So what I want to start today is talking

about insurance starting with the concept of insurance, of, and then I want
to reiterate a theme of this course that
financial institutions are inventions. There are structures that someone had to
design and made work right. Sometimes they don't work right.
Then I wanted to move to an particular example
of insurance which was until recently, the biggest
insurance company in the world called the American International Group, or AIG. And
it's particularly important that, that
we talk about this example.
Because on March 2, we have the, former CEO of AIG, Maurice Hank Greenberg, coming
to our class. So I thought it's appropriate that we use
AIG. Well, not only because it was the biggest
insurance company in the world but also because he's
coming here. So, the fundamental concept again is risk
pooling. the, the idea of insurance goes back to
ancient Rome, but only in very limited forms. But the idea of risk pooling is, is
is
kind of an obvious one. People form organizations probably to risk
pool. So in ancient Rome, a form, a common form of insurance was death insurance
that
would pay funeral bills. And people in the ancient world believed
that, you had to get a proper burial or your soul would wander
forever. not, so insurance salespeople associated
with guilds, or business organizations would
sell funeral insurance. But they didn't have a very clear idea of
the risk pooling concept, it must have under,
underlain their thinking. But it wasn't until much later that people began to
understand the concept. There were, there were examples of
insurance throughout ancient and medieval times, but they're very
blurred and sparse. I remember reading an insurance,
supposedly an insurance contract written in Renaissance Italy and
translated into English. But it was hardly recognizable to me as an
insurance concept, contract. It didn't have the concepts down. It seemed to have a
lot of religious
language in it. Which normally, we don't think of as something that's part of an
insurance
contract. But it, it seemed like insurance came in,
in the 1600s, at the same time that certain concepts of mathematics were
began to be developed. Notably the concept of probability became
more widely known in the, in the 1600s. According to one historian, the oldest
known description of the insurance concept goes to a, goes back to a Count
Oldenburg. Actually, it's an anonymous letter to
Count Oldenburg written in 1609.
And the letter says, why don't we start, I'm, I'm paraphrasing at the moment, why
don't we start a fund in which people pay 1% of the value
of their home every year into the fund, and
then we will use the fund to replace the house if
there's a fire? And now quoting this anonymous writer,
this writer said he had no doubt that it would be fully proved if the calculation
were
made of the number of houses consumed by fire within a certain space in the course
of 30
years. That the loss would not amount by a good
deal for the sum that would be collected in
that time. Okay.
It was just intuitive. He said, there can't be that many fires. And if we collect
that amount of money
every year, we can pay for all the houses that are
burned down. So it didn't, it didn't express any
mathematical law, but it's the concept of insurance. You don't find that before
that, before
1609. So, I guess we don't have, any clear
statement of insurance before then. Actually you can find a statement,
approximate statement of the law of large numbers. I'm thinking of Aristotle, the
philosopher. He wrote in [NOISE] this is, in ancient
times. And I'm quoting from De Caelo, his book,
Aristotle. To succeed in many things or many times is
difficult. For instance, to repeat the same throw
10,000 times with the dice would be impossible, whereas to make it
once or twice is comparatively easy. He doesn't have the language of
probability but he knows you can't throw a dice a thousand
times and come up with a same number every time.
Now we have a probability theory about it. So, we know that if you have n events,
each occurrent with the probability of P,
then the average proportion out of the, the,
the n events, that are, that are, that occur, oh I'm sorry, yeah, n
trials, an event occurring with probability P.
And the standard deviation of this proportion of events that occur is P times 1
minus P all over n to the 1/2
power. And that's the theorem from probability
theory. The standard deviation of the proportion
of trials for which the event occurred,
assuming independence, is given by this. And so you note that it goes down with n,
as n entries as it goes down, I should say, the
square root of n. So that means that if n gets very large,
if you write a lot of policies, then the probability of deviating from the
mean by more than one or two standard deviations becomes
very small. Which is what Aristotle said. But making insurance work as a as a as a
institution to actually protect
people against risk is, is, is rather difficult to achieve. And that's because it
has to, things have
to be done right. So, let me, let me just remind you. What are the basic types of
insurance?
This is what Fabozzi talks about. There's life insurance that ensures people
against early death. Of course you still die. What it really insures is your family
against the loss of a breadwinner, the father or the
mother. So you, life insurance is suitably given to families, especially
with young children, to protect the children, was
very important. It used to be very important when there
was a lot more early deaths. Now very few young people lose their parents, so life
insurance has receded in
importance. Another example is health insurance. This is insurance, of course, that
you get
sick and you need medical care. Then there's property and casualty
insurance insuring your house or your car. And then there's other kinds of you
might call investment oriented products
like annuities. This is a table in your textbook by Fabozzi, which lists these
categories
of insurance. But but any of these insurance types are inventions and I
want to, specify that.
We have the idea that an insurance company could be set up that would, say, insure
houses against fires. And we, we just heard it intuitively in
this letter to Oldenburg long ago. But to make it work, and to make it work
reliably, involves a lot of detail. So it's like, you know, you can think of
the idea of making an airplane, but to make it really work, and to make it
work safely is another matter. So first of all insurance needs a contract
design that specifies risks and excludes risks
that are inappropriate. An issue that moral, that, that insurance
companies reach is moral hazard. [SOUND] Something rubbing when I. Okay, I'll try
not to.
What's doing this? It's this one. Oh okay. Moral hazard is a expression that
appeared
in the 19th century to refer to the effects of insurance on people's
behavior that are undesirable. So the classic example is you take out
fire insurance on your house, and then you burn it down deliberately in order to
collect on
the house. Or another example is you take out life
insurance, and then you kill yourself, to give, to
support your family. These are undesirable outcomes. And they, they could be fatal
to the whole
concept of insurance because if you don't control moral hazard, obviously
the whole thing is not going to work. So what they do in an insurance contract
is they exclude the risks that are particularly
vulnerable to moral hazard. And so that means they you would exclude certain causes
of death
that, that might look like suicide. You can do other things to control moral
hazard than excluding certain causes. You can also make sure that you don't insure
the house for more than it's worth,
right. If, if someone insures a house, and the insurance does not cover the full
value of
the house, then there's no incentive to burn
it down, you might as well just sell the house,
right? No, no point in burning it down, you'll
still lose a little bit of money. so, that's one of the problems that
insurance companies face, and part of the design of the insurance contract has to
prevent moral hazard from becoming
excessive. An analogous thing is selection bias. [SOUND] That occurs when, chalk
keeps breaking.
Selection bias occurs when the people who sign up for your
contract know that they are higher risk. And so that they then want to what, for
example, health. People who know they are, have a terminal
disease and are about to die, they'll all come signing up for
your life insurance contract. That will put immense cost on the
insurance company. And if they don't control the selection
bias, they will, they will have to charge very
high premiums. And then that will force other people who
don't know they're going to die out of the business, so, so
out of buying insurance. And so that's a fundamental problem. But again, something
has to be done to
define the policy. So one thing you can do is exclude in life insurance certain
causes of death
that are likely to be known, and you only put on causes of
death that, that people wouldn't be able to
predict about themselves. okay. Another aspect of insurance is that you
have to have definitions of the, very specific, precise definitions of the loss,
and what constitutes proof of the insured
loss. If you're not clear about that, there's
going to be ambiguities later, which will involve
legal wrangling and dissatisfaction. We'll see in a minute that these problems
are not minor, and they keep coming up. That's a constant challenge for the
insurance industry. Then we need, third, we need a
mathematical model of, of risk pooling. Well, I just wrote one down here, but it
might be more complicated in some
circumstances. This is assuming independence.
And that's if you don't assume independence, you can
do you can make more complicated models. Then third, then fourth, you need a
collection of statistics on risks and, to evaluate and you need to evaluate the
quality of those of those statistics. So for example, in the 1600s, people started
collecting mortality
tables for the first time. There was no data on ages at that. It began in the 1600s
because people were
building an insurance industry and they needed to
know those things. Then you need a form for the company. What is the insurance
company?
Who owns it? It could be a corporate form, there are
shareholders who are investing in the company, and they're taking the
risk that some of our policy modeling, our handling of moral
hazard or selection bias wasn't right. Some insurance companies are mutual,
rather than shared. The, the insurance is run for the benefit
of the policy holders and they're, and they're,
they're like a nonprofit, in the sense that the founders of the
company pay themselves salaries, but the benefits go
entirely to the policy holders. Then you need a government designed so
that the government verifies all of these things about the insurance
company. The problem with insurance is that people
will pay in for many, many years before they ever
collect, right. Especially if you're buying life
insurance, you hope never to collect. [LAUGH] And so you don't know whether it's
going to work right. That's why you need government regulation.
You need government insurance regulators. And that's part of the design of
insurance. It doesn't work if you don't have the
regulators, because you wouldn't trust the insurance company.
So these are problems that that have inhibited making insurance work.
I want to give you an, an example. Let me start, and adding it makes it more
concrete. If we start out with talking about a
particular example, and I said I was going to talk
about AIG. It's a very important example, not only
because it was the biggest insurance company, it was also the biggest bailout
in the entire, sub prime financial crisis we've seen now. So, AIG, it's an
interesting story.
It was founded in 1919 in Shanghai.
And you why, wonder why it's called American International
Group if it's founded in Shanghai. It was founded in Shanghai, called
American Asiatic Underwriters and it was founded by
Cornelius Van der Starr.
[SOUND] It was an American who just decided to go to Asia and start an
insurance business.
Shanghai in 1919 was a world city. It was not really under the Chinese
government. It was something like Hong Kong. It, it had constituencies representing
many different countries. And so it was a very lively business
center. It's kind of interesting that the biggest insurance company in the world
emerged
from Shanghai. And also one of the biggest banks in the
world, HSBC. You know the you know what HSBC means? They haven't, they don't
emphasize that
any more. It's Hong Kong and Shanghai Bank
Corporation. So AIG was founded by Mr Starr in 1919, and, started doing an
insurance business
in China, and moved their headquarters to New York just before
Chairman Mao took over China. And then it became a kind of a Chinese
investment company in the United States. Cornelius Van der Starr ran the company
from 1919 until he died in 1968.
So he was CEO for 49 years, a half century.
And then when he, just before he died, he appointed Hank Greenberg, who will visit
us as the CEO in 1962. So that was 49 years under Starr, and then
Greenberg took on, and then ran the company until 2005.
So it was 37 years under Greenberg. So two men ran the company for almost a
century. Since 2005, Greenberg is is has been
succeeded by three CEOs.
The usual thing the usual company has, turns over CEOs.
The real problem occurred with AIG after Greenberg left.
So Greenberg left in 2005 and then the company absolutely blew up, and
absolutely had to be bailed out. And the reason they had to be bailed out
was, it was primarily due, almost entirely due to, and a failure of the
independence assumption, I would say, that underlay
their risk modeling. Namely, they, the company became exposed
to real estate risk. And the idea that their risk models had was that it doesn't
matter that we take on
risks that home prices might fall. Because they can never fall everywhere. They can
fall in one city, but it won't
matter to us. That's just one city, and it all averages
out. But what actually happened after Greenberg
left was the company took huge exposures towards
real estate risk. And it, it fell everywhere.
Home prices fell everywhere. Just exactly what they thought couldn't
happen. So the the company was writing credit
default swaps, which are, I told, I told you about those
before. They were taking the risk. They were insuring basically against
defaults on companies whose credit depended on the real estate
market. They were also investing directly in real estate security, in mortgage
backed
securities that depended on the real estate market for
their success. And when all this failed at once, the AIG
was about to fail. That meant that the federal government
decided in 2008 to bail out AIG.
And the total bailout bill, well, the total amount committed by the US
federal government was 182 billion. That didn't all actually get spent.
It was 182 billion committed to bail out AIG.
That's a lot of money. I think that's the biggest bailout
anywhere at anytime. So a lot of people are angry about this. You know, part of
this bailout came from
what we call TARP. This is the Troubled Asset Relief Program
which was created under the Bush administration, and it was a proposal
of Treasury Secretary Henry Paulson. And it was initially run by Paulson. But it
was not just TARP. There was also loans from the Federal
Reserve. It was a complicated string of things that
were done to bail out AIG. So why did they do that? Why did the government bail out
this
insurance company? The, the main reason why they did so was
their concern about systemic risk. [SOUND] It wasn't I'll come back to other kinds
of
bailouts of insurance companies, but the problem was that AIG,
if it went under, all kinds of things would go wrong.
All kinds of things would go wrong. All these insurance policies that it wrote
on people's casualties. Their, their their travel insurance, their any of these
policies would all now be
subject to, to failure. Because people who have these insurance
would find that the company that they bought it through was disappearing, but it
would go on even beyond that. Lots of other companies, investment
companies, banks would fail too, or may fail too, because they're involved in some
kind of business dealings with AIG, which would
now become part of the AIG bankruptcy. If AIG failed, anybody who had any
business with AIG would be starting to wonder, what's going to mean,
what's this going to mean to me? AIG owes me money or what's going to
happen. And so there was a worry that it would
destroy the whole financial system. This was big enough to cause everybody to
pull back, and if everybody pulls back then the
business world stops. It would be like a stampede for the exits. Everyone hears AIG
goes under, and so many
people do business with AIG, they decided it was
intolerable. And so the government came up with the
money massively and quickly. If you remember the story, Henry Paulson,
who was Treasury Secretary, first went to Congress asking for a blank
check. He didn't say to bail out AIG, but that's
what he. He got sort of a blank check from Congress
because the, the story was told. Paulson told the story that if we don't do
this, if we let a company, he didn't say AIG, he was, he actually asked
for the TARP money before the AIG bailout. But he said, if we don't do something to
prevent a collapse, we could have the Great Depression again. And so, nobody liked
to hear that, but
they believed him. And they didn't know what else to do, and
so they allowed they allowed the TARP money, and they allowed the Federal
Reserve and to, to bail out this company. [MUSIC]