Sunday, September 28, 2008

Should Insurance Be Provided To Troubled Companies In US?

Student’s question: Should insurance be offered to the troubled banks & mortgage companies?

By the way, your question is actually the same by saying ‘Whether the US government should bail out these troubled companies?’ The outcome is still the same & that is those financial companies will be finally bailed out. The difference is who should bail them, government or insurance companies?

I’m not an expert about insurance here, but I’ll try to reason it out. Before arriving at your question, I need you to understand the purpose of insurance & the concepts of moral hazard.

Insurance is a form of risk management tool which means transfer of loss to another party. Moral hazard is defined as the risk of a presence contract will actually change the behavior of a party. Say (hypothetical example), if your car is not insured, then you will take good care of it to avoid being stolen. If it was insured for its full value, then if stolen you do not really lose out. Therefore you have less incentive to take care of it

Same goes for banks & mortgage companies here. If their risk is insured, they may start again another round of reckless lending which may cause all of us to end up in another sub-prime mortgage crisis, knowing that the government & insurance companies are ready to bail them out once again. From free market point of view, these ‘inefficient’ companies should be left out, allowed to bankrupt & perish.

However, I argue against the usage of free-market principle in this case. If those banks were insignificant to global economy then yes, they should be left out. Somehow, influence of Freddie Mac, Fannie Mae, Merrill Lynch, Lehman Brothers & many more are just too great to be ignored just like that. It’s better to harm the taxpayers’ wallet than to see everyone being jobless, increase in crime rate, worsening poverty rate & global economy slowing down which feeds through the multiplier effect

Hope that answer your question Paul.

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