Insurance

“Insurance is one of the great inventions of all time.
It compares in importance with the invention of the wheel.” —Andrew J. Galambos

SYNOPSIS

Insurance is one of the most important social institutions ever created by human beings. It is also a social tool that can be expanded to provide far better than the political state all the functions that people commonly believe are uniquely suitable only to a political state. These include protection of life and all other forms of property from criminal attack, both domestic and foreign; and protection from losses due to exceptionally destructive natural phenomena.

The invention of insurance compares in importance with the invention of the wheel because insurance is the most effective way to prevent loss and thereby protect property. Loss prevention is an already existing and emerging element of virtually every form of insurance. However, if a loss does occur, insurance will compensate for the associated financial damages.

Insurance evolved in human society as a way of sharing losses that would be catastrophic for an individual, but are not catastrophic if the risk is shared with a group of people. The whole group bears easily all the single losses which might otherwise be crushing blows to individuals.

As of the early 21^st century in the United States of America, as well as in other economically advanced nations, the political state functions as the largest insurance company of them all. However, the political state is bankrupt at almost every level of political organization in America, and in other political democracies as well. This bankruptcy has not been acknowledged in the U.S. except in a few municipalities of which there have been three in California in the early years of the 21^st century. ¹

The basic assumptions and ideas of this chapter are set forth in greater detail in earlier chapters of this book. Here we set forth these ideas in summary form as the foundation for all that appears hereafter in this chapter. These assumptions are that:

1. When we use the term “political state,” we mean that form of rule common to humanity wherein the most important societal decisions are made through coercive political action rather than through free and voluntary cooperation of people in the exchange of ideas, goods and services.
2. The political state is already failing in everything that it does that purports to be in the nature of insurance. If the state appears to be succeeding in an insurance program such as Social Security or Medicare in the U.S., or public employee pensions in states such as California, that is only because most people are not aware of the dire financial predicament of such political institutions.
3. The state succeeds only at coercion.
4. The state is everywhere in a condition of financial bankruptcy in that states have made promises they will be unable to fulfill. The financial bankruptcy of the government of the United States of America is known to politicians who disregard it with willful blindness.
5. The political state does not protect property, including life; rather it endangers and attacks life and property through its perpetual warring and its taxation to pay for wars and for non-military activities.
6. The political state does not pay reimbursement for the losses it causes by its failure to protect persons and property nor for its actual attacks on persons and property.
7. The decline and fall of every civilization that ever existed down to the present, and the decline of currently existing political states, portends the failure of every presently existing political state. They will all go out of existence eventually with the only question being whether they will be followed by an even worse form of political rule or instead will be succeeded by proprietary, profit-seeking enterprises that by their very nature will be successful in protecting life and property.
   

NOTE: We do not foresee or predict a sudden collapse of every political state during the lifetimes of readers of this book. Rather, we posit that 1) private, proprietary, profit-based governance has been emerging gradually in human society beginning with the innovation of insurance in the trading and commercial civilizations around the Mediterranean Sea 1,500 years B.C.E.; and (2) the institution of insurance will expand to replace the political state by including loss prevention in every contract of insurance via technological means together with provision of free enterprise security services.

Everyone has a risk of loss of property, including their property in the form of their lives. Property in one’s life includes not only life itself but also the desirability of having protection from serious though non-fatal injuries, and protection from the health care expenses of catastrophic illness.

For a price, insurance companies assume the risks that their customers do not want to bear. The exchange between the insured and the insurer amounts to the insured’s payment for protection by the transfer of part, and occasionally all of the risk of a specified loss to the insurer, and the insurer’s assumption of that risk, by promising to reimburse customers’ for losses, in exchange for the insured’s payment for protection.

In an ideal operation of insurance, insurance companies would have much more than the responsibility to pay for losses suffered by an insured. For example, a fire insurance company would provide recommendations for prevention of fire in each insured structure, with rates variable in accordance with customers’ implementation of the suggested prevention measures. An insurance company has a proprietary incentive to protect the customer from the actual occurrence of loss. If the insured suffers a loss so does the insurer. If the insured is protected from loss, both the insured and the insurer benefit. By purchasing insurance the insured would be purchasing an ally in a company that would have a great deal to gain by protecting its insureds and a great deal to lose if it fails to protect the insureds from losses.

That is currently not the present condition. In the relatively primitive nature of insurance under control by the political state and its coercive monopoly of protection there is relatively little an insurance company can do to protect its customers. Under government control, insurance companies can do little more than provide advice about loss prevention and the maintenance of constant ability to honor their promises to pay claims for losses when claims are presented.

The institution of insurance has the capability of expansion to provide real security against domestic crime and foreign aggression such as the military attacks of The Empire of Japan in 1941 against the military forces of the U.S. in Hawaii and the Philippine Islands. The institution of insurance also has the capability of preventing or providing successful defense against terrorist attacks of would be state organizations such as the terrorist organization that twice, in 1993 and again in 2001, attacked the World Trade Center buildings in New York City.

The idea of insurance for health care and old-age income has been badly misconceived and misapplied both by direct state action as a supposed insurer and by political laws and regulations that have the unintended but perverse consequences of increasing enormously the costs of health care and health care insurance and of decreasing old age financial security by inducing people to rely on pension promises that the political state will be unable to honor and fulfill. We concede that these are bold statements, however they are supported in prior chapters and shall be supported further in a subsequent chapter on Security.

Subsequent chapters will explore the enormous potential of the insurance idea to provide real security against any risk that is insurable.

At present, and only for the time being, some risks are not insurable, including (1) the overwhelming destructiveness of some natural phenomena; and (2) human-caused catastrophes due to political action, e.g., wars and domestic criminal activity the state fails to stop or which the state actually promotes by legislation that make crime highly profitable. Two prominent examples of the latter in the United States are prohibition of alcoholic beverages from 1919 to 1933 and the prohibition of narcotic drugs, known as the War on Drugs, that has been ongoing in the U.S. since 1914. ²

The insurance industry has the potential to be the world’s most needed and largest industry and to grow to a size and importance virtually undreamt of in the early 21^st century. For example, we envision, as did Andrew Galambos, that eventually insurance companies competing for business will supersede all (100%) of the functions now deemed almost universally to be a suitable monopoly for the political state. These include security against domestic and foreign attacks on all forms of property including life itself; providing a stable, durable and reliable source of funds for catastrophic expenses of sickness; and providing income for subsistence during old age.

Note: Piet (later Peter) Bos was a student in a presentation of Course 100, predecessor to Course V-50. Mr. Bos suggested to a colleague of Mr. Galambos, Alvin Lowi, that insurance companies could replace the state in the vital rôle of security and protection of life and property which Course 100 pointed out the state did very poorly. In a 1963 convention of students of Galambos’ Course 100, Mr. Bos made a formal presentation of his idea that the insurance mechanism could replace the state. ³ Galambos incorporated this idea into his lectures where it became a fundamental feature.

* * *

The concept of insurance

Insurance is a contract by an insurer to assume specified risks of loss of the insured and to pay a contractually specified amount for losses that occur. Insurance evolved in human society as a way of sharing losses that would be catastrophic for an individual, but are not catastrophic if the risk is shared with a group of people. The whole group bears without great difficulty all the single losses which might otherwise be crushing blows to individuals.

At the outset we acknowledge that despite the fact that insurance has been a valuable development in human society, the insurance industry in general has suffered from a less than stellar reputation. It is true that some insurance companies have engaged in unethical behavior such as denying claims they think are questionable rather than submitting the validity of the claim to immediate arbitration; stalling on payment of claims to hold onto the money longer; or refusing to settle all tort claims against an insured and forcing the case to trial. However, this sort of conduct is not true of most companies.

Where this does occur, the solution is the credit mechanism, discussed at length in the prior chapter. The credit mechanism would publicize and expose unethical conduct by an insurer, thereby creating an incentive for insurance companies to refrain from unethical business practices.

Loss prevention

Following is a brief listing of activities that insurance companies use to prevent losses or minimize the risk of loss:

• Lower costs for customers who take precautions to minimize risk of loss, e.g. non-smoker, lower rates for life and health insurance; discounts on auto insurance for customers with a safe driving record
• Protective Insurance Company provides loss prevention services and safety information for customers in the transportation industry ⁴
• Great American Insurance Group property and casualty insurance companies provide safety training and information to help property and casualty insurance customers minimize the risk of losses. ⁵
• Some fire insurance companies provide prevention services including private firefighters to protect still undamaged homes of customers from nearby fires. ⁶
  

These examples portend the ultimate potential of insurance as a loss prevention service in addition to its traditional function of reimbursing customers for losses. The subject of insurance as a protector against the occurrence of loss is explored in some detail in subsequent chapters on security, justice, and defense.

Insurance and security

Insurance and security are related. Andrew Galambos stated that security is the lowest form of happiness. Thus, to avoid unhappiness people seek to prevent or cope with anxiety about the risk of physical injury and financial insecurity. Insurance is a practical measure for reducing the risks of life to a manageable scope, thereby affording a measure of peace of mind.

In German, Italian and Spanish the word for insurance has its genesis in the word for security. ⁷ The English word for insurance, like many other English words, is French in its origin. In French the word for insurance is assurance; that was also the English word for insurance through the mid-17^th century. ⁸

Insurance companies can expand their investing into business activities directly related to insurance. An important example is the private security industry, to be discussed in detail in a separate chapter on security. Well financed insurance operations combined with capable security operations could provide far better protection of life and property than has heretofore been imaginable by almost everyone, except Andrew Galambos who had the vision to foresee the power and potential of an alliance of insurance and private security.

Proprietary, profit-seeking insurance as an industry has immense advantages over the political state as a source of security of all kinds, including the following:

• Insurance companies profit when their customers do not experience losses. The state is not a profit-seeking entity, so it gains nothing when its citizens are kept safe from harm.
• An insurance company suffers loss if its customers suffer loss. The state suffers no loss when its citizens suffer loss.
• Consequently, the profit motive of insurance companies is beneficial to their customers while the profit motive is anathema to the political state.
• Insurance companies use actuarial science to make realistic appraisals of the probabilities of loss. The state does not.
• Insurance companies price their promises of protection through the process of underwriting. The state does not employ underwriting principles to establish a price for its protection services.
• Insurance companies collect payment in advance and use the payments to accumulate assets to pay eventual losses. The state does not; it has no assets obtained by voluntary subscription of customers or otherwise. Therefore, at the most unfavorable time for citizens, when they have already suffered losses, the state compounds their losses by tax increases to pay for its protection services.

A subsequent chapter on private security analyzes the ways in which insurance and security businesses could function so well that they would supplant and supersede state and local police, absent political coercion restricting or outlawing some or all the activities of private security businesses.

Insurance and defense

Currently, insurance companies are not in the business of providing defense against aggression originating outside the territory of the state in which customers live. Insurance companies could provide such protection. At present they do not provide such protection only because the state claims and enforces a monopoly of the business of defense against external attack.

If insurance companies were not legally precluded from offering defense insurance, in that business they would have the same advantages mentioned above in regard to private security against domestic attacks on persons and property.

A subsequent chapter analyzes and discusses national defense as it could be provided by free enterprise operations of insurance companies and security companies.

Insurance and health care

Most contracts of health care insurance in the United States are not insurance at all. Why is that? It is because by and large Americans have come to expect and demand that their medical insurance will pay for any and every medical service, including by way of example but not limitation, doctor visits for relief from the normal aches and pains of life, prescribing eyeglasses and hearing aids, routine annual physical checkups, etc. Such medical services are not genuine insurable risks because they do not involve catastrophic expense. The expenses are within the means of people to pay for out of pocket, or are discretionary expenses that people choose to incur, not calamitous expenses such as life-threatening illness or injury.

Economics professor John H. Cochrane makes the following perceptive observations about health care insurance in the United States. 

“None of us has health insurance, really. If you develop a long-term condition such as heart disease or cancer, and if you then lose your job or are divorced, you can lose your health insurance. You now have a preexisting condition, and insurance will be enormously expensive—if it’s available at all. Free markets can solve this problem, and provide life-long, portable health security, while enhancing consumer choice and competition.

“‘Health-status insurance’ is the key [to solution of this problem]. If you are diagnosed with a long-term, expensive condition, a health-status insurance policy will give you the resources to pay higher medical insurance premiums. Health-status insurance covers the risk of premium reclassification, just as medical insurance covers the risk of medical expenses. With health-status insurance, you can always obtain medical insurance, no matter how sick you get, with no change in out-of-pocket costs. With health-status insurance, medical insurers would be allowed to charge sick people more than healthy people, and to compete intensely for all customers. People would have complete freedom to change jobs, move, or change medical insurers. Rigorous competition would allow us to obtain better medical care at lower cost. . .” ⁹

Andrew Galambos anticipated Professor Cochrane’s views on health status insurance. Galambos innovated the idea of birth defect insurance, which could be purchased at the time of the establishment of the knowledge of pregnancy. ¹⁰

Another knowledgeable observer of health care insurance, businessman and author David Goldhill, has observed that the very high rate of increase in the cost of health care and insurance for health care is attributable to the willingness of most people to pay almost unlimited amounts for health care insurance. In large part this is due to the role played by federal and state laws that hide the real cost of health care and health insurance from consumers by subsidizing health care expenses and by means of federal tax laws that move most of the cost of health care from individuals to their employers. Mr. Goldhill observes that Medicare, Medicaid, new insurance mandates, elimination of coverage caps, Part D drug coverage and the Affordable Care Act [of 2010] (“Obamacare”) have been the economic equivalent of baseball’s pay-tv revenues, new luxury boxes and online subscriptions services: huge new sources of revenue to organized, major league baseball that has caused an enormous increase in the salaries of major league baseball players. ¹¹

In an excellent book, Mr. Goldhill argues persuasively that too much insurance coverage is the root cause of the extraordinary rise in health care  costs in the U.S. since World War II. Mr. Goldhill posits that medical insurance for non-catastrophic expenses has banished the law of supply and demand from the market for health care and eliminated the role of prices as the lifeblood of the economic circulatory system. ¹²

Health insurance premiums would be lower without political interference. Since the government has mandated that employers provide health insurance, people have become accustomed to having their insurance company pay anytime they use medical services. This is a recipe for expensive insurance coverage because there is no incentive for self-rationing. Because insurance companies cannot compete across state lines, this lack of competition keeps insurance prices higher than they could be.

Between the federal government and the states there are upwards of 2000 health insurance mandates, which altogether have added considerably to the overall cost of health insurance. ¹³ Such mandatory coverage requirements are a manifestation of collectivist thinking and political action. Legislators decide that because some people want a particular insurance coverage, that feature must be in the insurance policies for everybody. The insurance company must include the cost of that coverage in every insurance policy thereby raising the cost to all customers including those, which could be most customers, who would prefer not to be insured for that particular risk if it raises their insurance costs.

Social welfare programs

In the long run insurance for retirement income and health care will be provided privately, to the extent people are willing to pay for the protection—and most will be willing to pay. For people of modest means it seems probable that the insurance industry could develop relatively low-cost insurance programs that are affordable by less affluent people while still providing a worthwhile supplement to personal savings.

For people lacking the means to buy any insurance for health care and retirement the social institution of charity will be available, especially when the state has vanished and with it the enormous tax burden borne by most people. In that circumstance it is reasonable to expect that those better off than others will give to charities that help the less fortunate.

More importantly, with the end of the political state and its ever-growing exactions of taxes from the public, the overall standard of living is bound to increase so much that even lower-income members of society will have means to provide for their financial well-being in their later years. ¹⁴

An example of how this is possible even at present appears in the book Wealth on Minimal Wage (1998) by James Steamer. The book tells the true life financial story of a married couple, both college graduates who never earned much more than the minimum wage provided by federal law. By 1997 when they were just entering middle age, this married couple had one child and had already accumulated $250,000 in investments and home equity from combined average annual income less than $20,000 (in 1997 U.S. dollars). Note: In 1997, according to the CPI Inflation Calculator of the U.S. Bureau of Labor Statistics, $250,000 and $20,000 respectively were the equivalent of $370,000 and $29,600 in 2014. ¹⁵ According to a communication from the author of this book, by the year 2007 the married couple’s net worth had increased to approximately US $1 million including the value of a residence owned free and clear of debt, and without benefit of inheritance. That $1 million value has remained unchanged throughout the financial turmoil since 2007.

Innovation and technology in protection against loss

So far, no political catastrophe has been as threatening to the human species as would be the impact on earth of a large asteroid. Geologists, paleontologists, and other scientists have concluded that a large asteroid that struck planet earth 65 million years ago caused climate changes that killed off 70 percent of all plants and animals on earth at the time. ¹⁶ Science and technology could develop means of steering such an asteroid slightly out of its orbit and away from a collision with earth. The asteroid evasion problem is already the subject of thought and effort by scientists and engineers at Jet Propulsion Laboratories and the California Institute of Technology.

Man-made catastrophes

Man-made political catastrophes have killed enormous numbers of human beings, including at least 185 million people during the twentieth century. ¹⁷ With the destructive capacity of weapons of mass destruction made possible by advances in the physical and biological sciences it is conceivable, and not at all conjectural, that man-made catastrophes from use of weapons of mass destruction could be as destructive to all forms of life on earth as the asteroid impact of 65 million years ago.

It was the goal of Andrew Galambos and is the goal of CTLR to explore the possibility of greatly reducing, or completely eliminating man-made catastrophes by the development of voluntary, non-coercive, competitive protection and security services that would supplant and supersede political states.

Much of this book is concerned with the identification of the enormous social problems and destructiveness caused by politics, political action, and the assertion of a state monopoly over the business of protection.

It is the position of CTLR that over time politics and political states will become defunct, obsolete, and extinct; and as the political state withers away due to its self-destructive nature, private and voluntary means of property protection will expand from their present limited role in human affairs to the universal means of protecting life and property.

The pseudo-insurance operations of political states

A remarkably perceptive and articulate American advocate of human freedom from all forms of political coercion, Lysander Spooner, observed that “. . . the theory of [the U.S.] Constitution is that . . . our government is a mutual insurance company, voluntarily entered into by the people with each other; that each man makes a free and purely voluntary contract with all others who are parties to the Constitution, to pay so much money for so much protection, the same as he does with any other insurance company . . . But the practical fact is that the government, like a highwayman, says to a man: Your money, or your life . . .” ¹⁸

As noted sociologist Charles Tilly (1929-2008) observed, “governments are in the business of selling protection, whether people want it or not. . . ¹⁹ Someone who produces both the danger and, at a price, the shield against it is a racketeer. Someone who provides a needed shield but has little control over the danger’s appearance qualifies as a legitimate protector, especially if his price is no higher than his competitors. Someone who supplies reliable, low-priced shielding both from local racketeers and from outside marauders makes the best offer of all.” ²⁰

Spooner’s statement about the coercive nature of protection offered by the U.S. federal state is true of every other political democracy in which voters choose representatives who impose taxes on them for governmental protection services.

This is not true insurance, as Spooner observes, because it is forced exaction from individuals to pay for government protection services that individuals may not want, or might prefer to buy from some source other than the political state, especially if the cost were lower and the protection more effective.

Furthermore, in the case of the United States, and every other political democracy, unlike insurance companies the state protectors do not engage in actuarial analysis to determine the degree of risk that they are insuring, do not engage in underwriting to price the cost of protection, and do not accumulate a fund of assets to pay claims for losses when they occur. Therefore, all political democracies in existence in the early 21^st century are bankrupt because they will all become unable to honor their promises due to this defective mode of operation.

The importance of insurance in the management of the risks of life

Human life is subject to many kinds of risk. It has become the role of insurance to provide people with security through protection from losses due to risks to which all are subject. Financial historian Peter L. Bernstein made the following observations about the relationship between risk and insurance.

“The word ‘risk’ derives from the early Italian risicare, which means ‘to dare.’ In this sense, risk is a choice rather than a fate . . . Today, we rely less on superstition and tradition than . . . in the past, not because we are more rational, but because our understanding of risk enables us to make decisions in a rational mode . . . The capacity to manage risk, and with it the appetite to take risk and make forward-looking choices, are key elements of the energy that drives the economic system forward . . . [T]he free economy, with choice at its center, has brought humanity unparalleled access to the good things of life . . .” ²¹

In early 21^st century America, insurance reduces the risk of activities as pervasive and diverse as driving an automobile; utilizing commercial air travel; buying and owning a home; and in the creation and operation of businesses.

Spontaneous human development of insurance

Insurance evolved gradually through trade, commerce and usage, in a manner similar to the development of agriculture, art, contract, language, law, markets, money, music and science. Note: The historical survey of insurance that follows is based on the account in Peter L. Bernstein’s book Against the Gods: The Remarkable Story of Risk (1996).

To protect against losses in shipping was one of the early uses of insurance, going back nearly 4,000 years into antiquity. The earliest historical record of insurance for shipment of goods dates back to the Code of Hammurabi which appeared around 1800 B.C.E. in Mesopotamia. In both ancient Greece and Rome, occupational guilds maintained cooperatives whose members paid money into a pool that would take care of a family if the head of the household met with premature death, a practice still found in England in the late 17^th century C.E. ²²

By the late 17^th century in England all the basic principles of insurance had been established. These principles included:

• The concept of insurable risk
• Actuarial calculation of the probability of loss
• Underwriting by which an insurer agrees to assume the risk of loss in return for payments by the insured in advance of loss
• Identification of risks that were uninsurable due to moral hazard or because actuaries could not calculate the probability of loss
• Application of these principles to myriad risks including loss of life, bodily injury, fire, maritime loss, and funding of future income through the device known as annuity.
  

Actuarial foundation of insurance

The business of insurance was enabled to expand to cover a wide variety of risks because of intellectual developments that have become known as actuarial science.

Actuarial science is the discipline of analyzing the financial consequences of risk in insurance, finance, and other activities and industries. Actuaries use mathematics, statistics, probability theory and financial theory to study uncertain future events, especially those of concern to insurance and pension programs. They evaluate the likelihood of those events, design creative ways to reduce the likelihood and decrease the impact of adverse events that actually do occur.

In the field of property and casualty insurance, actuaries must be skilled in the analysis, evaluation and management of the financial implications of future contingent events.

In the field of life insurance, annuities, and pensions, actuaries use historical data on human mortality and life expectancies and also projections of future life expectancies in analyzing and calculating the risks of life insurance and annuity contracts and pension programs.

The actuarial basis for modern life insurance, annuities and pensions was pioneered in large part by the statistical and theoretical work of five Englishmen: John Graunt (1620-1674); Edmund Halley (1656-1742) of Halley’s Comet fame; Daniel Defoe (1660-1731), author of the famous novel Robinson Crusoe, Thomas Bayes (1701-1761); and Richard Price (1723-1791). ²³

According to financial historian Peter L. Bernstein, “by 1725 mathematicians were competing with one another in devising tables of life expectancies, and the English government was financing itself through the sale of life annuities.” ²⁴

Insurance underwriting

Insurance underwriters use the risk calculations of actuaries to decide upon the price to be charged for a contract of insurance. Warren Buffett tells the story of the establishment of the most famous insurance underwriting operation in history, as follows. “[A]round 1688 . . . Edward Lloyd opened a small coffee house in London . . . His shop was destined to achieve worldwide fame because of the commercial activities of its clientele—ship owners, merchants and venturesome British capitalists. As these parties sipped Edward’s brew, they began to write contracts transferring the risk of a disaster at sea from the owners of the ships and their cargo to the capitalists, who wagered that a given voyage would be completed without incident. These capitalists eventually became known as ‘underwriters at Lloyd’s’ . . . Over time the business broadened beyond marine risks into every imaginable form of insurance . . .” ²⁵ For example, American film star and dancer Betty Grable (1917-1973) was celebrated for having the most beautiful legs in Hollywood. She had her legs insured through Lloyd’s of London.

Peter L. Bernstein explained as follows the derivation of the terms “underwriters” and “underwriting” in the method of establishing an insurance contract at Lloyd’s of London.

“Then as now anyone who was seeking insurance would go to a broker, who would then [offer] the risk to the individual risk-takers who gathered in the [London] coffee houses or in the precincts of the Royal Exchange. When the deal was closed, the risk-taker would confirm his agreement to cover the loss in return for a specified premium [payment] by writing his name under the terms of the contract; soon these one-man insurance operators came to be known as ‘underwriters’ . . . By the middle of the [18^th] century, marine insurance had emerged as a flourishing, sophisticated business in London.” ²⁶

Underwriting, that is the pricing of insurance, is related to risk reduction by the insured or by cooperation of the insured and an insurer. For example, a fire insurance company will lower its fire insurance rates on structures that are fire resistant. Life insurance companies charge lower rates for people who don’t smoke or consume alcoholic beverages.

However, life, accident, and health insurance rates may be higher than normal in the case of people who engage in risky activities, such as skydiving or riding a motorcycle.

The state maintains a virtual, but not complete, monopoly on dispute resolution, including resolution of disputes that involve insurance that a party may have in order to provide payment of claims for alleged liabilities. Warren Buffett observes that in the state judicial system, there has been a disturbing ingredient in judicial decisions and jury verdicts, namely “. . . the acceleration in ‘social’ or ‘judicial’ inflation. The insurer’s ability to pay has assumed overwhelming importance with juries and judges in the assessment of both liability and damages. More and more, ‘the deep pocket’ is being sought and found, no matter what the policy wording, the facts, or the precedents.”

Judicial and social inflation undermine and sabotage the ability of insurance companies to calculate and charge properly for likely future claims. This is harmful not only to insurance companies but also to their customers. That is because insurance companies must charge higher premiums and can be bankrupted by losses beyond what they undertook to insure. A prime example is litigation over damages caused by exposure to asbestos. After decades of litigation and billions of dollars of payments, users of asbestos and their insurers were faced with legally sanctioned claims for emotional distress of people who feared they would get sick from asbestos exposure even though they had no medical indications of actual damage to health from asbestos exposure.

Insurable risk and moral hazard

Noted liberal (as that word is used in CTLR) economist Murray N. Rothbard explained the concept of insurable risk as follows. ²⁷

“Insurance properly applies to risks of future calamity that are not subject to the control of the [insured], and where the incidence can be predicted accurately in advance. ‘Insurable risks’ are those where we can predict an incidence of calamities in large numbers, but not in individual cases: that is, we know nothing of the individual case except that he or it is a member of a certain class. Thus, we may be able to predict accurately how many people aged 65 will die within the next year. In that case individuals aged 65 can pool annual premiums, with the pool of premiums being granted as benefits to the survivors of the unlucky deceased.

“The more, however, that may be known about individual cases, the more these cases need to be segregated into different classes. Thus, if men and women aged 65 have different average death rates, or those with different health conditions have varying death rates, they must be divided into separate classes. For if they are not, and say, the healthy and the diseased are forced into paying the same premiums in the name of egalitarianism, then what we have is no longer genuine life insurance but rather a coerced redistribution of income and wealth . . .

“[T]o be ‘insurable,’ [a risk] has to be outside the control of the individual [insured]; otherwise, we encounter the fatal flaw of ‘moral hazard,’ which . . . takes [a risk] out of genuine insurance.” ²⁸

The term moral hazard refers to situations in which a party is more likely to take a risk because he or she does not bear the cost of the risk; or to incur a loss deliberately in order to collect insurance payments. Moral hazard also exists in the case of individuals whose past conduct indicates that there is a risk that their dishonest behavior will cause a loss.

For example, fire insurance contracts disallow reimbursement for losses due to fires set by the insured. For this reason, in suspicious circumstances insurance companies use arson investigators to discover if a fire was set by the insured. Insurance companies write contracts known as fidelity bonds to reimburse employers or principals for losses incurred on account of the activities of employees or agents entrusted with control of the monies or property of an employer or principal. An employee or agent known to have a record of dishonest conduct presents a moral hazard; therefore bonding companies will not insure against loss due to acts of such an employee or agent.                                                                                           

Risks too large to be insurable

Some risks that otherwise would fit the foregoing definition of insurable risk are actually not insurable because the scope of damage they could cause would exceed the ability of the insurance industry to pay. Up until the 21^st century, and probably beyond, war is such a risk. Therefore, property and casualty insurance policies universally exclude insurance coverage for damage caused by war. The enormity of war damage is illustrated graphically by photos of cities, such as Dresden, Germany, or Hiroshima, Japan, devastated by bombing in WW II.

Some natural disasters could cause damage even greater than any caused by human wars up until the early 21^st century. Examples include the impact of large asteroids on planet earth and eruption of the largest volcanoes on earth.

Terrorist attacks on heavily populated metropolitan areas could cause total damages beyond the current capacity of the insurance industry to pay. Consider, for example, the terrorist attacks of September 11, 2001 against the Twin Towers in the World Trade Center at New York City. According to Lauren Pachman of the American Academy of Actuaries, “among the many insurers that were providing terrorism risk insurance on September 11, 2001, Lloyd’s incurred $2.9 billion in losses from the attacks and nearly went bankrupt paying its claims. Munich Re and Swiss Re, the largest reinsurers in the world, paid out $2.4 billion each.” ²⁹

Note: Notwithstanding this terminology used by Ms. Pachman, Lloyds is not an insurance company but rather a marketplace for insurance companies.

Lacking any means of anticipating or preventing terrorist attacks the insurance industry would necessarily exclude terrorism damage from its insurance coverage, or alternatively make a charge for limited coverage, that is a maximum amount payable per customer per incident.

Subsequent chapters on security and defense will explore the possibility of such events as terrorist attacks and natural catastrophes becoming insurable risks due to advancing technology in both the physical and biological sciences and insurance. For insurance to constitute a viable protection from such disasters, there are three requirements. First, the insurance industry would have to expand far beyond its size as of the early 21^st century. Second, to minimize or prevent war damage, insurance as an industry would have to collaborate with the security industry, i.e., the industry now known as private security. Third, science and technology would have to advance to a point where natural disasters could be headed off. For example, insurance could be a source of financial assets to pay for developing a technology in which asteroids would be steered away from earth, and where the massive forces within active volcanos would be vented gradually rather than being allowed to build up to a giant explosion. ³⁰

The business of insurance: promises, float, and integrity

Insurance companies sell promises. Customers pay money to buy the insurer’s promise of reimbursement for a possible future loss. Of course, insurance companies and their customers hope there will be no losses, but losses there will be or there would be no reason for insurance.

Insurance executive Warren Buffett explains that “this collect-now, pay-later model leaves [our company, Berkshire Hathaway, Inc.] holding large sums—money we call ‘float’—that will eventually go to others. Meanwhile, we get to invest this float for Berkshire’s benefit. . . If our premiums exceed the total of our expenses and eventual losses, we register an underwriting profit that adds to the investment income our float produces.” ³¹

The essence of integrity and competence in the operation of an insurance business comes down to the ability of an insurance company to keep its promises. As Warren Buffett puts it, he always wants his insurance companies’ checks to clear. Insurers are temporary custodians of customers’ money which resides with the insurance company as float—funds to be invested for the time being that must be paid out eventually to the insured customers.

Mr. Buffett observes, however, that historically intense and perennial competition in the insurance industry as a whole has caused the industry and most insurance companies to generate significant underwriting losses. Those underwriting losses are, in effect, what the industry pays to hold its float. Therefore, despite the float all insurance companies have, the insurance industry as a whole has a dismal record, earning subnormal profits as compared to other industries. ³²

Most Americans will be surprised by the idea that insurance companies are less profitable than American corporations in general. There are several reasons for this counterintuitive phenomenon. The most important reason is poor underwriting discipline. A secondary reason is poor investing, discussed below under the heading “insurance and investment.”

As mentioned above, in the underwriting process an insurer sets a price for the risks it insures. Setting aside moral hazard and catastrophes too big for the present size of the insurance industry, in principle most risks are insurable at a price that compensates insurers for taking the risk. For example, life insurance and medical expense insurance, ordinarily, are available for people with serious health problems, but at a price higher than for healthy people.

Underwriting is not a science like physics or biology. It is a discipline, like the practice of professions such as accounting, law and medicine. Insurers can make mistakes that bankrupt them, including defective actuarial assumptions, overly optimistic underwriting assumptions, failure to maintain adequate reinsurance, and incompetent investing. For example, the 1994 Southern California earthquake known as the Northridge earthquake bankrupted a small insurance company then known as 20^th Century Insurance, which had excessive concentration of risk in home owners’ insurance for residential real estate located in the area where the earthquake occurred. The company also had inadequate reinsurance.

In addition to the foregoing principles of underwriting, a company insuring against a variety of risks can limit its risk by providing a maximum loss amount payable under every contract of insurance.

Furthermore, risk is almost always shared by the insurer and the insured through provisions for deductible amounts and co-payment amounts. These are amounts for which the insured is responsible in addition to the amounts the insurance company is responsible to pay.

An insurance company can also reduce its risk through reinsurance, by which a primary insurance company transfers some of its risk to a secondary level insurance company known as a reinsurer. For example, a property and casualty insurance company that underwrites risk of loss by fire may enter into an agreement transferring to a reinsurance company the risk of losses over a specified amount per claim.

The primary insurer may be likened to a retail seller of insurance to the public and the reinsurance company may be likened to a wholesale seller of reinsurance to other insurance companies. With one contract of reinsurance the reinsurer may assume the liability for part of the risk of many individual insurance contracts written by the primary insurer.

Insurance companies must operate at a profit. If they lose money they will be unable to keep their promises. Trying to keep prices low by operating without a profit is a recipe for failure of an insurance company. People may complain that their insurance costs more than they like, but such complaints pale into insignificance compared to the complaints people would have if an insurance company were unable to keep its promises to reimburse its customers for losses.

Insurance and investment

Competent investing is an important component of the business characteristics that are necessary for the insurance industry to achieve its full potential, namely the financial strength and size to provide reliable insurance for all the insurable risks of life including protection of life and property from criminal attacks, terrorism and war; catastrophic health care expense, old-age retirement funding, and reimbursement for losses from natural disasters.

Poor returns on an insurance company’s investments will be reflected in higher long-term costs to customers. In a worst case scenario, incompetent investing can bankrupt an insurance company and leave its customers without the insurance protection they have paid for.

In America, monetary inflation, judicial and social inflation, taxes, and the state’s monopoly of much of the American economy are the biggest obstacles to the insurance industry realizing its full potential. Failure to invest to minimize the impact of monetary inflation and poor underwriting are managerial mistakes that can be rectified by adhering to the core principles of insurance operation and investing.

Better investing results will be necessary for the insurance industry to expand to a size adequate to provide all forms of security previously considered uniquely suitable to the state. In this regard there is in existence already one insurance company that can serve as a role model for investing by insurance companies, or anyone else. That is Berkshire Hathaway, Inc. (Berkshire), the American company that has since the late 1960s been managed by Warren E. Buffett (Buffett), in consultation with his colleague Charles T. Munger.

Almost all insurance companies, and except for Berkshire virtually all large insurance companies invest predominantly in interest-bearing assets such as bonds and real estate mortgages. Berkshire is different. Its investing emphasizes equities, including both stock market investments in company shares traded in the public stock market, as well as controlling interests in entire companies. Utilizing the value investing discipline of his teacher and role model, Benjamin Graham (1894-1976), Buffett has enabled Berkshire to achieve long-term investment success in equities without incurring losses that would jeopardize the ability of the company to pay claims promptly when due.

Beginning with Berkshire’s initial venture into the insurance business in 1967, Berkshire has increased its shareholders’ equity from $36 million in 1967 to $141 billion at yearend 2013, for an annualized rate of return of 19.7%. Although the annualized rate of return has slowed considerably with the growing size of the company’s capital since the mid-1990s, in the 21^st century Berkshire’s investments have continued to out-perform by far those of conventional insurance company investments. ³³

Insurance as an integral element of all other forms of property protection

This chapter’s examination of the ideas and principles of insurance serves as an introduction to subsequent chapters examining the use of insurance to provide human security, a humane and effective system of justice, security against domestically originating attacks on life and other forms of property, and large-scale defense, heretofore commonly referred to as “National Defense.” As we have indicated in chapter 1, Replacements for the Political State, and will elaborate further in later chapters, defense of a nation is a problem limited to the transitional period between the present existence of nation-states, and what CTLR posits is the ultimate and inevitable extinction of the state as a form of human governance.