Wednesday, December 30, 2020

2020 was an economic lesson about insurance

My report on superannuation came out at the beginning of 2020. One of the main arguments in that report is that Australia’s superannuation system is not a retirement income system because it cannot perform an insurance function.

I didn’t know then that how we handle insurance at a society-wide level would be the most important economic policy lesson of 2020.

To explain what I mean, I must first differentiate between insurance in the financial sense and insurance in the economic sense.

Financial insurance smooths balance sheet variation when specific low-probability events occur. It works because any one person or group faces idiosyncratic risks so that pooling many people in an insurance system allows it to pay out for those few events from the funds collected from others.

But economic insurance is much different. Economic insurance deals with real resources, not financial ones.

A financial insurance system is an economic insurance system for any individual. As long as an individual’s loss of real economic resources—buildings, vehicles, equipment, stock—from an insured event is small relative to the system as a whole, these real economic losses can be easily replaced from the production of others without widespread economic disruption.

But when losses from an event are large relative to the productive economic system as a whole, simply repairing the balance sheets of individuals with cash payments will not overcome the resource loss that will affect many individuals across the system as a whole.

Consider a small island community who eat 100% of the food they grow to survive—there is not one bit of waste. If a cyclone destroys 50% of their food crops for a season, it won’t matter what sort of financial insurance systems they have in place. Their ability to feed themselves this season has declined by 50% and the loss will be felt across society, not just by the farmers whose crops were destroyed. Financial insurance cannot provide economic insurance for this type of event. The island community must suffer the loss of food and nutrition regardless of whether they can repair their financial balance sheets.

The reality of economic insurance is why I have argued in the past that a food production system that wastes a large portion of the food grown and cultivated is a type of economic insurance that provides a real resource buffer against large unforeseen shocks to the food supply system.

The military also has the features of economic insurance. Why employ tens of thousands of troops when your country is not at war? Why build and maintain ships, tanks, submarines, and jet fighters during periods they are not needed?

The answer is that financial insurance cannot stop the real resource losses from war. You must have some form of economic insurance in place with a real resource buffer being produced just in case of war. Often that requires spending years or decades devoting substantial materials and manpower to maintain a military with nothing to do.

So why is economic insurance the big lesson of 2020?

Because the health system in most countries is not run like an economic insurance system against large health shocks, even though it is clear that financial insurance will not help deal with the next pandemic. Hospitals are incentivised to run at, or near, full capacity at all times, even though health needs fluctuate, sometimes substantially, just as we have seen this year.

If we ran the health system like we do our military, or our food production systems, we would maintain a large buffer of real health resources. That would mean hospitals with surge capacity and staff maintaining them. It might involve, for example, international joint health operations to practice developing and distributing drugs and medical equipment in case of emergency.

If we ran our health system as an economic insurance system, like we do our military, that would mean an enormous expansion of health services generally. As well as being maintained as a buffer in case of emergency, these additional healthcare resources could be used for training and treating less serious health problems.

What has surprised me in 2020 is that few people are looking at the way we manage health resources and why the healthcare system is not designed as an economic insurance system like our military.


  1. Was there a shortage of health resources in 2020? Because I sure haven't noticed one.

    Even in other places (possibly excluding short period in some areas in Italy) where the numbers of hospitalizations were large, I don't think shortages were a big issue.

    Compare that to a sizable, permanent, artificial increase in the healthcare sector (which is quite large I reckon) with correspondingly lower production in other sectors.

    Can you really say it's a good deal?

    1. I certainly agree that COVID was no where near as serious as first thought, though many still seem to believe it is. Because of this, we haven't really encountered shortages. Recall back in April the panic was all about ventilators and ICU beds. Perhaps if we have a health system that was prepared for, resourced for, and trained for, these events, there would have been far be less panic. The story of "lockdown to preserve the healthcare system" would not fly. We may have avoided the disastrous policy responses we saw. This is my view—if the health system was designed for surges, then if one were to occur, there would be less reason to panic.

    2. The story is no longer about saving the health system. There's objectively very.little to panic about, but here we are.

      Hoping that a larger health case system would somehow help seems ... Optimistic.

      And as the other commenter wisely observes, the opportunity cost is very high.

  2. Given the "economic rationalist" tenor of most of your articles and comments, it is surprising that you should be proposing "an enormous expansion of health services generally" without any consideration of the financial and organizational consequences other than "additional healthcare resources could be used for training and treating less serious health problems". Health care resources are highly specific, and not multi-purpose. Australia already spends 9.3% of GDP on health services. Military spending is 1.9% which is about the same as China, indicating the scale problems intrinsic to small countries.

    1. I'm not clear what consequences you are thinking of here. Of course there are opportunity costs to devoting more resources to economic insurance in the health sector, just as there are in the food sector and the military. I'm not arguing this is costless. Just that when we make these policy trade-offs we need to understand that a buffer of resources has a value because of its insurance function, which could be quite high.

    2. The value of any insurance has to be assessed against the cost of the premiums. The cost of the premiums could be "quite high".