If a modern society wants to organize financial security for its members it will necessarily face a dilemma: does everybody save for himself, having to depend on charity at the moment of a calamity, or does the state provide for relief? Hurricane Katrina was definitely such a calamity that laid bare the flaws of the current insurance structure. It became apparent that private insurance companies tried to devolve payments to the state (by ‘proving’ that damage was not done by wind, which is insured by the private insurers, but by flooding, which is insured by the state). Nowadays, big parts of the New Orleans coastal zones are not insurable any more. Insurance has been invented hundreds of years ago (1350), mainly as a coverage that ship owners or businessmen organized for themselves. Life insurance existed as well, but it was by the discovery of the following parameters that risk and coverage thereof was properly understood: probability, life expectancy, certainty (law of large numbers), normal distribution and volatility, utility (value of a good is not the price paid but the utility derived from it) and inference (what counts is the probability of an event times its impact). These components were used in Edinburgh to build a life insurance for the ministers of the Church of Scotland. Robert Wallace and Alexander Webster raised enough money from the group of 930 ministers to profitably invest it and pay out the widows of these ministers from the profits of these investments. From there it very quickly evolved into a large institution, increasing predictability of payouts. Insurance companies became the biggest investor in British companies, having a third of major UK companies by 1950. Britain is to date also the most insured country, where premiums paid annually are twice as high as in Germany. Otto von Bismarck was the first to promote a state-sponsored method of providing for the poor and old by setting up a system of pensions for the elderly. Britain copied it 20 years later and expanded it significantly given the electoral power the poor masses got. During the First World War the state insured the merchant fleet as private firms could not afford it any more. But it was Japan who, after the Second World War, took the British model to a whole new level. The state insured any negative effect, such as illness, unemployment and age, for the entirety of the population. In truth, there was a trend towards insurance in the years before the Second World War as well. By the 1970, Japan had become the welfare super power, leading the world in terms of life expectancy and education. Meanwhile in Britain and other parts of the Western world the welfare state had evolved to a system of confiscatory taxation, removing all incentives for hard working people and handing out state incomes to those who slacked. The result was stagflation whereby production per capita grew very slowly while inflation rose. It seemed that by removing the exposure to risk the welfare state was doomed to lethargic inaction. Milton Friedman was the brilliant, Nobel Prize winning, professor that flew to Chile in 1975 for an economic experiment under the government of General Pinochet. The money supply was drastically cut in order to revive capital markets. José Piñera from Harvard came back to Chile and transformed the state owned pension system by offering the choice to migrate a more individualistic one. By 1990, 70% of the workers held a private pension system. The savings rate went up to 30% and nearly all the saved monies were re-invested in Chile, turning it into Latin America’s most prosperous country. Much is to be said about the US healthcare and social security. It is becoming more and more apparent that a large portion of Americans is dropping out of the private health benefit insurance, while social security has overtaken the national security budget in 1993. Given the rapid increase in 65 and older Americans, their inadequate savings will become a burden on the whole society. Also healthcare is growing much more than the inflation rate; by 2019 Medicare will gobble up 24% of all federal income taxes. The only country that is in even bigger trouble in Japan, where the retirees will overtake the workers in numbers by 2044. And the real catch is that politicians need to press through reforms with voters who will all be affected themselves. One other fear is a rise in major calamities where private insurers need to get help from the government. Katrina and 9/11 may be two recent examples, but also climate change will have an impact. One way to cope with this is to add an increased-risk premium to the individuals choosing to live in risk zones. Another way is to hedge risk. This may be through forward pricing, or to trade options (weather options being a specific subset). The world is more and more falling apart in two groups, whereby companies or those who can afford will be hedged and the individual will not. Those individuals will have to depend on insurance, the welfare state, own savings and one investment, typically a house. About which more in the next chapter.
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