Tuesday, March 21, 2017


History teaches us things that we could not learn otherwise. Only in retrospect does the mode, meaning and intent become clear. Without much ado, let us go back to the most defining moments in the recent past dating back a few decades.

Liability is an all-encompassing word that deals with every nuance of human behavior. The morality of escorting this behavior into the domain of risk managers is Odysseus’ siren song of the mantic truths of Social Responsibility. Here “some” (insurer) take the risk of “others’ (principle) behaviors. The moral of the story (I will give it to you right up front), however is cushioning ‘others’ bad behavior encourages more bad behavior due to information asymmetry. While “Less is More” is a product of the lessons learned from such moral hazard, applying it appropriately is a nuance of judgement. Both Welfare and Disability are the current norms in a society filled to the gills with moral hazards. Welfare incentivizes poverty while disability payments empower people to look for compensations. Although some (Pauly 1968) have tried to remove the “Morality” out of the moral hazard to make it less appetizing to the sensitive souls, it remains an issue of perverted incentives based on well-intentioned efforts. Similar efforts are being espoused daily under the premise of financial redistribution. Those receiving the redistributive wealth are incentivized to do less as ultimately those that are doing more to create wealth, reach the point of diminishing incentives (Margaret Thatcher would simplify by saying “When you run out of other people’s money).

Many years earlier there was a President who envisioned in his heart and mind with a well-intentioned view that everyone in the country deserved a picket fence to realize his or her dream. And so, began a race to foster such a provision. Another President echoed those sentiments and continued the compassionate policy.

"A policy of cheap money for picket fences lead people to hazard bets they could ill afford" 

The policy was to make money available to everyone at cheap rates so that people of all stripes could afford a home. Soon people with meager means realized that they could use the cheap money to buy and sell and reap the appreciating reward. This was euphemistically termed “flipping.” Flipping continued and many a person with meager means grew to amass a reasonable sum of money. But that did not stop the wheel from tumbling. The people started to make bigger and bigger bets with larger and larger sums of money that they could ill afford to pay off should the counterparty not be available to purchase. Meanwhile the banks realizing the benefits of cheap money scaling into a larger sum of money started writing larger number of mortgages to anyone who would ask. In so doing and not holding the mortgage bag for long the banks decided to package good mortgages and those that potentially might default into baskets or (Hi + Lo Risks) tranches and sold them to other investment houses based on Moody’s Risk Ratings (And Moody was paid by the Investment Banks to rate). Given the complexity of the risky nature of these tranches, the banks worldwide got into this easy money-making machine and went to the Insurers to insure their mortgages in case of default. The Insurers realizing a nice size premium from the insured expanded their reach to underwrite any bank that was willing to follow. Essentially trillion dollar bets were made and hidden in open sight for the willing blind to see. What happened was when the music stopped, (bubble burst in slang parlance) and mortgage default rates started to rise, the banker, insurer and the politician, all saw blood on the street. Wall Street panicked and huge wealth dematerialized. But the Policy-makers were not done, they decided that the banks had to lend to “unfreeze” the bank loans to the consumer (the little people). Congress under pressure from the then Treasury Secretary (Hank Paulson) and the Federal Bank Chairman (Ben Bernanke) agreed to print up $700 Billion as a “toxic asset relief program” or TARP. The funny thing about the $125 Billion of loans forced on the banks to unfreeze the lending market were never paid out as loans. Those assets were used by the banks to shore up their balance sheets. Since those heady days of looking at the financial abyss, the government has issued $4.5 Trillion in paper money to bail out the U.S. Streets. Most of the money has trickled into the banker’s, Insurers and their CEO’s portfolios and not too much into the worker, consumer or the little people. Hence the steep rise of the wealth inequality) Moral Hazard, you say. Um yes, totally. A policy of cheap money for picket fences lead people to hazard bets they could ill afford and when they couldn’t anymore they allowed foreclosures on property. The market value of Real estate plunged, leading JPMorgan to buy out Bears Sterns at pennies on the dollar US government bailed out AIG to protect its tentacles into risk management that AIG could not manage and Freddie and Fannie Macs. Only Lehman filed insolvency.

"A top-down policy of good intention by giving every household in a dilapidated aging housing project with corroded gas pipes, a large candle, in case the lights go out."

Free markets resolve issues by entrepreneurs and market forces. The slack is removed in time, the errors are corrected, the faults are masked over, innovations blossom and paradigms get shifted in scope and scale. A form of Taleb’s Antifragility exists when free market forces are at play. A top down policy is a petri dish cultivating a dangerous pathogen that ultimately destroys the laboratory, its creator and the people that come in contact. A top-down policy of good intention by giving every household in a dilapidated aging housing project with corroded gas pipes, a large candle, in case the lights go out. 

"Taleb’s "Antifragility" exists when free market forces are at play."

As hazards go, moral hazard, that is, after the debacle that pushed a lot of people through greed or innocence into a financial abyss, 9 US Banks held up and now control 77-80% of the U.S. Assets. These institutions are now considered “Too Big To Fail,” you see the moral hazard there, don’t you? As things go, being that these behemoth banks, large and clever, with financial wizardry they also became big policy maker’s hand-shakers to effect policies in their favor. Morality has been buried in plain sight. Now, there are High Speed Computerized Algorithmic Trading and Dark-Pool market-places where only a few participate. Flash crash hazards will become all too common as incentives to catch the microsecond information asymmetry, overwhelm morals. A new moral hazard is brewing before our eyes.

Not to be outdone, the policymakers looked at the medical industry and there too, under the guise of “greater good” or “public good” they jumped into the medical industry with both feet. To weed out the wicked and not tempt the good people from doing bad things, they were determined to exorcise the whims of immortality.

Seeing a potential windfall, a few insurance intellectuals decided to move into the medical industry to carve out a niche for themselves. With well-informed lobbyists inhabiting the various nooks and crannies in the Capital Building in DC. They decided on underwriting the health risks of individuals with a slow ever-escalating premium scheme. The asymmetry of human behavior manifested as people started utilizing these cards for even the most minor of complaints, jamming into emergency rooms and doctor offices (Moral Hazard). The business of medicine went into overdrive. Seeing the payouts skyrocket, the Insurance executives put constraints on physicians with preauthorization requirements and then used their patient population reach to contract prices with the physicians for services rendered. The private and public insurance party was in full swing. The public sector was similarly enmeshed with overuse of services, physician offices and the hospitals were brimming with Medicare and Medicaid patients. Various acronyms PQRS, AHRQ, PCORI etc. were floated and they finally rested on the term “value” as the arbiter of physician payments under the MACRA program. The experts from the private sector and the academic circles had jumped into the public sector to regale their opinions. Soon the public sector was living the dream of the academics and scholars who had never worked a day in their lives except for pontificating. As technology blossomed so did the need to incorporate it into the medical sector. It was professed that every encounter between the patient and physicians would be digitized and yield benefits to the healthcare of individuals through data gathering. A policy was enacted between the U.S. Chief Executive and HITECH was portrayed as the next coming of sliced bread.

Disentangling Moral Hazard and Adverse Selection in Private Health Insurance (NBER Working Paper No. 21858) the authors wrote; In 2005, the last year the single plan was in effect, enrollees paid no deductible, had a 20 percent co-insurance rate, and there was no cap on out-of-pocket medical expenditures. Subsequently, the company offered three plans that were similar in all respects other than their deductibles, co-insurance rates, and out-of-pocket maximums. As of 2007, the most generous plan featured a $250 deductible, a 10 percent co-pay, and a $1,250 out-of-pocket cap; the least generous had an $800 deductible, a 20 percent co-pay, and a $4,000 cap. The researchers calculate that adverse selection added $773 in per-person costs to the most generous plan. Enrollees had to pay an additional $60 a month in premiums in order for this plan to break even. Overall, the study concludes that moral hazard accounted for $2,117, or 53 percent, of the $3,969 difference in spending between the most and least generous plans. It attributes the remaining 47 percent to adverse selection.

"The gaming had begun."

Within the technology industry a few well-placed cronies found the niche to market their Electronic Medical Records and soon millionaires became billionaires with the fortune of knowing the right people in the right place at the right time. Meanwhile the hazard of caring increased and physician time became an expensive commodity. Soon the patient-physician relationship collapsed because the eyeballs were focused on the flickering screen and not on the patient and as per queue, the blame was laid at the physician's feet. The policy-makers ratcheted that up by demanding x-numbers of minutes or hours spent would receive y-amounts of reimbursement for the services. The gaming had begun. Prosecutions erupted like dormant volcanoes all over the country as lawyers looked at numbers of patients serviced and hours in a day and deemed the impossibility of such encounters did not deserve the invoiced amount therefore the payments were considered a fraud crime. The policy rope kept growing in length and soon to circumvent further payouts, the noose tightened and the wonks decreed readmissions into the hospitals within 30 days was a non-reimbursable event. The hospitals found themselves on the wrong end of the deal and made it the physician responsibility to the detriment of the patients many of whom died at home from lack of hospital care. If you were a hospital employee as a physician and your “activity” did not make money for the hospital, then you were looking at a pink slip. Those physicians, adept at the game, survived and thrived. Others simply decided to call it a day and retired prematurely.

"What we find is the institutionalization of the moral hazard by top-down policies that have dearly hurt the country in overall wealth, health and happiness."

What we find is the institutionalization of the moral hazard by top-down policies that have clearly and dearly hurt (and continues to hurt) the country in wealth and health. A policy decreed by academics with no “skin in the game” leads to unintended consequences that they can never foresee in the real world. Enacting policies that are thrust from “high on up” who decide reality based on a few variables end up exacting real burden on people. Insurance then is a means to guard against loss. Yet it falls prey to both Moral Hazard and if provoked through policy, Adverse Selection. To decide healthcare premiums, based on the information asymmetry, high risk and low risk individuals are pooled together to create the actuarial data of low and high premium averages for a given individual’ risk of contracting illness or disease. Not having the low risk individuals in the pool to offset those premiums, forces the premiums for high risk individuals to sky rocket and become unaffordable as evidenced in the Obamacare disaster - where both moral hazard and adverse selection are in play. The moral hazard here was excess use by the high-risk-covered entities and the low risk decided to pay the penalty and not play the game of chance. The penalties were not enough to offset the insurance costs. Everyone suffered.

All models ultimately show that insurers face larger increases in occurrences, magnitude and costs against what is insured. The society rests on the prevailing doctrine that insurance shields us from disasters thus modifying behavior. Further adding subsidies for the greater good leads to even greater losses due to adverse selection and more risky behavior:

(The horizontal axis represents the supply curve S for these resources and is assumed to be flat The demand curve, D, is downward sloping to reflect the wide variation in the value of activities. At the actuarial equilibrium point A, where the D intersects S, resources are used up to the economically appropriate level QA. The government induced distortion expressed as a subsidy, in the amount s per unit of invested resources, the resource levels rise above the optimal level to the level QB associated with the point B on the demand curve. This now represents the total available resources. The loss from this moral hazard distortion? The right measure of loss is represented by the triangle formed by the points A, B and C).

Ultimately the Free Market principles and entrepreneur led innovations result in the best outcome for all. The old-adage of “skin in the game” teaches us all a valuable lesson in moderation and self-responsibility. Subsidies and entitlements, enable.

Now to convince the Regulators…Oh but that is a wonderful pipe dream. Isn't it?