Editorial opinion

Misconceptions About Insurance

by Carole E. Scott

Carole E. Scott is a Professor of Economics at West Georgia College and Editor of Business Quest.

Many years ago I watched as Newt Gingrich's opponent in a Congressional campaign jumped on him like the proverbial duck on a June bug when he said that Social Security needed to be changed. Like other politicians until quite recently, Newt quickly backtracked.

Politicians in both parties today dare to propose changing Social Security because the public has been educated about its nature and the impact on it of future demographic changes. Unfortunately, what the public has been told is not true. They have been told that what's wrong with Social Security is that, unlike real insurance, it is an income transfer program. The truth is that real insurance is an income transfer program. What is really wrong with Social Security is that it is a Ponzi scheme.

The Mechanics Of A Ponzi Scheme

Like weeds in your lawn, Ponzi schemes are constantly springing up. I had not been teaching long when some of my students asked me what I thought of an investment that I suspected was a Ponzi scheme. They had seen an advertisement on television by a company which promised to pay people who bought their "thrift notes" an above average rate of return. Supposedly their money would be invested in second mortgages.

For awhile investors earned an above average yield, but their earnings didn't come from interest earned on second mortgages. Instead, it came from the money collected from people who "invested" after they did. Ponzi schemes inevitably collapse, because they can continue only so long as new investors outnumber existing investors. (The more rapidly a Ponzi scheme promises to return its customer's money and then some, the more quickly it will collapse, because the virtually fixed number of potential customers will be "used" up faster.)

The Social Security system has largely operated like a Ponzi scheme. Money currently being collected from workers has been used to make payments to those currently entitled to receive them. Because the amount of money retirees are entitled to receive has periodically been raised and people are living longer after they retire, to date, what has been paid out on behalf of an age group has fallen short of what it this group paid in Social Security taxes in nominal and real terms. (Often when workers die, payments continue, as spouses and children of deceased workers are entitled to benefits.)

Because people start collecting Social Security benefits so long after they begin paying Social Security taxes, a rising birthrate and/or the immigration to the this country of young people, could provide Social Security with a long life. However, the birth has actually declined.

To convince the public that Social Security cannot continue to be operated as it has, they have been told it is an income transfer program, rather than insurance. To demonstrate this, Social Security has been contrasted it with whole life insurance. If a person purchases a whole life insurance policy, the life insurance company invests the excess of the premiums paid by the insured over its operating expenses and profit. The liquidation (sale) of these investments and/or income earned on them provide it with the wherewithal to pay a deceased policy holder's beneficiaries or provide the policy holder with a retirement annuity.

Premium payments from whole life insurance policy holders who have not died is paid to the heirs of policy holders who die before they have paid enough premiums to cover the death benefit. Therefore, whole life insurance is, in part, an income transfer program. However, unlike term life insurance, enough is collected from policy holders so that everybody, directly or indirectly through their heirs, eventually collects. This is why whole life insurance is described as a combination of pure insurance, like term life insurance, and a savings plan.

Term life insurance is entirely an income transfer plan. Only people whose homes burn down receive any money. Only the heirs of members of an age group who die during the term of the policy--a year or a few years--collect any money. Because a term life insurance company pays out premium income so soon after it is received, relatively little of what it pays beneficiaries comes from income earned by investing this money.

Fire insurance is pure insurance. Through fire insurance, a group of people, none of whom may be able to afford to replace their homes if they burn down, can, for a modest amount of money, assure that their homes will be replaced if they burn down. Everybody pays premiums, but only the few people whose homes burn down receive any money. Therefore, fire insurance is an income transfer plan, but it is not a Ponzi scheme, because every policy holder is not promised they will be paid anything, much less more than they have paid in premiums.

A few years ago Social Security taxes were raised so that more money would be collected than was currently needed to pay beneficiaries. This excess is invested. However, what it is invested in is not the stocks, bonds, and mortgages private insurance companies mostly invest in. Instead, it is U.S. Treasury Securities.

When, in the future, the money put into Treasury securities is needed because what is then being collected from workers will be less than what retirees are entitled to, either other taxes will have to be raised so the federal government will run a surplus and, therefore, can retire the bonds held by the Social Security Administration, or the Treasury will have to borrow the money needed to retire these bonds.

Insurance Is Not The Best Way To Cover Many Costs

Originally financial institutions were not interested in lending individuals money to buy homes. Some aspiring homeowners dealt with this by pooling their savings and lending this money to a few of those who put money into the pool so they could buy homes. As these loans were repaid and more savings were added to the pool the remaining members of the group got loans. If, as was planned, the interest earned on the loans exceeded the amount needed to offset loan losses, the interest on these loans increased the size of the pool. (These pools were originally called building and loan societies. In this country, they eventually began calling themselves savings and loan associations.)

Relatively large losses, such as the loss of your home, that are unlikely to be experienced are the only type of costs appropriately covered by insurance. If everyone is going to experience a particular type of cost, insurance makes no sense, because no money is saved. If, for example, everybody's house is eventually going to burn down, collectively home owners would have to put into an insurance pool enough money to replace every home; so, by pooling funds, home owners would not save money.

Although insurance is economic only when it covers relatively large which occur infrequently costs which people cannot afford to pay, today insurance is often used to cover costs everybody incurs and can afford to cover. Why this is uneconomic is not difficult to illustrate.

If, for example, when you went to the grocery store, either a private or a government insurance plan paid 90 percent of the bill, while you paid only 10 percent, you would buy more expensive food and buy more food than you otherwise would. Before you had this insurance you may have bought hamburger at $2.00 a pound. Afterwards you might trade up to steak which cost $20 a pound because your out of pocket cost for it would be only $2, or you might buy 10 times as much hamburger because 10 pounds would cost you as much as one pound used to. (Why, people would ask themselves, should I pay a premium and get nothing, when I can get something?)

Before you had food insurance you might not have bought chocolate-covered pigs' feet at $1.50 a pound because there was a good chance you would not like them. After you got this insurance you might buy them because all they will cost you is 15 cents, and at that price you can afford to throw them away if you didn't like them. If you threw them away, more than $1.50 would be wasted. This is because the premium you would have to pay for your food insurance would have to cover both the $1.35 the insurer paid the grocer for the pigs' feet plus what it cost to process your claim.

If food insurance had not been introduced, the price of the pigs' feet would be less than $1.50. In the absence food insurance your grocer might have gotten away with raising the price of the chocolate-covered pigs' feet from $1.00 to $1.05. With food insurance, he could get away with increasing their price from $1.00 to $1.50 because this would also only increase what you pay him by five cents.

If you did not have food insurance you might go to another store to buy the pigs' feet because it only charges $1.00 for them. Because you would only save five cents by going to the other store if you have food insurance, you would then be much less inclined to go to the other store. If you don't go to the other store, you do not put pressure your grocer to reduce the price of his pigs' feet.

People with food insurance will eventually realize that what they pay grocers plus the premium on their food insurance exceeds how much they previously paid for food. Because of the food-insurance-caused escalation in what people without food insurance were having to pay for food, uninsured people would be hurting even worse. Those with food insurance will then probably demand that food insurance premiums cease to rise or even be reduced. Those without food insurance will demand they be provided with it.

To control its costs, the food insurer might sign up a grocer who would promise to provide each insured family with a given amount and type of food for a fixed price. Then the insurer would tell you that you would have to buy your groceries from this grocer. If this was government-provided insurance, it might be illegal for you to offer the grocer a few extra bucks to provide you with steak rather than ground beef.

After your insurance company starts picking up the tab for most of your grocery purchases, because there is less in it for him to do so, the grocer may not exert as much effort as he used to in trying to please his customers. This is because he is mainly answerable, not to who he is serving, but to the insurer. The insurer's interests are not identical to those of the insured; nor is the insurer as well positioned as is its customer to protect customer's interests.

Unlike this hypothetical food insurer, fire insurers receive no claims from most customers. Therefore, unlike a company covering relatively small costs which are continuously experienced, a fire insurer's processing costs are relatively low, and a fire insurance company paying bills for its customers does not put strong upward pressure on prices or promote wasteful spending by its customers.

Although we do not have anything as ridiculous as food insurance, we do have a good deal of analogous health insurance, some of which is government subsidized, that has had some undesirable consequences like those which food insurance would be expected to produce.

The only kind of health insurance that makes economic sense is policies which cover only the extraordinary health care expenses seldom experienced and, perhaps, through a savings plan like that of whole life insurance, the usual cost of a terminal illness.

The Superiority Of Private Pension Plans

This country made a big mistake when it decided to provide the elderly with money they need to purchase food, clothing, and shelter with a public pension plan, rather than with private pension plans.

As has been pointed out, Social Security taxes are paid out to beneficiaries, who use it to support themselves, or is loaned to the Treasury. Most of the money the Treasury borrows is used to finance entitlements, that is, payments made to people who use it to support themselves. Most of the remainder covers the cost of national defense, general government expenses, and interest on the national debt. Relatively little government spending promotes wealth creation, that is, is used in a way which will make it possible the nation's workers to produce more goods and services.

Private pension plans, on the other hand, are forbidden by law from simply passing the money they are collecting from younger, working people on to older, retired people. Instead, the money the older people receive comes from what is earned on the investments made with the money they put into the pension plan before they retired and/ or the liquidation of these investments.

One has only to look at the financial statements of the nation's businesses to see what happens to money collected from the public by financial institutions. It finances the acquisition of more and better capital stock, that is, productive assets like factories. It is these assets which makes it possible for us to produce goods and services, and their quantity and quality plays an extremely important role in determining the level of output per worker.

In the absence of large numbers of young immigrants who greatly outnumber older immigrants, the ratio people paying Social Security taxes to people receiving Social Security checks is going to continue to decline. Due to the large increase in the birth rate for two decades after World War II and its subsequent large decline, the ratio of people paying into the system to those drawing from it will be very much lower in the next century than it is now.

The more productive is the labor force, the greater is the level of output per capita. The only way to prevent the standard of living of the labor force from declining when the ratio of workers to total population declines as a result of a larger share of the population being retired is to increase productivity enough to offset the decline in this ratio. A substantial increase in productivity requires a substantial increase in investment in real and human capital.

Because Social Security reduces the need for private savings, it may reduce the amount of personal savings and, therefore, reduces the amount of productivity-increasing investment which takes place.