Solving the financial crisis: Why is Step Three so difficult?

In my previous posts I propose ways to solve the banking regulation question, and the "investment banking" too big to fail question.  In this post, I'll begin to address the difficulty of insurance companies.

Insurance poses a significantly different problem than banks and investment banks.  Let's first agree what the insurance business is.  Insurance companies have huge piles of money (call this surplus) that they use to convince policyholders that when they have a claim against the insurer, the insurer will have enough cash (capital) to pay the claim.  As a result, policyholders hand over relatively small amounts of cash (premium) in exchange for a promise to pay under certain conditions (claims.)

At first you could imagine applying my same logic about banks to insurance companies.  Just make the insurance companies hold capital that meets the combined limits of all the risks they write.  That might work. 
However, as a quick thought exercise, let's look at two numbers for a household.  The first, relevant for the banking discussion, is the fraction of household wealth held in cash at banks.  This is not money market funds.  This is not mutual funds.  Basically, this is your checking account, maybe your savings accounts.  Think about everything you have that is FDIC insured.  How many months living expenses do people keep in in the bank, on average?  (I'll confess that at my peak of paranoia in the financial crisis, I hit something like 48 months, but this is not normal even for me!)  In the aggregate, this is a very small number compared to insured values.

Remember, fully backed insurance would require insurance companies had enough capital to cover all potential losses they insure at any given moment.  Let's think about that.

First example: Bob is single, employed, and drives a 1990 Oldsmobile Cutlass Supreme with 145,000 miles valued at $163.  His employer provides healthcare through Aetna.  Bob bought a big screen TV last month, spending all $800 of his savings.  He paid with his Visa to get the miles.  And, Visa covers the TV if it is stolen in the first 90 days.  He bought the extended warranty, (yes, he was ripped off.)  Especially since the TV has a two year warranty.  His Directv installation was free when he bought the TV, and the box has a warranty too.

Let's look at his insured values.  They get big, quickly:

• NJ minimum auto insurance covers $5000 of property damage, and under certain circumstances, up to $250,000 of personal injury protection for others.
• The TV is insured for full retail once (credit card,) and wholesale twice: manufacturers warranty and the extended warranty.  Call it $1600 even.  The mileage credit sits as an insurance-like policy too, but forget it for now.  Similar story for Directv box.
• Health insurance gets crazy: $5 million lifetime maximum payout is pretty typical.

So, our guy with nothing carries well over $5.3 million of total insured values, just for doing nothing. 

Second example: Reasonably wealthy household of four.  Two cars, valued at $30,000 each.  House valued at $500,000.

• Two cars, New Jersey "typical" policy has $500,000 per accident bodily injury coverage, $100,000 property damage, $250,000 personal injury, and coverage for the car.  All doubled for two cars.
• Home insured for replacement cost and contents.  Typically, replacement cost in NJ exceeds value of house, especially in older homes.  $700,000 for home, another $700,000 for contents.  And, $1 million liability with that.
• Don't forget the healthcare: $20 million lifetime limit for the family.

So, back of the envelope, $24.3 million for this household.

I think we get the problem: Fully backed banks, while capital intensive, are possible.  Fully backed insurance companies are not.  There insured values far exceeds the assets that exist.  Remember, insurance has to pay no matter how many bad things happen at once.  (For dreadful examples, see the Lloyd's Realistic Disaster Scenarios.  And remember, these are ones they consider realistic!

The theoretically logical solution requires making all insurance companies mutuals with unlimited liability.  This is not particularly good sounding in theory, although in practice it falls down NOT where you'd expect.  Mutual insurance companies are owned by their policyholders.  Thus, any profits and losses accruing to the company flow through to the policyholders.

The unlimited liability part sounds very bad.  It is, theoretically.  Imagine you get a call from a cute little reptile, saying rush hour in L.A. was a complete disaster, all the cars crashed and nobody died, they're all completely disabled, please send me your 401(k).

So, I'd love to propose that as the solution: mutuals with unlimited liability.  This would very likely work, without having insurance companies hold capital to their risk limits.  However, history has shown where it goes wrong...

That's why I'm still thinking...but frankly, I'm not sure there's that much wrong with the way insurance companies work right now.