Risk as Part of the Product

Ann Torrence left a interesting comment on my last post about a thing called the New Zealand's Accident Compensation Scheme.

The ACC pretty much picks up the tab for anyone hurt in an extreme sports accident. The result is that the extreme sport industry is huge in New Zealand.

I am not familiar with the ACC or how it is funded. Instead I want to contrast models where you externalize liabilities verses those that internalizes liability.

Before making my reply, I have to make an embarrassing public confession:

Well…as you see …deep down inside … I am a wuss.

I am a wuss in a weird way. I really am not scared of falling off a cliff and dying. I simply can't stand the idea of falling off a cliff and failing to die. When I am trying to make some gnarly move on a rock face, I don't think of the pain that would happen when I slip. The thing that drives me to distraction is that idea that I would end up being a burden on everyone. It is the idea of my actions harming others that really hurts.

The other thing that gets me is that I hate the idea that someone's life depends on a knot that I tied. Packing a parachute looms worse in my mind than jumping out of a plane. Doing an overhanging rappel is a blast. My nightmares are about setting the protection and the possibility of the bolt giving away on the next climber.

(This site shows my last climbing partner)

My inner wussness doesn't really come from a fear of bad things happening to me, but a fear that I might do great harm to others.

Being a wuss should disqualify me from talking about extreme sports, but here goes.

My deep moral conviction is that people should bear the brunt of the risks they take. As such, I prefer the business model where companies internalize risks to those that externalize risks.

To make this point lets look at a Bungee Jumping firm. Let's say the basic materials for doing a bungee jump cost $7 a jump, and the bungee jumping firm takes $3 in profit. So they charge $10.

Let's say that the cord snaps in 1 of every 200,000 jumps. When the cord snaps, the jumper gets splattered. Let's also say that 1 in every 100,000 jumps the cord frays and the jumper is scrunched.

The case of the bungee cord snapping isn't a big deal. When the jumper gets splattered, the bungee jumping company would need to fork out five grand for the funeral. The bungee company firm could probably pay for a funeral or two from petty cash. The funeral probably costs less than a new bungee cord.

The real scary risk for the bungee jumping firm is the 1 in every 100,000 jumps where the cord frays and the jumper get scrunched. A scrunched bungee jumper is going to cost a good $600,000 in medical expenses. This expense falls outside what a typical bungee jumping firm could handle. The bungee company firm would want a policy with a $10k deductible, and would need insurance for the scrunched bungee jumpers.

So, in our model, 1 in a 100,000 bungee jumpers result in a $600,000 expense. So, the liability is about $6 per jump. The insurance company is full of greedy people who want to make an outrageous profit on this misery; so they charge $8 per jump for the insurance.

The bungee jumping firm only makes $3 a jump in profit. They can't pay the $8 out of their $3 in profit and have to raise prices. It turns out that they are greedy too. Instead of raising the price $8, they decide to raise it by $10.

It seems counter intuitive; yet the model where businesses internalize risks and pay for the damages they do can increase profits.

The model where you make risk part of the product increases profits. Since the consumer sees the full cost of the product plus risk, they are likely to make better consumer choices. If the prices reflected risk, then the prices could help a sports adventurist decide between doing the BASE jump or the swim in shark infested waters.

The best part of this model is that a group that when a group that control a risk internalize the risk, they can take steps to make things safer. Our bungee jumping firm might find that it can reduce risk by occasionally replacing the cord.

Another cool thing about the economy where companies internalize risks is that it puts consumers in a better position to make their consumer choices. An adventure traveler has only a fixed amount of time and limited resources.

The higher prices might price some people out of the adventure travel market. My inner wuss tells me that this may not be all that bad. When prices accurately reflect risk, then you reduce the number of people who get scrunched by the risks.

The down side of internalizing risks is that it takes a lot of work and monitoring. Efforts to internalize risks can open the door to fraud. The system also transfer a great deal of wealth and power to the middle agents that cover the risk. The system where a third party owns the risk transfers control over a person that might best be left in the hands of the individual.

I admit, I've yet to figure out if internalizing or externalizing risk is better for society. A free market would tend to transfer control over risk to the agent best able to control the risk. In an employment arrangement or bungee jumping, the company is in the position to control risk. In rock climbing and skydiving, the individual has more control over the risk. The ideal solution is not to saddle part of the economy with all the risk. The ideal solution would demand that people know the costs of risks involved in activities and have the risks covered.

BTW, I think the real difference between the ACC is not so much that the government owns adventure sports related risks, but that their system limits personal injury lawsuits.

In the American system, bastard trial lawyers take shove their hands in the process and take the lions share of the money that we've set aside to tend to the injured. In the US it takes a million dollars to provide $500k once a court gets involved.