Insurance Musings

My understanding of financial / insurance markets is weaker than I'd
like, but here are some thoughts I've been chewing on for a few weeks.

Perhaps I'm naive or reactionary, and but I'm not convinced that
insurance markets in the US work at all. As a society and as a
market, we seem to be truly awful at risk management (ex: Katrina),
and insurance is a financial embodiment of our risk management
capabilities. Insurance, if priced properly, allows the insured to
pool risk and hedge risk. (ex: Buffett's philosophy on insurance.)
When priced improperly (companies writing policies that they can't
afford to pay), the financial market becomes a series of dominos.
(ex: The CDS market, AIG, ....)

There seems to be an inherent moral hazard to providing insurance. An
insurer has a financial incentive to provide insurance policies
against 1-in-100 year events (Katrina, World Trade Center) that it
can't afford to pay out on when these events occur. Executives can
pocket multimillion dollar salaries and bonuses each year, selling
policies at rates too low to afford payout. When the events occur,
payouts make the firm insolvent, and the executives walk across the
street and get jobs with a new firm. For the individual executive,
there is infinite upside potential and limited downside potential.

A similar sort of moral hazard / risk management failure played a
large part in the death of the investment bank this year. For the
last ~30 years, investment banks have been financing their operations
largely through proprietary trading desks. The traders would earn
multimillion dollar bonuses when performance was very good. During
good market times, the traders (quite rationally) took on excessive
leverage to magnify their gains (and thus their bonuses). If a trade
blew up, they would be fired, go across the street, and work for
another firm. For the individual trader, there was infinite upside
potential and limited downside potential.

The beauty (and horror) of the CDS market is that now _everybody_ can
be an insurer, and everybody can write policies that they can't
afford to pay. (If I'm wrong about this, please correct me. CDS is
still Big Voodoo to me.)

***

None of that really addresses the issue of healthcare and health
insurance, however. The biggest problem I see with the US health
insurance system is how it hides prices from consumers. When you buy
a pizza, a car, or a house, you know what it costs. These prices act
as a signal, and let you pick cheaper goods, when appropriate. When
you go to the doctor, you (with an HMO) don't see what the office
visit costs. When you buy prescription medication, you don't know
what the medication actually costs. Insurance providers decide how
much they are willing to pay, and doctors charge as much as the
insurance company will allow. Hiding prices like this breaks
capitalism. If we're not going to let consumers make decisions
rationally, based on prices, we might as well move to socialized
medicine. In the worst sense, we're already there.

***

Risk management (and writing corresponding insurance policies) is
incredibly difficult, few are qualified to do it, and there is a
severe risk of moral hazard for the employees and executives that
write the policies. Even when insurance policies are priced properly,
they can be structured in such a manner that they hide costs from
consumers, and lead to a less efficient overall market. In a sense,
we might be better off if nobody had insurance for anything. There is
an elegant simplicity to the idea that people should bear the
consequences for the actions they take, and shouldn't be able to to
transfer, buy, and sell those risks to others.

Clearly, this is a naive and idealistic argument. I'm curious--why am I wrong?