Policies to insure against the future
Sydney Morning Herald June 11 2003
Ross Gittins reflects on the ideas of a visiting Yale finance professor, who would make our lives far more financially secure by reducing the threat to our incomes.
Robert Shiller is a man with a vision. He can see a way to make our lives far more financially secure by reducing the threat to our incomes from job loss, economic recessions, career setbacks or other mishaps. We could just stop worrying about all that stuff.
Shiller would bring about this miracle by "radical financial innovation". He'd take the secrets of high finance and "democratise" them, spreading them from Wall Street to Main Street. In the process, he'd create a new "risk-management infrastructure" and a whole "new financial order" for the 21st century.
If you find that a bit hard to take in, try this: he'd invent new kinds of insurance policies we could buy. More imaginative use of insurance, he assures us, could transform our lives.
Shiller could be a crackpot writing letters to newspapers. In fact, he's a professor of finance at Yale University. He's the celebrated author of Irrational Exuberance, in which he pooh-poohed the New Economy and warned that Wall Street's boom couldn't last.
So his feet are closer to the ground than most economics professors'. And they're on Australian ground at present as he visits to promote his new book, The New Financial Order, published by Princeton University Press.
The book's thesis is that "recent advances in financial theory, information technology and the science of psychology allow us to design new inventions for managing the technological and economic risks inherent in capitalism".
We live our lives surrounded by a multitude of risks to our economic wellbeing. Shiller believes that further technological change will increase the risks we face in the coming century.
Our careers could prosper, or we could be sidelined. We could find our jobs had been eliminated by new technology, that we had to retrain, or accept a less well-paid job. Lots of other possibilities could adversely affect our incomes, the value of our homes and other assets, or the value of our retirement savings.
The discipline of "finance" - which is a branch of economics, but with a lot of fancy maths - deals with the "management" of risks. It sounds complicated (and it is when they bring out the maths), but at base it's pretty simple.
One "risk-management contract" we all understand is the home insurance policy. It's not possible to eliminate risk (there's still a chance your house will burn down), but it is possible to virtually eliminate the effect of the risk. So, even though your house has burnt, you don't feel the financial effect because you're insured. What's happened is that the risk has been shifted and spread so thinly to so many other people that it's almost disappeared.
Insurance involves a lot of people pooling their risks. Provided there are enough of them, the laws of probability assure us that only a tiny number of them will make claims.
The hard part about running an insurance pool is gathering a lot of information about the size and frequency of claims stretching over many years. You need this data so you can be sure of setting a premium that, while low enough to attract a lot of people to the pool, is high enough to cover all the likely claims.
Shiller's point is that we now know more about the maths of probability and, more importantly, the IT revolution has made the collection, storage and processing of information a lot easier and cheaper.
So we're in a position to think about offering new, even revolutionary forms of insurance.
To date, insurance has focused on quite narrow and specific risks to our income - from our house burning down or being burgled, from a car accident, and so on. Shiller says we can improve on this piecemeal approach and be offered comprehensive insurance against all risks to our income.
Such "livelihood insurance" would require the development of many indexes for the growth in average salaries paid to people in particular occupations. So the policy for an employed male architect, for instance, might involve him being reimbursed by the insurance company for half the gap between his salary and the average salary for architects. This would leave him with an incentive to work hard in his career and thus would overcome the "moral hazard" problem that comes with all insurance - the temptation to stop trying once you're covered.
Now, you may wonder what would happen to an insurance company that had issued a lot of these livelihood policies when the next recession hit. It would have a "recession risk" it had to manage by spreading in some way. And here Shiller steps up with an answer: "macro markets". Insurance companies, banks and suchlike could issue a share-like security that paid a quarterly dividend equal to, let's say, one-trillionth of that quarter's GDP for the US economy.
That dividend would be worth about $US10 a year, but would change in line with the growth in US GDP. The security might sell for about $US200, but its price would vary in line with expectations about GDP as it was bought and sold on the macro market.
The insurance company that raised money by issuing such securities would use the proceeds to buy securities linked to a lot of other countries' GDPs. So it would end up with payouts linked to its own country's GDP, but income linked to other countries' GDPs. Get it? Provided all countries didn't go into recession at the same time, the company would have shifted some of the risk of a local recession.
If your head's still reeling from that one, here's another that's a lot simpler - and nicer. Shiller observes that the conventional way of borrowing from a bank - with a set interest rate and set monthly repayments - is largely a product of the olden days when interest calculations had to be done by hand and money payments were cumbersome.
But now we have computers to do tricky calculations and low-cost electronic payments, it's possible for us to invent new forms of loan agreement that do a better job of (you guessed it) managing risks.
The conventional loan allows problems to build up until they reach breaking point in the humiliation (for the borrower) and loss (for the lender) of bankruptcy.
So why not offer income-linked loans, where your interest and principal repayments were higher in years when your income was growing strongly, but lower in years when your income fell?
Shiller has at least as many more "radical financial innovations" to propose as part of his new financial order, but you get the idea. If you think it all sounds a bit futuristic, I think you're right. But it also sounds like where our future may be headed.