Is It Fair To Price For Risk?

Edward J. Dodson

[An unpublished essay, written October, 2009]

Integral to market-oriented economic systems is the practice of pricing for risk. Factoring in the costs of specific risks is often what distinguishes profitable businesses from those that end in bankruptcy. In the public realm, however, costs are generally allocated without regard to risks and rewards. On the one hand, those with sufficient personal financial resources tend to have considerable influence over public policy decisions so that costs are shifted elsewhere. At the same time, elected representatives must do enough for the general public to convince voters to return them to office.

The world's social democracies are today under close scrutiny by proponents of various schemes of reform. Some argue for a far smaller public sector, others for an enhanced public role in areas where the private sector has failed to deliver needed goods or services at affordable cost. In this essay, I address two areas where the debate is most intense: financial services and health care.

Who Is Creditworthy?

Until fairly recently, the business of banking was fairly straightforward. Banks were started by groups of investors who exchanged financial reserves for shares of stock in the bank. After securing a government charter and meeting minimal capital requirements, the bank opened its doors for business. The bank offered individuals checking and savings accounts in order to attract deposits (liabilities for the bank), then used these funds to make loans at interest to other individuals or businesses (and, occasionally, to not-for-profit organizations or even government agencies). Credit markets dictated what could be charged for access to credit, and individual lending institutions competed for deposits by paying interest. Profits were determined by how effective the bank was at controlling its costs and by the performance of its loan portfolio and other investments (e.g., in government securities, in shares of stock or bonds issued by other corporations). Individually and in the aggregate, the banks priced for the risks they took.

Default risk is just one form of risk to the banks. There is also the risk of lending long-term while borrowing short-term (i.e., the risks associated with interest rate volatility and asset/liability duration). Banks are also exposed to regulatory risks. For example, when the definition of "money" was restricted to "gold" coins or bullion, the banks were required to hold gold in reserve in order to meet demands for redemption of paper currency.

For a very long time now, banks have not been required to hold precious metals in reserve to back currency in circulation. They must keep a portion of their currency assets in reserve with the central bank, and this reserve requirement is subject to change at any moment based on monetary policy objectives desired by the central bank's governing board.

There is also political risk, that is, the risk that lawmakers will suddenly change the rules of the game. This occurred in the early 1970s in the United States, when new laws permitted creation of money market funds but prohibited the commercial or savings banks from competing until a decade later. By that time, the money market funds had captured a huge portion of individual deposits. The savings banks (i.e., the "thrifts"), whose main business was financing home purchases with long-term, fixed rate mortgage loans, quickly became insolvent and thousands closed their doors. When finally granted the ability to compete by issuance of certificates of deposit and diversify their loan portfolios, many of the surviving thrifts attempted to generate higher revenue by moving into business areas where they had no expertise. Ignoring the instances of outright fraud and insider dealing, the inability to accurately assess and price for risk caused the failure of even more of these institutions.

We will recall that the 1980s saw in the United States, the United Kingdom and some other countries a rapid shift in law and policy designed to unleash the financial services sector from past restrictions. In the United States this resulted in the disappearance of thousands of local and regional institutions, their assets acquired by the handful of mega-bank holding companies headquartered around the globe. Then, the mega-bank holding companies began to gobble up one another. These changes attracted investors and enabled the largest banks to achieve double-digit growth each year, even as their capital positions strengthened and they achieved geographical diversification of risk. Managing this diversification over the longer term has proven far more difficult than the deal-makers recognized. So now, from the standpoint of overall stability of the global financial system, the risk associated with the failure of just one or two of the top companies is now systemic.

During my twenty years with Fannie Mae in the United States (the first ten years as a manager in the credit risk management area, then as a market analyst and business manager), I watched what happened as annually more and more of our business came from fewer and fewer lenders. Our ability to establish firm eligibility and creditworthiness criteria was slowly eroded as the major loan originators played Fannie Mae and Freddie Mac off against one another. In the 1990s, the federal government program run by the Federal Housing Administration also claimed some of the conventional market when granted authority to insure mortgage loans with higher maximum loan limits, made to households with higher incomes. The Federal Home Loan Banks also entered the picture with their own mortgage securitization program offered at rock bottom guarantee fees to member banks.

When a company such as Countrywide Funding is originating one in every five mortgage loans made in the United States, their ability to obtain pricing that does not fully reflect the risks involved is difficult to counter, unless you are willing to give up that 20 percent of the market. Now, add to the mix the direct issuance of mortgage-backed securities by Wall Street firms with essentially no effective quality control measures applied, with huge fees paid to loan originators based solely on volume produced, and disaster is only a matter of time.

Who Is Health Care Worthy?

Here in the United States there are an estimated 40 million people who are without any means to obtain health care. They are not eligible for government-subsidized programs because they are too young. They do not have the disposable income sufficient to pay the annual premiums for health care programs available from private insurance companies. Or, because of existing health problems, they are not able to obtain insurance coverage at any price.

Other nations have responded to the health care needs of their citizens with a decision to make health care a benefit of citizenship. Ensuring that all members of society have access to least a minimum level of treatment is deemed to be in the best interest of all, that a healthy citizenry is a "public good." Individuals with lower household incomes are not required to make the difficult choice of either using limited finances for the purchase of food or to pay for housing or for the cost of visiting a doctor or medical clinic. Hospitals are created as public institutions, and the physicians, nurses and other staff are salaried employees of the publicly-owned and administered hospitals. No one has claimed this structure is without fault. Access to certain types of care is rationed, and certain procedures are not available at all.

The logic behind private insurance programs is simple. Everyone pays into the system; and, in return, is given access to the health care professionals without additional cost. Until the last forty or fifty years, there was no great need to price for the risks associated with individual members, so long as the pool of members was sufficiently large to ensure a greater inflow of premiums than was needed to pay for health care services. Population demographics then began to dramatically impact this relationship. Advances in medical procedures meant that people were living much longer with serious health conditions, conditions that required ongoing attention for years if not decades. Many more infants born with serious health challenges survived but only because of access to very expensive procedures and ongoing treatment. Thus, the ratio of healthy individuals contributing premiums to the system but not accessing much health care to those absorbing many multiples of their contributions was turned upside down. Keeping insurance programs financially solvent required that all or some premiums be increased, or that the premiums be subsidized by government and/or by employers. Increasingly, employers and those who believed they were lower-risk members demanded that individual premiums reflect actual risks. This introduction of the market dynamic of "pricing for risk" raised its own set of controversies.

One could make the argument that the American mythical attachment to the values of "rugged individualism" have been on a collision course with reality for a long time. The so-called American System is grounded in privilege for the few to an extent not generally understood. The successes of the various "rights" movements have not been a catalyst for true "equality of opportunity." Yet, the illusion of such equality of opportunity paralyzes efforts to address our health care disparities.

Of course, there are valid questions regarding the responsibility of individuals for their own health. We cannot help that we are born with serious health problems. And, our moral obligation to the young is to provide as much nurturing (including health care) as we can reasonably provide. However, determining what is "reasonable" creates another set of societal challenges. Public resources are not unlimited; so, is it reasonable to spend, say, $1 million to keep an infant alive who will never enjoy a decent human existence, rather than provide vaccines to 100,000 children to prevent them from ever contracting polio or small pox? Who is to be authorized to make these decisions? A similar moral dilemma arises when disease strikes the elderly who may already have survived past the life expectancy of those in that society. When there is little or no chance of regaining one's health, should extraordinary measures (and expense) be applied to extend a person's life by a few months or even a few years, if the person will live bedridden and connected to feeding tubes and injected with a toxic cocktail of pain relieving drugs?

Even more controversial is the testing of individuals for inheritance of genetic abnormalities that expose them to an increased incidence of disease, or, when producing offspring, the offspring are certain to inherit the same genetic characteristics. In the United States, such testing may result in denial of health insurance or setting of premiums at an astronomical level. If adults are made aware of the risks and choose to go ahead and produce offspring, is it fair to ask others to pay taxes to ensure that the children of these individuals receive any required health care? Or, is it just for society to intervene and - based on the assessment of risk by health care professionals - require that the reproductive systems of the adults be disabled? These are issues that only the few and the brave are willing to bring up in a public forum.

We also know that among the young there is a high propensity for risky behavior. The list of such behaviors is long and includes not only substance abuse but engaging in extreme sports and unprotected sexual relations. Should the insurance premiums charged to a family be based on the pricing of such risks, with an escape clause for the insurance provider in instances where not all behaviors are fully disclosed in advance? Think about the cultural ramifications of trying to price for the risk of cocaine usage or engaging in unprotected sexual relations.

And yet, when it comes to automobile insurance, a hierarchy of risk factors is priced for without any serious problems. Those the private insurance companies decline to cover are put into high-risk pools with insurance provided by (or subsidized by) government. Although the ability to drive an automobile is in the United States a necessity for most adults, one must qualify for a license, which is defined as a privilege rather than a right. Cause an injury or death to another person or the destruction of the property of another person while driving "under the influence" or alcoholic beverages or mind-altering drugs and the result is likely to be loss of driving privileges, a heavy fine as well as imprisonment. The law assumes that when we reach a certain age we become "competent parties" and are subject to the laws of society. By abusing certain substances, we, in effect, voluntarily become "incompetent" and take on the risks of punishment when we do so. However, if, through no fault of our own, we never achieve the status of a competent party or involuntarily become incompetent, the moral obligation on how society treats us is very different. Society has a moral obligation, in fact, to intervene on our behalf if our biological or other legal caretakers are not providing the appropriate level of care and nurturing.

Who Is Ultimately Responsible to Decide?

I wish I could end this commentary with a set of proposals that would satisfy the concerns of reasonable people committed to the protection of our shared rights. Unfortunately, we are still a long way from consensus over what our shared rights are. The greatest thinkers in each generation have struggled to answer this question. Even so, adherence to ideas of rights based in moral relativism is as strong today as ever before in recorded history. As the Swiss philosopher of the Enlightenment period wrote:

"If poetry, geometry, astronomy, and, in general, all the sciences advance more or less rapidly, toward perfection, while morality seems scarcely to have left its cradle, it is because men, being forced to unite in society to give themselves laws, were obliged to form a system of morality before they had learned from observation its true principles."

Before we can establish a just system of money or credit, or put into place an effective universal system of health care, it seems to me we need to have a far-reaching fundamental discussion over the operative moral principles upon which such systems must be based.