The report on the failings of the life insurance industry raises the wider issue of how we regulate markets throughout the economy.
The headline ‘life insurance firms put sales and profits ahead of customers’ is a troubling one. It summarises a report by the Financial Management Authority (FMA) and the Reserve Bank (RBNZ) which concludes that some life offices have often been working against the interests of their clients. My troubling does not arise because the proposition is false; it is almost certainly true. But it is very subversive to the standard way we think about the economy. .
Consider Adam Smith’s
'He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was not part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.'
Couple this with
'It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages.'
There is an ideology that draws on these sentiments to argue that the pursuit of profits is always in the consumer’s interest. Clearly the FMA and the RBNZ do not agree.
(Neither did Adam Smith. Note the ‘frequently’ in the first quotation, which is sometimes left out by those who use it. Moreover, it is rarely mentioned that the first quotation is in the context of businesses ‘preferring the support of domestic to that of foreign industry’, which is hardly making a case for the open economy.)
Yet the notion that the best economic outcome arises from each economic agent seeking its own interest is hardly controversial. We frequently assume that if someone pursues their own interest, the economy will benefit. This applies not just to the butcher, baker, brewer and insurance company. Have you noticed how the defences to concerns about the environmental pressures from tourists are from those whose self-interest is profit from a bigger tourist industry?
Non-ideological economists have struggled for two hundred years over the strengths and weaknesses of the invisible hand – of letting market transactions be dominated by self-interest and profit. Their broad conclusion is that often the mechanism works reasonably well, providing there is an appropriate regulatory framework. The FMA/RBNZ report says that the life insurance industry has not got one.
The problem is that there are hidden assumptions necessary to make a market work properly. Here is a list with some brief illustrations (not all apply to life insurance).
Many are what are called principal agent conflicts. Often the consumer (principal) depends upon the supplier of the product, service for advice (the agent) to act in their interests. They may not.
For instance, financial advisers before the GFC pretended they were giving independent advice but they were getting a kickback from the finance companies they recommended. Did they tell you? Would you have trusted their advice if you had known?
Incidentally, I was surprised there is no general provision in law that someone giving advice is required to tell the customer where there is a conflict of interest. As far as I know, no financial advisers were sued. Perhaps it is too complicated given that the whole economic mechanism is based on self-interest.
A particular problem arises from the asymmetry of information between the principal and agent. This applies to financial advisers but a starker example occurs in medicine. A doctor knows much more than you do. You trust that your doctor’s advice is independent but how do you know that the recommended treatment is objectively of little benefit to you but financially benefits the doctor? This ‘supplier induced demand' may not be widespread but it is common enough to be a concern in health policy.
This was a part of the concerns in the early 1990s about the ideological proposal that the medical sector should be commercialised, so that the profit incentive would become dominant. (As an aside, a recent study found it very difficult to identify anyone who owned up to supporting the redisorganisation. Some of those involved had to rewrite history to hide their culpability.)
For a market to work properly, the principal needs to be informed and rational. We’ve already seen the difficulties of being informed – sometimes the agent/supplier will actively confuse the information. (For instance, putting key caveats in fonts too small to read or in complex legal language.)
As for rationality, we know that decisions may not be time consistent. Which is why some transactions have a cooling-off period.
A couple of technical issues important in insurance schemes are moral hazard, where the principal knows something the agent does not (applying for life insurance when one has cancer) and adverse selection, in which the agent excludes people who may prove costly (so a disabled person cannot get insurance).
When these problems are acute, as they are in the medical and insurance industries, it is necessary to have additional laws and regulation, which is what the FMA/RBNZ report recommends..
Other parts of the finance industry have also proved problematic. Only last year some trading banks proved to have incentive schemes which encouraged bank officers to behave against the interests of their customers. (I was especially appalled because it was these sorts of schemes – although grosser – in America which contributed to the impact of the GFC. The recent report on Australia’s financial industry suggests it is far more heinous than ours.)
Another instance is that you were thought to be protected from losing your funds in a trading bank crash, by their publishing detailed accounts by which depositors could judge the bank’s soundness. Yeah, right. The appalling behaviour of financial advisers before the GFC has already been mentioned.
Why are medicine and finance like this, but not bread? Bread purchase is a regular transaction; if you make a mistake the cost is small and you can learn from it – changing the shop or the line. (That there is competition among bakers helps.)
Medicine, finance and some other products (such as housing; remember leaky buildings) are different because transactions are rare, the cost of a bad decision is high, and one needs considerable technical knowledge to make a quality decision. So they have to be regulated more intensely.
The thrust of this column is to stress that it makes sense to use the market mechanism driven by self-interest in many parts of the economy. But frequently it requires special regulation. In some places, self-interest needs to be played down. I do not mind my doctors having a decent income, but when we are making a decision I trust that professionalism, not profit, is dominating their advice.
There are other areas where I find the case for self-interest, profit and competition unconvincing – education is a big public-sector one. Ideally I would like transactions in the rest of society to be based on cooperation and trust. Many are, but the rigorous use of the pure market mechanism in the economy has, regrettably, trickled through into our social relations.
Ultimately the market mechanism – whose greater use I was advocating in the 1970s when it was unfashionable – is a means, not an end.