Insurance and Systemic Risk

Today, insurance giant AIG reported a record $61.7 Billion loss. This record loss was seen a big blow to a weak economy. People are worried that all of the weird financial arrangements of AIG might weaken other firms.

Apparently, AIG was heavily into a weird derivative called Credit Default Swaps. These are some sort of funky derivative that banks had been using with the hopes that could insure loans and other investments.

Pundits on the left are using the failure of AIG to push the case that financial markets need powerful centralized regulation.

I wish to toss out a different argument.

I argue that the failure of AIG shows that credit default swaps in specific (and perhaps insurance in general) shouldn't exist.

The idea of insurance is to pool together all of the small risks that we face in life into a large ocean of risk.

No matter how one shapes the large ocean of risk, this ocean of risk is susceptible to catastrophic (tsunami-like) failure.

Unfortunately, I fear that many people will interpret the failure of the insurance paradigm as a failure of the free market. I contend that this episode simply shows the inherent instability of the insurance paradigm.

Interestingly, the insurance paradigm has many of the same goals as socialism. Insurance companies are set up to redistribute income and to regulate risks. It is essntially the same idea as Socialism, but held in private hands.

Like socialism, insurance leads to a great deal of waste, poor service for the individuals using insurance. As we see in health care, insurance destroys the feedback mechanisms the help set price and it leads to inherently instable economy.

I believe that the Libertarians of the past generation got so caught up in the argument of private v. government ownership that they failed to realize that when the private sector tries to create big business to regulate the economy that the big business will suffer all of the same faults as the socialized government.

Speaking of socialized governments. We all know that the US is doing poorly, the socialized countries in Europe are faring even worse in the economic meltdown.

I hope that future generations of Libertarians realize the grave mistake made by our naive faith in big insurance.