When Insurance Fraud Becomes Public Policy

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What is insurance fraud? And why does democracy work so hard to stamp it out in the private sector yet embrace it in the public sector?

Insurance is a complex product built on a foundation of trust. In return for a stream of cash payments, today, insurance providers promise a payout, tomorrow, should some bad thing happen.

After-the-fact fraud is easy to spot but hard to redress. If your house burns down and you discover that your insurance company absconded with your money, is there any doubt you’ve been defrauded? By that point, though, there’s not much you can do.

That’s why regulators are empowered to ferret out fraud before-the-fact, aiming to protect consumers from companies whose assets are insufficient to cover their liabilities. As a result, well run insurance companies tend to be large, profitable, and long-lived. It’s ultimately what makes their promises worth something. Would you buy insurance from Vinnie the Bookie?

Despite the whining, insurance companies secretly love regulation. Being large, profitable, and long lived they can “invest” in politicians. In return, politicians deliver a controlled market relatively free of price competition, protected from new entrants, and amendable to profits that yield campaign contributions year after year. These politicians also have the power to make laws that force consumers to buy insurance. If you’re an insurance company CEO, what’s not to like?

Nothing. Until politicians get into the business for themselves.

Like lottery tickets, most customers who buy insurance never get anything tangible in return. (Dang, I didn’t smash my car!) When you buy something and get nothing in return, do you feel cheated? When a politician invites you to vote for lower insurance rates, do you find it hard to resist? Who doesn’t want lower prices?

Insurance companies forgo profits lost under price controls and make it up with profits gained under protection from competition. As long as all their customers don’t all die or get in car accidents at the same time, the political pendulum swings seeking equilibrium.

But the game becomes unstable when massive amounts of correlated risks need to be insured. Floods, earthquakes, and hurricanes may be unpredictable in the short term but insurance companies have learned to manage risk long-term by hoarding profits during good times to cover payouts during bad. These profits get plowed into massive portfolios of financial assets waiting for The Big One. Insurers also balance risk by selling some to global re-insurance companies.

Most importantly, insurers are happy to charge customers higher rates when they build papier-mâché houses on sand dunes, McMansions on flood plains, or condos on earthquake faults. By building risk into the cost of a house, fewer houses get built in high-risk zones, innovative building techniques get developed that help houses withstand The Big One, and ecologically sensitive land becomes less attractive for development.

Until unconstrained democracy enters the picture. Why pay more when you can vote to pay less?

Because “long term” to a politician means “until the next election,” beating down insurance companies’ unfair rates and excess profits is a perennial vote getter. Even when insurers flee the state, as State Farm recently did in Florida joining Prudential, Allstate and Nationwide, the legislature can whip up a government run insurance company. Give it a catchy name like the Citizens Property Insurance Corporation, charge the lowest rates in town, throw all accounting rules out the window, and before you know it Vinnie the Bookie is insuring every home in the State.

Can’t get a commercial re-insurer to buy any of the underpriced risk on those papier-mâché houses? No problem! Create a government re-insurance entity and name it the Florida Hurricane Catastrophe Fund. Fill it up with IOUs financed by bonds that obscure the tax impact and let the good times roll.

Potential liabilities of CPIC and FHCF exceed assets by over $400 billion dollars, and growing. Under commercial regulations and accounting standards, these Government Sponsored Entities would be declared insolvent and their officers would be indicted for fraud. But with the fox guarding the henhouse, fraud will only be “discovered” after the next big hurricane blows through. Similar follies are unfolding in earthquake land.

Are Florida homeowners worried that their home-grown Vinnie might not be there when the bills come due? Are they begging State Farm, Prudential, Allstate, and Nationwide to come back, even if it means paying higher rates? Are they thinking twice before they build more papier-mâché houses on sand dunes? Is the governor in charge of this mess the least bit concerned?

“Floridians will be much better off without them’’ bellows said governor. Asked if State Farm was playing chicken when they asked for, and were denied, a rate increase, he replied: “I don’t really know, and I don’t really care.’’

Isn’t that a fitting motto for unfettered, know-nothing democracy – bound by no limits and bowing to no constitutional constraints? “I don’t really know, and I don’t really care.’’

Sovereign states can’t go bankrupt, right? There will always be a taxpayer somewhere who can be forced to bail them out. If not their own state’s taxpayers, then - even better - someone else’s! After all, Florida is a swing state representing 27 electoral votes. What creature of Washington will ever give Florida voters what they deserve, which is nothing, when their houses blow down and their politicians-cum-bookies cry, “We didn’t know!”

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