When the Bush-Cheney administration proposed to replace Social Security with a system of individually accumulated, individually owned, and individually invested accounts, my first thought was that its goal was to take the Social out of Social Security. It took a few minutes longer to realize that it also intended to take the Security out of Social Security.
That attempt failed. In recent years, however, a mixture of public and private policy decisions and impersonal market developments has had the broad effect of shifting many financial risks from established institutions, including even society at large, to individuals who are unable to cope with them in an adequate way. Information may be impossibly difficult for citizens to process; or else the basic information may not be available to individuals or private groups. Sometimes the scale of the possible bad outcomes may be overwhelming. Sometimes the appropriate insurance market cannot function or just does not exist. The result is that individuals and families can be the casualties of situations that once would have been handled by a more centralized and more bearable allocation of risks.
The current turmoil in credit markets and the recession that is sure to follow are likely to drive this trend further. Banks, insurance companies, and other financial institutions have seen too many risks go sour. They will be more determined than ever to push further risks onto those needy borrowers who are too weak and too ignorant to bargain hard. Families, small businesses, and other borrowers of last resort will be under great pressure.
Peter Gosselin’s excellent and thoughtful book, High Wire: The Precarious Financial Lives of American Families, is not the first to explore this territory. Two others that come to mind are Louis Uchitelle’s The Disposable American1 and Jacob Hacker’s The Great Risk Shift.2 Gosselin is like Uchitelle in combining social criticism with substantial stories of recognizable people who have been trapped by bad luck or bad judgment in this new you’re-on-your-own world; he differs in covering a much broader variety of risks and risk-bearers than Uchitelle’s focus on workers and job-related risks. Hacker’s book also ranges over many issues, but does not have Gosselin’s expert journalistic use of recognizable cases. (Professor Hacker is currently engaged in a Rockefeller Foundation–sponsored effort to construct a general “Index of Economic Security”—to show empirically how economic security varies over time and across social groups.)
Gosselin, who works in the Washington bureau of the Los Angeles Times, does a fine job of connecting the stories he tells to general ideas and to economy- wide statistical markers, some developed for his particular purpose. He has produced a readable and valuable book. In this connection it cheers me up to see how he has profited from a stay at the Urban Institute, a leading non- ideological research center in Washington. (I am on the board of the Urban Institute, but our paths never crossed there, though we are acquainted.)
A grasp of the basic principles of insurance will provide indispensable background for understanding both the scope of Gosselin’s argument and also the possible remedies for the failure of social arrangements that he highlights. So I include a brief primer on that subject, using the relatively straightforward example of fire insurance.
Imagine a population of a million similar families, living in a million more or less similar houses. From long experience it is known that the chance that any given family will suffer a severe fire in any given year is about one in ten thousand. In other words, we can expect about a hundred fires per year. The same experience tells us that the average amount of damage per fire is $200,000. So the total damage per year is some $20 million. Serious house fires are rare, but when one occurs it is devastating to the unlucky family.
The existence of fire insurance makes an enormous difference. If each of the million families pays an insurance premium of $20 a year, all damages can be reimbursed. Major house fires would still not be welcome events; but they would not be financially catastrophic. The small probability of a large loss is eliminated, and replaced by a small but certain cost. Insurance companies would have to charge a bit more than $20 per house, to cover administrative costs and profit. Also companies would have to build up a reserve, to allow for the fact that annual losses would surely fluctuate around the average of $20 million, with an occasional bad year. On the other side of the ledger, investment of the reserves, presumably in reasonably safe and liquid securities, would offset at least some of the costs of the system.
Nevertheless, fire insurance has its problems, two in particular. Notice, first, that the existence of fire insurance does nothing to diminish the number of fires. Insurance is a way of pooling or sharing risks, not of eliminating them. In fact the opposite is true: the existence of fire insurance probably increases the number of fires. In the absence of insurance, one has to expect that home owners will be very careful about loose matches, old soldering irons, and other such dangers. The knowledge that they are fully covered may lead to some carelessness, and to more fires. This sort of effect is called “moral hazard.” (It is why subsidized flood insurance encourages people to live in flood plains.) Insurance companies have devices to discourage moral hazard. Deductibles and co-payments are two such devices: no fire is costless to the insuree. Required precautions are another device; every insured home is supposed to have an approved extinguisher and smoke alarms.
The second problem is different. All houses are not alike, after all. Some are more fire-prone than others. To take an extreme case, suppose that 90 percent of the million homes have, for various reasons, essentially no risk of fire. The hundred fires per year all come from the remaining 100,000, each with a probability of one in one thousand. They are responsible for the annual damage cost of $20 million. The 900,000 fire-free home owners very likely know this. They are in effect subsidizing the fire-prone houses, so they will choose not to buy insurance. Only the fire-prone homes will be in the market.
This is called “adverse selection.” To be viable, insurance companies will have to charge a premium of $200 per year, and even some of the fire-prone home owners may balk. You can easily imagine how the whole insurance market might unravel if there are houses of many degrees of fire-proneness: each time the rate rises, the least vulnerable, least fire-prone customers may drop out, leading to a still higher rate and still more dropouts. Insurance companies may respond by refusing coverage altogether to very fire-prone houses (or refusing health insurance to people who look as if they might actually become seriously—or expensively—sick). Modern information technology and data-mining techniques make it possible for insurance companies to pinpoint the known risks associated with individual applicants and quote “appropriate” rates.
Naturally, they do; but this only further undermines the insurance principle. Unless something drastic is done about it, adverse selection can lead to a situation in which precisely those who need insurance most cannot get it, or cannot afford it. Keep in mind that it is in the self-interest of the safe or healthy not to be in the same insurance pool, paying the same rate, as the fire- or sickness-prone, because they will be paying in more than the costs they incur, so that others can pay in less. In such cases, if adequate insurance is to be provided, there may have to be external regulation or direct public provision.
Gosselin interprets his theme broadly, and his book covers a lot of ground. A sample of topics will convey the scope:
(1) A marked tendency for incomes to become more subject to large fluctuations, especially recently, so that both poor and moderately affluent people are increasingly exposed to the risk of a large—like 50 percent—drop in income from one year to the next.
(2) The growing unwillingness of employers to support defined-benefit pension plans that impose on them the obligation to pay benefits based on previous earnings to retired employees, and the replacement of such plans by defined-contribution plans, 401(k) and others. These leave the retirees facing the possibility that their own bad investment choices or just the accident of retirement during a down period in the securities markets will reduce eventual benefits below normal expectations. This risk is on top of the well-known fact that many employees, out of ignorance, inattention, or inertia, simply fail to accept clearly favorable options when offered, and for the same reasons, as well as bad luck, often invest predictably badly. It seems inevitable that the recent volatility in equity markets will induce even more employers to convert pension plans to forms that leave the risks of stock market and bond market fluctuations squarely on the employees.
(3) The erosion of employer-provided health insurance, and the occasional tendency of insurance companies to welsh on expected benefits, either by appealing to small print in the contract or simply by stonewalling.
(4) The failure of the federal government to produce an organized plan for the resettling of the victims of post-Katrina New Orleans, leaving many former inhabitants with the Hobson’s choice of either trying to rebuild in the absence of any assurance that enough of their neighbors will do the same, so as to render the old neighborhood livable, or else abandoning their property and moving elsewhere.
That is quite an assortment of contingencies, and there are others. What they have in common is that individuals have difficulty coping with situations that combine high uncertainty and large potential loss. Neither collective protection nor private insurance on affordable terms is available to them. This striking variety of circumstances adds interest and importance to High Wire, especially by showing, with some drama, that the shifting of risks from institutions to individuals occurs up and down the income scale, affecting the apparently solid middle class as well as the poor.
This expository advantage comes at some cost, however. Different circumstances implicate different aspects of the insurance principle. Gosselin’s agenda does not permit him to discuss them all in any depth, or to show how they are related through the general properties of insurance. I will try here to sketch a few of the complexities in the hope of helping readers to see that the issues emphasized by Gosselin’s account are really quite central to major matters of social policy.
Start with the most general and most complex indicator of risk: the year-to-year volatility of personal incomes. Gosselin’s statistical analysis confirms what others have found. Although precise results may differ according to the source of the data, the time period, the definition of income, and the population studied, the general conclusion has to be that ordinary people are now more likely to experience large fluctuations in earnings than they were three or four decades ago. There is an element of paradox here: during the very same period—from the mid-1990s to the present—year-to-year fluctuations in national income have become noticeably milder, a fact that has come to be called the Great Moderation. So the aggregate economy has become more stable while individual fortunes have become less stable.