-makers can sometimes be better for the economy. The full article can be found on Singapore Angle.