Claiming Race

(What follows started out as a comment to a blog post, but growed like topsy, so it's ended up here. I've edited it, and added some additional context so that it stands alone.)

Here is the blog post on "claims inflation"
Here is the paper by the blog author
Here is the 2005 paper referenced in the author's paper

What caught my eye was the word 'inflation', since, these days, there's nearly always some agenda hidden in the bushes. And given that the topic was being explored by the insurance industry, well, like a multi-car pileup, I had to look. The blog author is a regular on R-bloggers, and is generally math-y and stat-y, so I was expecting to see a treatment that was data-y, math-y, and stat-y. Yet somehow above and beyond what one gets from BLS (and given that the author is EU based, UK/OECD/ECB/etc. stat offices). Much to my surprise, both the author's paper and the foundational paper are mostly handwaving verbiage. As my psychometric friends say, not much face validity.

And, why now to broach the subject? Unless one has been sleeping under a rock, it's clear that macro-inflation is really macro-*de*flation, thanks to the idiots running monetary policy in the UK and ECB. Even Japan, which had been the poster child for Prosperity Through Austerity failure for *two decades*, have finally gotten some smarts.

The motivating study opines:

Perhaps unsurprisingly, subjective judgement was the most common source of inflation assumptions for every class.

Well, I for one, am surprised. Actuaries, at least in the US, are drilled in maths and stats and data to a faretheewell, so that winging it bears on incompetence. It's not as if insurance is some newfangled enterprise with no history. Lloyds goes back to 1774, before we kicked the Brits out, for crying out loud. Although, one hears that most actuaries spend their day transferring standardized table data into standardized macro-laden Excel speadsheets. (If that sounds like you've heard that recently, well it is a Jonah-ish story.) Not that I'm being accusatory, only that's what one hears, sometimes.

One should read this paper albeit it being UK written, with a critical and jaundiced eye. If this is the state of the art in actuarial practice (and financial services broadly), then The Great Recession is unusual only for its rarity.

A number of problems:
- there are three sources of inflation; cost push, wage push, and demand pull
- holders of wealth (and insurance companies are numero uno) seek deflation, thus increasing their wealth with no risk or effort or intelligence
- all such *flation indexes are, of necessity, founded in sample surveys, and thus contain error. few, even professional economists, bother to read the details behind the BLS indexes. doing so reveals that the CIs are as wide as the Atlantic Ocean (New York to London). some even straddle zero! measuring *flation is really a fool's errand, be that as it may...
- injecting technological change to balance today's price of widget X over its predecessor is a dicey endeavor: today one spends $2,000/annum on "telephone" service where it was nearer to $200 a decade or so ago. is this service worth an order of magnitude more? is this a case of hyper-inflation? is this a case of stupid consumers over-paying for a basic service? how, if at all, is today's "telephone" service superior to yesterday's? certainly, call quality hasn't improved. is this inflation, or a new "good"? should any algorithm seeking to model claim inflation include such goods? is there any value add for higher priced robotic surgery, for example; or is such just inflation? if one uses macro-inflation indexes, such bending of the underlying data is not trivial.
- interest rates really do include a *flation premium, and thus it matters only if one's specific field of insurance does deviate widely from the norm

The result is: holders of wealth portray *in*flation as the norm, and thus seek law/regulation to hold them harmless, regardless of actual events. Until post-WWII in the US, the norm was *de*flation from the founding of the country, in fact. And this was due to lack of specie in circulation to keep up with the expansion of the economy. With fiat currencies, there is a proclivity by wealth holders to have them treated as specie, which is to say, *de*flation is preferred by wealth holders (as it always was), who have better access to government to influence decision making. The German/EU "Prosperity Through Austerity" cabal is a prime source. Japan has followed PTA precepts for more than 2 decades, and it hasn't worked out well; at least at the macro level.

The study of *flation is a topic of, officially, Political Economics, and holders of wealth take a position which is wholly Political and not much Economics: according to their rubric, all inflation is wage push or demand pull. Which is to say: unionism and Big Government dropping moolah from the sky; if only both would go away, Eden would flourish. This blindness to reality is what has fostered their continued harping that wages are too high and "Bernanke is causing hyper-inflation, and it's just around the corner!!!" Hasn't happened, and won't (at least not due to Bernanke), since all that moolah central banks are tossing around is going to current large holders of wealth, and not The Common Man. Only if, and when, The Common Man gets more moolah in his pocket will The Common Man have greater (what economists used to call) Real Demand for goods and services. This week's release of import/export prices by the US government has them down, again.

What all this has to do with claims inflation? In the near term (and the medium term if the Smart People in the ECB follow their Japanese colleagues), especially in the EU countries so enamored of Prosperity Through Austerity, *de*flation will be the event. The only certain source of *in*flation is resource failure (aka, cost push); all else is up to human folly. Well, turning corn into fuel had a signficant effect on the price of tortillas; again, human folly. Changes (increases, by assumption) in technology in medical can be viewed as resource scarcity: more expensive procedures which didn't exist earlier drive up costs (even if they're promoted as cost saving, of course) in the near to medium term. Robotic surgery is prime example; some in medicine are now looking more closely at the claims of superiority. Finally.

From Gesmann's paper:

The RAND Corporation published a detailed review of the dramatic increase in claims frequency and severity of medical malpractice claims in the US in the early 1970s [9]. Its model suggested that the single most powerful predictor of claims frequency and severity is urbanisation.

If ever there were a confounded bit of econometrica, this would be it. Urbanization, per se, is not meaningful; too general to have much use. What matters are the underlying factors of malpractice: nature of procedures (cities provide a wider gamut, thus a higher risk "index" overall), availability of patients for risky procedures (ditto), availability of lawyers (ditto), and so on. If one were to follow the implied wisdom of the conclusion of the study, insurers would only have country doctors as clients.

The major driver of insurance profitability is clever contracting and thus limiting payouts. Followed by interest rates. With the Greenspan/Bernanke monetary lever to motivate economic recovery, bond earnings have diminished. To the extent that insurers by law, regulation, or preference hold primarily/only bonds as investment instruments, they will forgo non-premium income (and would need sharp minded investment offices to manage an equity portfolio, hopefully not A London Whale) and rely more than historically on premiums, raising same. This will drive out marginal clients, incrementally, thus reducing the pool, and putting yet more pressure on premiums. Rinse, repeat. In other words, even the 1% need ObamaCare; in extremis even they won't be able to afford insurance which covers only them. Who'll cover the amortization of all those MRI machines, and the like? I suppose the Koch brothers can buy one for themselves.

Historically, *flation really is global, and is thus reflected in returns on investment. To the extent that technological change is drawing out payback periods, especially for "new" tech, (and by simple arithmetic) thus lowering real rates of return, having investment income to subsidize premiums may be coming to an end. (Aside: real returns on physical capital are what matter, and should governments raise risk-free interest rates to satisfy financial services companies, this will siphon off yet more moolah from real investment. It's a zero-sum game, I'm afraid.) To the extent that the political Right hacks away at the middle classes, thus shrinking the size of the insured pool (insurance, by definition, is pooled risk) *flation will be the by product of competing forces; on one hand insurers continue to evict marginal clients (thus reducing payouts; perhaps greater than lost premiums), while on the other socialized insurance (to whatever extent) pays for those evicted. Socializing costs, while privatizing profits.

And there is, by the bye, little evidence that long-term interest rates must needs be higher than short-term rates since long-term projects are, by definition, riskier. They're not. In fact, The Great Recession was motivated by fiddling in the short-term rate venue. The risk of a project rests in its physical reality (if any), not financial engineering. The real interest rate is solely determined by technological change, as it is embodied in new, superior, plant and equipment. To the extent that technological change turns out to be log on time, rather than (non-)linear, coupon clipping will survive only by force of law. The economics and engineering determine the real outcome.