The State of the Union: Campaign Finance

Last night, the President stated:

With all due deference to separation of powers, last week, the Supreme Court reversed a century of law that I believe will open the floodgates for special interests, including foreign corporations, to spend without limit in our elections.

I don't think American elections should be bankrolled by America's most powerful interests or, worse, by foreign entities. They should be decided by the American people.

He received much applause from the floor, but earned a quiet "Not true" from Justice Alito.

Laying aside the issue of trying to intimidate the Justices and whether corporations are politically "people", there is a simple flaw in the President's argument. He fails to acknowledge the behavior of national and state parties and associations in crossing state and district lines respectively to imbalance elections. Imagine a scenario where House candidates only receive funds and volunteer assistance from within their district, and where Senate candidates only receive funds and volunteer assistance from within their state. This is a fantasy, far removed from the truth of how campaigns are financed.

Let's face facts. The national parties are special interests in local and state races. Out-of-state corporations and associations are "foreign entities" under state laws. We have the fundamental rights to associate and to petition our government for redress of grievances. (Together, these rights allow us to try to get our candidates elected--the ultimate opportunity for redress of grievances.)

It is hypocrisy to point out the mote in someone else's eye and ignore the log in your own. If you want to clean up campaign finance, examine out-of-state and out-of-district contributions. By definition, that means that you are examining foreign contributions.

Tax Time Stinks

Forget the winter blues. I've got the taxation blues.

I'm busy closing my year-end accounts for tax filings for my businesses. Every January (and at the beginning of each quarter--January is just the worst) I really hate having to be Uncle Sam's and the Commonwealth of Virginia's uncompensated tax collector. Last year I got smart and paid my accountant to do the annual payroll tax filings (W-2's, 1099's, etc.).

Has anyone ever sent government an invoice for tax collection services rendered? Had it paid? Does this make me a slave to my government?

And it will only get worse for me if Congress passes the health insurance reform bill. I hope that Brown wins in Massachusetts, and that the Democrats don't use reconciliation to pass the bill without cloture.

Please, God. Put an end to it! I don't want to suffer more!

The Tolkien Professor

A friend of mine sent me this wonderful site containing an ongoing series of podcasts about J.R.R. Tolkien and his writings. The author writes concerning himself and the site:

My name is Corey Olsen. I am a professor of medieval literature and an English PhD, and I have been a student of Tolkien’s works for as long as I can remember. On this website, I am posting a series of FREE audio lectures on Tolkien’s major works for you to download and listen to on your computer, your iPod, or wherever. I hope you have as much fun listening to my lectures as I have making them!

He is not too far along, so it won't take long for you to catch up.

Quote of the Day

"Apathy and inertia are the handmaidens of indifference."

--Over the Hedge comic strip, 9 January 2010

The Law and the Profits, Part 3

Still in chapter 1.

Professor Parkinson relates the general process of government budgeting: The civil servants create the budgets in such a way that the previous year's dollars are adjusted for inflation, and then a percentage is added for good measure. These values trickle up to the Treasury, at which point revenues are allocated to meet budgetary demand. The legislature plays a role in the authorization and allocation, but if the system of accounts is not robust (as it was in Britain despite major reform efforts in 1666, 1689, 1826-29, and 1904), then the legislatures role is practically limited.

The United States federal government has spent many years attempting to improve its system of accounts, yet after so long still regularly fails to modernize and make reliable the financial systems at key departments. (See the Financial Report of the United States, past and current, specifically the auditor's reports.) Having read the U.S. financial reports for nearly a decade, it is clear that progress is being made. Nevertheless, politics interferes with budgeting reform. A fascinating paper by Theresa Kohler of Virginia Tech examines some of the major problems of legislative involvement in budgeting, and reviews some concepts for improvement. A list of recommendations from the Heritage Foundation identifies seven steps for current budget reform. Parkinson has his own suggestion for reform, which is stated simply: "Ministers should not begin by ascertaining what the departments need. They should begin by asking what the country can afford to spend." This is after all the basis for household and business budgeting; why not the government as well? More in part 4.

The U.S. is a long way from the Britain of Parkinson's time (1957), and yet we are still very close in many ways. He states, "The accepted principle is that new expenditure is watched by the Treasury, old expenditure by the departments themselves." In the U.S., most budgeting is done by incremental changes to the baseline, which is determined by the departments. New allocations are an amalgam of legislative and departmental desire. There is so much happening in the federal budget that the 535 people who are our representatives cannot know what is going on in any significant detail. Therefore, they must deal in "deltas" from baseline, allowing what presently is spent to continue to be spent. This is the reason that few government programs are ever ended despite the clear end (successful or not) of their mission. It is simply too difficult to identify these living-dead programs and to end them. Now, in modern times, using the internet as a tool, some efforts to bring transparency to the federal budget are having the effect of allowing more citizens to review the budget and to make their voices heard concerning the waste. What remains to be seen is whether politicians will have the political fortitude to end the waste.

Parkinson writes concerning the watchdog,

"The ordinary taxpayer is often in a better position to know about waste in administration than either the politician or the journalist. For one thing, he may himself be employed in the [government program]. It is theoretically in his interest as well as his duty to come forward and denounce extravagance when he sees it. He does nothing of the kind, and that for two distinct reasons. In the first place, he stands to gain nothing but unpopularity and abuse, being likely to be regarded as at best a crank, at worst a spy. In the second place, he knows perfectly well that the money saved in one direction will certainly be wasted in another. Nothing he can do will reduce the tax he has to pay. So he wisely decides to say nothing and keep the good opinion of his neighbors. In matters of public expenditure no help is to be expected from the public at large unless the informant is personally rewarded and at the same time assured that all savings will go to the reduction of the taxes to which he is subject."

He did not foresee the internet, nor the rise of watchdog groups. He saw the heroic individual standing up for what is right in the face of "unpopularity and abuse." The watchdog groups still receive "unpopularity and abuse," but the effect is diluted and easier to individually bear. There is strength in numbers, and I must caution that not all interest groups are evil or self-interested.

Next time, how much taxation can a country afford, and what types of taxation are appropriate?

The Snow Cometh; the Snow Goeth

2009 Christmas Blizzard

The Law and the Profits: Part 2

The Law and the Profits, by C. Northcote Parkinson (of Parkinson's Law fame). Chapter 1, continued.

Chapter 1 delves into the reasons for increasing taxation before attempting to persuade concerning the evils of excessive taxation. In short, he attributes the trend increase to "temporary" wartime increases that are never fully decreased once the war is over. This long paragraph, excerpted from the beginning of Chapter 1 is too well-written to attempt a paraphrase:

Governmental as opposed to individual income is historically linked with the incidence of war. In all systems of revenue there has always been the provision for the temporary expenses of conflict. During a time of emergency, with our interests, our beliefs, our pride, or even our existence at stake, we agree to pay almost anything as the price of victory. In theory the revenue should fall to something like its previous level. In practice it seldom does. While the governmental income remains almost at its wartime level, peacetime expenditure rises to meet it. In times past the action of this law was slightly restrained, to be sure, by two considerations which no longer apply. In the first place, it was usually felt that taxes had to be reduced somewhat in time of peace in order to allow for their being raised again in time of war. During a century, however, when each successive war is judged to be the last, this theory finds no further support. In the second place, there are types of extravagance which yield only a diminishing return. To the provision of banquets and the enjoyment of dancing girls there is (eventually) a physical limit. The same is not true, unfortunately, of departmental and technical luxuriance. Economic and cultural advisers can multiply beyond the point at which concubines might be thought a bore; beyond the point even at which they might be thought unbearable. Financially, as well as aesthetically, the situation has become infinitely worse.

One can look into the history of the United States to understand when taxation has been introduced. Article 1 of the U.S. Constitution provides for "Taxes, Duties, Imposts and Excises," of which primarily duties, imposts and excises were chiefly in force in the colonial period. The first instance of the income tax is in 1861 during the Civil War (at a mere 3% single top rate). Though struck down as unconstitutional, it was introduced again in 1894 during peacetime (at a mere 2% single top rate), but was struck down again as unconstitutional. It was revived permanently (thus far) in 1913 following ratification of the Sixteenth Amendment. The highest rates were increased from 7% to 77% between 1916 and 1918 during World War 1. Following the war, the rates were reduced (generously, we might think) to (only) 24%, though it took until 1929 to reach this nadir. Rates went up again (to 81% by 1941) to combat the Great Depression, increased further to 94% (by 1942) during World War 2. Rates came down (only) to 82% (by 1949), then increased again to 92% in 1952-1953 (the onset of stalemate in the Korean War). Since then, rates have trended downward to the present highest rate of 35%. (See this Wikipedia article for the details.)

Payroll taxes were introduced to combat the Great Depression (Social Security) and the War on Poverty (Medicare), and have been expanded several times over several decades to increase revenue and expand public services.

It is clear simply from U.S. history that Parkinson observed correctly. Taxation does not seem to return to pre-war levels, giving rise to the statement of the second law, that expenditure must inevitably rise to meet the increased level of taxation.

In the next article, we shall take up the details of taxation somewhat from the civil service and political viewpoint.

The Law and the Profits (Part 1)

Earlier this year, I read The Law and the Profits, by C. Northcote Parkinson (of Parkinson's Law fame). This book was first published in 1960, and though the subject of the analysis is Great Britain and the supporting figures are many decades old, the theme is still true and relevant today in the United States.

(My 1960 first edition American printing was recently shredded and eaten by my two dogs, so I have since acquired--for around fifteen dollars--a replacement 1960 first edition London printing from Alibris. The drawings within are different, but the text appears to be the same. This survey of the book is based on the first edition.)

I have not found (by Google search) any material about this book, save a brief mention in this Wikipedia article concerning Parkinson's Law, and then only to call it a corollary to the first law. It is in fact Parkinson's Second Law--claimed so by the author himself in Chapter 1.

Chapter 1 is titled "Parkinson's Second Law" and opens thus:

Expenditure rises to meet income. Parkinson's Second Law, like the first, is a matter of everyday experience, manifest as soon as it is stated, as obvious as it is simple.

The first example is of a family implicitly obeying this law. However, the subject of the book is government, and to that he moves in the second paragraph and rarely leaves this subject again for the remainder of the book.

It is less widely recognized that what is true of individuals is also true of governments. Whatever the revenue may be, there will always be the pressing need to spend it. But between governments and individuals there is this vital difference, that the government rarely pauses even to consider what its income is.

("What its income is" does not refer merely to accounting, although the early 20th-century British government appears to have had a problem even with this. Rather, this phrase, as we will see in later installments, refers particularly to the nature of the income and not merely its quantity.)

It is arguable that governments that annually rely on deficit spending are described perfectly by this statement. I will need to return to this topic later.

With this simple understanding of Parkinson's Second Law, let me quote now from the "Preface:"

The first purpose of this book is to show that there are limits to the collection of revenue and that evils multiply when these limits are ignored. However, the tendency to cross these limits appears to be universal, eternal and all but irresistable: the growth of taxation is clearly subject to a law.

The second purpose of this book is to show that a greatly reduced revenue would bring about an improvement, not decline, in the public services. It is the paradox of administration that fewer people have less to do and more time, therefore, in which to think about what they are doing. When funds are limitless, the only economy made is in thinking. The worst inefficiencies do not stem from a lack of funds, but from an initial failure to decide exactly what the object is. It is this muddled thinking that leads to waste, and often to waste on a colossal scale. Towards eliminating public waste an essential step is to reduce the total revenue. Officials are less inclined to squander what is not there. A knowledge of the law which governs expenditure should ensure that the profits from taxation are rarely thrown away.

I believe that Professor Parkinson succeeded completely in this book achieving his first purpose. I will determine through this survey whether I think he succeeded in the second.

I have observed in recent decades in the United States that the reduction in revenue was tried in the 1980's, but because a reduction in spending was politically impossible and that seemingly limitless borrowings were available to fund the annual deficit, that the government-reducing scheme was a failure. I do not think that this disproves Parkinson's second purpose, because I do not think he imagined a government with a fiat currency. The second purpose would hold if government were somehow constrained to spend within its means.

This quote leaps out at me: "When funds are limitless, the only economy made is in thinking. The worst inefficiencies do not stem from a lack of funds, but from an initial failure to decide exactly what the object is. It is this muddled thinking that leads to waste, and often to waste on a colossal scale." If you substitute the concept of "family" or "small business" or "association" or "church" in place of "government" in the preface, the raw and personal truth of these statements becomes clear. If it were my own money and my own decision, I would be inclined to be thrifty and clear on what I spend it.

Next in the series, I will continue with Chapter 1 concerning the rise in taxation over time.

The Santa Instantiation Hypothesis

Today, Kathy and I spent the afternoon at the mall marketing our veterinary business next to the Pictures with Santa fantasyland. At one point, I explained to Kathy that in the moment that the picture is taken, the real Santa momentarily exchanges places with the fake Santa. In this way, the picture with Santa is always with the real article, and the real Santa can spend his time preparing for Christmas.

She didn't believe me.

Seen on a T-Shirt

"I've just kidnapped myself. Give me $100 or you'll never see me again."

Politically Powerful Dinner Guests

Let's say that you are into the health care reform debate in a big way. Let's also say that a Democrat leader from the Senate is your Thanksgiving dinner guest this year. (Let's also pretend momentarily that your fellow hosts have not forbidden political discourse--which they actually have for the sake of peace and harmony.) What questions would you have to ask your guest? Here are mine:

1. The U.S. spends considerably more per capita on health care. Leaving aside the assertion of disparate outcomes, how much is the spending influenced by demand factors such as demographics (particularly age and other factors), lifestyle choices, wealth and income effects, geography and population density (see also the demographics link); by supply factors such as pharmaceutical (PDF) and capital equipment expenses (and associated research and development expense), labor expense (and associated regulatory costs, such as licensing, the Fair Labor Standards Act, etc.), and facilities expense (and associated regulatory code compliance expense); and by price factors such as state insurance mandates (PDF), Federal regulations, insurance market structure, foreign price controls on pharmaceuticals, and financial market performance (both for access to credit and for investment income purposes)? Is the comparison influenced by currency exchange rates, or is a more stable method of exchange utilized?
2. Where does the Constitution grant Congress the authority to compel a private citizen to purchase health insurance? Does this conceptually abrogate the freedom of the private citizen to contract with providers of goods and services? What is the limit to what Congress may compel the private citizen to purchase? Can Congress compel a private citizen to associate with any group, regardless of whether the mission and values of the group are antithetical to the beliefs of the private citizen? If we pierce the veil, isn't the "tax" upon the private citizen for failing to purchase health insurance really a penalty or fine? What does the concept of "liberty" mean, and does it include the freedom to not act just as much as it includes the freedom to act.
3. What is the contribution to the rate of growth of private sector health care costs that is attributable to price caps enforced for public sector health costs? (Mathematically, if the growth rate of the public sector half of the health care spending is artificially lowered, then the growth rate of the remaining private sector half must be artifically higher in order to balance to the average growth rate of the entire amount spent--which I assume is presently based on demand, not on government decree. In equation form, P1 * Q1 + P2 * Q2 = Pavg * Qavg. where P is price, Q is quantity, 1 is the public sector, and 2 is the private sector.)
4. What is the contribution to the expense of health care costs in general and on insurance premiums in particular due to government regulation, such as state mandates (PDF), prohibition on interstate commerce in insurance policies, and Medicare and other Federal rules for providers and insurers?
5. What are the desired effects of health insurance reform on Medicare, and what is the intended and estimated impact on the $36.4 trillion unfunded liability (pg. 69, infinite time horizon)?
6. With Medicare fraud in the billions of dollars, can the Federal government contain fraud in a Federally sponsored/managed insurer?
7. Why refuse to extend the Hyde Amendment to insurance subsidies contemplated in congressional health reform bills?
8. Why refuse to use the Systematic Alien Verification for Entitlement (SAVE) Program to prevent illegal aliens from utilizing Federal spending contemplated in congressional health reform bills?
9. How do ten years of revenues and six (House bill) or seven (Senate bill) years of expenditure produce a stable, long-term program?

I doubt that I could get many Federal politicians (of any party) to answer these questions without prevarication. If you watch enough of the BBC series "Yes, Minister", the reasons become evident rather quickly.

I think I'll stick to eating and drinking this Thanksgiving.

I'm a Tenther.... How about you?

Sticking "-er" to the end of the topic du jour seems to be in vogue: "birthers", "tea baggers", "truthers", etc. Tonight I decided that I am a "Tenther". That is, I am a believer in the Tenth Amendment to the Constitution. (That's the one that reserves to the states and the people all powers not granted to the Federal Government and all those powers not prohibited to the states.)

Wikipedia has an article about the Tenther Movement. I didn't know this name was already in use, so I feel smart for having coined it myself. (If Leibniz can get credit for developing calculus along with Isaac Newton, I can also get credit for coining the term.)

Note: Being a "tenther" doesn't make me a secessionist. There are good reasons to have a federal government. Too bad so many of those reasons are obscured by present practices.

Quote of the Day

"Congress is becoming increasingly corrupt. Pretty soon, they could put a fence around the Capitol and turn it into a minimum-security federal prison."

--Tommy Butler, WSJ Commenter

Article: Senate Alters Taxes for Big Companies

The GM Takeover by the Government

I don't agree with the takeover of GM (or Chrysler), but it is instructive to learn why and how it was done from the person who was at the pointy end of the spear.

Quote of the Day

To be GOVERNED is to be watched, inspected, spied upon, directed, law-driven, numbered, regulated, enrolled, indoctrinated, preached at, controlled, checked, estimated, valued, censured, commanded, by creatures who have neither the right nor the wisdom nor the virtue to do so. To be GOVERNED is to be at every operation, at every transaction noted, registered, counted, taxed, stamped, measured, numbered, assessed, licensed, authorized, admonished, prevented, forbidden, reformed, corrected, punished. It is, under pretext of public utility, and in the name of the general interest, to be place[d] under contribution, drilled, fleeced, exploited, monopolized, extorted from, squeezed, hoaxed, robbed; then, at the slightest resistance, the first word of complaint, to be repressed, fined, vilified, harassed, hunted down, abused, clubbed, disarmed, bound, choked, imprisoned, judged, condemned, shot, deported, sacrificed, sold, betrayed; and to crown all, mocked, ridiculed, derided, outraged, dishonored. That is government; that is its justice; that is its morality.

(P.-J. Proudhon, General Idea of the Revolution in the Nineteenth Century, translated by John Beverly Robinson (London: Freedom Press, 1923), pp. 293-294.)

Health Insurance Facts, Part 2: Why is Medical Insurance Different?

Link: Health Insurance Facts, Part 1

I have been brooding over the question of "Why Medical Insurance is Different" for many days now, trying to get succinct evidence to share. I have found it, and will present it shortly.

Medical insurance seems to have been first considered in 1694 [1], and first introduced into the United States in 1850 [2]. It was intended to cover injuries due to accidents, and seems to have been related to modern disability insurance. Sickness insurance followed in 1890, and employer-sponsored group disability insurance was first issued in 1911. [1]

Hospital and medical expense policies were introduced during the first half of the 20th century. During the 1920s, individual hospitals began offering services to individuals on a pre-paid basis, eventually leading to the development of Blue Cross organizations. The predecessors of today's Health Maintenance Organizations (HMOs) originated beginning in 1929, through the 1930s and on during World War II. [1]

The wage controls imposed during World War II are often cited as the leading cause of the importance of employer-sponsored medical insurance. With companies unable to offer greater wages to their workers by law, they turned to fattened benefits in order to compete for talented workers. Medical insurance policies covered more things as a result. This was fine for those individuals and families whose employers provided such benefits, but did no good for those employed elsewhere, such as by small businesses unable to afford such benefits, or unemployed (whether voluntarily or not).

Enter the states. Before I describe insurance mandates, let me take a moment to address the question of federal regulation of interstate commerce of health insurance.

The Health Care Choice Act, a bill introduced unsuccessfully into the House of Representatives in 2005 and 2007 has attempted to allow medical insurance to be sold across state lines, amending the Public Health Service Act (42 U.S.C. 300gg et seq.). I need more time to determine whether sections 300gg et seq. prevents interstate commerce with respect to medical insurance policies, but I think it is safe to say that if a bill in Congress is attempting to achieve the opposite, then it is safe to assume (for this article) that Congress has in fact prevented it.

Therefore, states have a monopoly on the chartering and regulation of medical insurance companies. Large insurers compete in states by creating (or acquiring) a subsidiary in the state in which they wish to do business, but all policies therein are unique to that state, even though the subsidiary is financially backed up by a multi-state parent insurance company. This type of organization raises the costs of entering the market in another state, and is therefore a barrier of entry to competition, and is one factor in the oft-cited fact that a few large insurers dominate the market in many states.

Add to this barrier of entry the manifold regulations by the states of what must be in policies. The Center for Affordable Health Insurance has catalogued 2,133 policy benefits mandated by the states in a 2009 report (pdf). (These 2133 mandates overlap considerably.) The report shows the mandates by state, and estimates the contribution of each mandate to the cost of the state's required policy. This means that medical insurance has evolved, under employers' hands and the state governments' hands, into something more comprehensive. What was once known simply as Accident Insurance, then (over time and as coverage increased) Hospital Insurance, Major Medical Insurance, and just plain Medical Insurance, now is known as Health Insurance, covering arcane things such as contraception and AIDS testing.

The method of payment for claims has also changed considerably over time. Insurance policies were once "indemnity" policies, meaning that we submitted our own claims and were reimbursed afterwards for whatever was covered. Later, insurance companies formed Health Maintenance Organizations (HMOs) and Preferred Provider Organizations (PPOs). In HMOs, the insurance companies own and operate the means of providing care, and employ the doctors and nurses. In PPOs, the insurance companies negotiate fees with the providers, and do not necessarily own the means of providing care. In HMOs, we pay whatever is not covered by our policy, and there is no extra paperwork between the provider and the insurer. In PPOs, the provider generally bills our insurer on our behalf, and collects the difference between what is covered and what is not directly from us. Preferred providers go a step further by waiving any part of their usual fee not allowed by the insurer (due to fee negotations). In short, we have become separated from the costs of care, because we no longer bear the full cost, no matter how temporarily, because the providers and insurers float the costs through their accounts payable/receivable. We once did the paperwork with the insurer for free; now we (or rather, our insurer) pay the provider to do it on our behalf.

I am forced to conclude that medical insurance is different from auto insurance and home insurance because we the people, ostensibly through our employers and elected representatives, have chosen it to be this way, for better or worse.

Ronald Reagan discusses Socialized Medicine

This is an audio link from YouTube. The recording dates from 1961.

Listen Here.

Quote of the Day: Health Care

"Health insurance companies refuse to cover pre-existing conditions for the same reason that you can't insure your automobile after you crash it." --Robert Tracinski, Real Debate Is Individualism vs Collectivism

The article is excellent throughout and pre-figures my Part 2 for understanding Health Insurance.

Quote of the Day

"The founding of this country was the result of a tax revolt."

--Breck Collingsworth, a Wall Street Journal subscriber, commenting on an article about Town Hall revolts in Maryland.

Perhaps those in the White House and in Congress who wish to tax us more (and more "progressively") should better remember our nation's history.

Health Insurance Facts, Part 1: What is Insurance?

On July 24, protesters picketed the Richmond headquaters of Anthem, a subsidiary of WellPoint, a national health insurance group. One of my relatives was among the picketers.

Before dinner the next evening, I had the opportunity to speak with my relative concerning the protest, and I discovered that certain facts had been asserted, and certain negative opinions had been formed. I recommended that she examine Anthem's financial statements, freely available online from the Securities and Exchange Commission, and to especially read the Management's Discussion and Analysis section. Not only does this check the asserted facts, but it puts the protester into the shareholder's and manager's perspective, inviting them to see the real constraints encountered in the health insurance industry, but also challeging them to think of what they would do better, and if that is the real substance of their protest.

I want to provide first a general discussion about insurance and learn what I can without deifying or demonizing any particular company. Second, I want to understand better why medical insurance (AKA health insurance) is different from other types of insurance. Third, I want to examine the real financial statements of a large health insurer and understand what events are occurring and what choices management is making.

Let us begin by answering the questions, Why do we have insurance, and what is it? In the simplest approach to insurance, one person who is going to perform a risky activity (the insured) contracts with another person (the insurer) who is willing to accept the cost if an adverse outcome occurs. The liklihood of the adverse outcome is usually low, and the cost is usually very high. The insurer charges an amount (proportional to the risk) for the insurance (the premium) and sets it aside until the insurance contract expires. If the adverse outcome occurs, then the insurer covers the cost, usually more than the value of the premium. If the adverse outcome does not occur, then the insurer profits from the premium, and the insured endures an additional, unneccessary in hindsight, cost of doing business.

One early use of insurance was to protect the owners of shipping vessels. Then, as now, shipping goods over the sea was a risky enterprise. The loss of a vessel was a real and substantial threat to the solvency of a shipping company. Those with money to invest would insure the shipping companies. If an insured ship was lost at sea, the insurer would compensate the owner for the goods and the vessel. Since the amounts at stake were so large, syndicates of investors would be formed for the duration of the insurance contract, and these syndicates would provide the necessary financial backing. By syndicating the risk, the value insured could be much larger than any single investor might be willing to lose.

It might seem that the insurer's profit can be quite large when the adverse outcome does not occur, but if you repeat the insurance contract over and over again, the insurer will pay according to the likelihood of the adverse outcome, and profit the rest of the time. A smart insurer will therefore set the premium large enough to break even over the long run, plus a bit more for the remaining uncertainty. The lesson here is that large insurance profits in one time period are no guide to the morality of these profits over the long run.

An extension of the single-event insurer is the cooperative insurer. The non-profit version of these insurers, often called mutuals, exist for the benefit of their members, and are often owned by their members. For-profit versions are also common, and transfer the risk of loss away from the policyholders and onto the owners of the insurer. The latter type is most familiar to us, having names like Allstate, Geico, Wellpoint, and Aetna.

The idea behind the cooperative insurer is that adverse outcomes do in fact occur over the long run, and that it is prudent to save over the long run in order to offset the eventual cost of these adverse outcomes. Ideally, all of our adverse outcomes would occur after we have had a chance to save for their costs. The reality is that it usually happens before we have saved enough. By joining together into a cooperative, we increase the likelihood that we will have enough resources to cover every individual adverse outcome, because the likelihood of them happening in large enough clusters in short periods of time in a way that exceeds our collective savings is very low. We benefit most when we are all long run members of these cooperatives.

The modern financial markets provide the insurer with an opportunity to turn these collective savings into investments that earn income. This income can then be combined with premiums to cover the costs of adverse outcomes (or claims). The greater the savings cushion, the greater the investment income, the lower that premiums need to be. The basic equation for an insurer is quite simple:

Investment Income + Premiums = Claims + Fraud, Waste, & Abuse + Overhead + Profit (or Loss).

(Reality adds more variables to each side, but the concept is unaffected.)

Profit is used in two ways: to reward the owner of the insurer for bearing the risk of loss, and to increase the amount of savings earning investment income. Loss reduces the amount of savings, and hence the investment income. (In a mutual, there is only the increase in savings when the insurer profits.)

Now there are some general points to draw from this model of an insurance company.

1) If claims exceed premiums and savings, then the company is insolvent.

2) If investment income falls, then premiums must rise.

3) Fraud, waste, and abuse, and overhead must be controlled if the insurer is to profit, and therefore leave its savings intact.

4) In a for-profit insurer, the owners provide the initial capital that funds overhead and claims until premiums and investment income are sufficient over the long run, and own the increases in the insurers savings.

Next: Health Insurance Facts, Part 2: Why is Medical Insurance Different?


EDIT: Added link to Wellpoint's financial statements at Edgar.

EDIT: Clarified for-profit cooperatives by providing named examples.

NOTE: About my use of the word "cooperative" in this article, I use it in a conceptual way, rather than in the manner of a legal organization. The article's concept of a cooperative is as a long-run, multi-participant insurance construct, as opposed to a single insurance contract between an insurer and an insured. I'll cover the legal organization in a later article. I suggest this article and this organization as starters.