How Is Insurance Fundamentally Different Than A Ponzi Scheme?

Question

After watching this video from the WSJ about long term care its problem, it seems to indicate the following:

1. Actuaries didn't think people would live as long as they have, so they wouldn't need the full amount of money. In other words, if 100 new people paid into the system, the theory is that only 60-70 of them would collect.
2. Actuaries didn't think that people would live outside of family care, so they wouldn't need that much of the money. In other words, of the 60-70 people who lived to collect, in theory, these people may only need 50% of their payment.
3. Actuaries miscalculated interest rates. Here I give them full credit, as this is not their fault and I can make a strong case that higher interest rates would make sense for long term care, since each payment would be earning interest and wouldn't be fully paid out.

It seems that actuarial science is hoping on two facts outside the sensible action of investing:

1. Most people won't collect.
2. Most people won't need the full amount of their collection.

If we consider a Ponzi scheme where new people pay in while old people get money out, if enough of the new people paying don't make it to become old people getting, in theory, a Ponzi scheme could continue indefinitely. This is further strengthened if enough old people getting don't collect the full amount of what they could be getting.

I know the difference is that insurance actually invests while Ponzi schemes are not, but in looking at the fundamentals of how they function, they both seem to require some eerily similar "hopes" about the people who put in and get out of the system.

Answer 1

Insurance is about pooling risk. Insurance companies will collect premiums from several clients with the expectation that it will pay out to a few clients a grand total slightly less than what it collects. The fact that the actuaries did not calculate the odds of individuals getting more than they paid from long term care insurance does not make it a scheme or fraudulent. It just means that the insurance companies will pay more than they expected, requiring them to raise premiums going forward to account for that loss.

From an individual standpoint, most of the people that carry insurance will not get back what they paid in, but that should be expected - you pay a relatively small amount to be protected in the event that you are one of the unlucky few that needs a larger payout. So your expectation should not be that you will "profit" from insurance.

With a Ponzi scheme, all investors have an expectation that they will get back more than what they pay in. In reality, though, the money taken from a large number of investors is given to a smaller number with the expectation that they will "invest" even more, encourage others to invest, etc.

Answer 2

The difference is that an insurance scheme has to collect enough in premiums and gains on its investments to cover the claims. A Ponzi scheme pays the schemers (and anyone who wants out) with the deposits from new victims, while lying to the existing victims about how much money is in the scheme.

Answer 3

You seem to be speaking of a particular type of insurance, not specifying exactly what it is, and treating it as simply generically "insurance". A full answer would require you saying exactly what sort of insurance you are talking about. For instance, whole life insurance is quite different from term life insurance. Whole life insurance is more comparable to a Ponzi scheme than term is, but that is because whole life involves both life insurance and an element of an investment, and it is that investment part that best admits a comparison to Ponzi scheme. So if you want to know how the investment part of whole life differs from a Ponzi scheme, it would be better to simply ask how investment in general differs from a Ponzi scheme, rather than asking about insurance, which is only tangentially involved.

they both seem to require some eerily similar "hopes" about the people who put in and get out of the system.

One difference is who bears the cost if those hopes don't come through. With a Ponzi scheme, there is no money backing up the obligations, so if it fails, the participants are the ones who lose out. Insurance companies are required to hold capital to back up their obligations, so if their projections end up being too optimistic, they are the ones who lose out.

Answer 4

All investments, not just insurance, involve hope. Hope is just a response to risk, and all investments involve risk. You do research, evaluate opportunities, lay down your money, and hope that your research and evaluations are correct. Actuaries don't just make up numbers like "expected life span of males born in 1956". The numbers are carefully measured, subject to all sort of mathematical analysis, debated and argued about. If they get the numbers right the investment will actually pay off, and provide the coverage their clients purchased. Are they always right? Of course not, but then Warren Buffet isn't always right about what companies will increase in value. When Buffet bought Dairy Queen, he had to make some sort of estimate of how much ice cream Americans would eat in the coming years.

By contrast, somebody running a Ponzi scheme knows that the investment cannot pay off, and their hope is that a miracle will happen, or that they can grab cash and flee before they get caught.

The one area of overlap might be an insurance company that already knows it's insolvent, but continues to sell policies it knows it can't pay on. It happens, and that's why there is usually government oversight of insurance companies.

Answer 5

In a Ponzi scheme, every investor believes that he will receive an extraordinary annual return and, eventually, on demand, the return of his initial invested capital. He has, in fact, been fraudulently promised it.

In insurance, no-one expects any return at all and certainly not the return of his annual premiums. In fact, he hopes that he will never, ever receive a dime! I willingly pay about $1800 per year to insure my car, but I hope and pray every time I drive it that I will not have an accident and collect insurance. I willingly pay my homeowners insurance and yet I’m quite happy if my house doesn’t burn down requiring me to collect insurance.

By pooling risk, the insurance company can collect a relatively small premium from many, perhaps millions of homeowners and therefore pay the claims of the few who suffer losses each year.

Answer 6

Very simply, premium dollars are not investment dollars.

Premium dollars buy a transference of risk and financial liability. Insurers actually pay claims based on that transference of liability.

Ponzi schemes are investment schemes where the schemers lie to participants about the value of their investment then embezzle the money.

Answer 7

The key difference is that life insurance companies, in general, tell their customers the truth about the nature of the product, while sellers of Ponzi schemes lie.

With a term life policy, the customer knows that if does not die within the term of the policy, he collects zero. If you cancel the policy, you stop paying premiums but you get nothing back. You know that the day after the policy expires or you cancel, it is worth nothing. The insurance company does not tell you that if you cancel the policy before you die that they will give you back your premiums and some profit on top of this, and then when the time comes it turns out that was a lie. They tell you up front that if you cancel the policy, you get nothing.

With a Ponzi scheme, the expectation is that you can cash out at any time and go home with a profit. You are not waiting for some essentially uncontrollable and unpredictable event, like your death. The seller of the Ponzi scheme tells you that you can quit at any time and walk away with a profit. But this is a lie. Some early investors make a profit, but most of the investors find when they try to collect that there is no money.

Term life may or may not be a good deal for you, but the time the insurance company honestly tells you what you are paying in and what you will collect and under what circumstances. (Well, honestly 90% of the time. As in any business, there are dishonest insurance salesmen.) With a Ponzi scheme the seller lies to you about how much you will collect and under what circumstances.

If a Ponzi scheme operator told you honestly up front, "I'm making payouts to early investors using money collected from later investors. If you try to cash out early, you can make a nice profit. If you wait too long, there won't be any money left and you'll lose your investment", and you decided to invest on that basis, I suppose it wouldn't be a con game. It would just be a very bad investment.

As @DStanley says, the fact that some insurance companies miscalculated expenses doesn't turn an honest product into a con game. The way insurance works in America, it's unlikely that any customers will not be paid the benefits they were promised. If a department store calculates that they can make a profit selling me a toaster for $15, and so I give them $15 and they give me a toaster and I take it home, and then the store discovers that it really cost them $16 to sell me this toaster so they lost money ... it's difficult to see how you could say that I was cheated or conned in any way on this transaction. Too bad for the store that they lost money, but that's not my problem. Presumably they'll raise the price so future customers will pay more, but again, not my problem.

I suppose that if a Ponzi scheme had enough new customers coming in, and a large percentage of the existing customers didn't try to cash out, the scheme could, theoretically, continue forever. In practice, for a Ponzi scheme to work you have to have ever-increasing numbers of new customers. Eventually you run out of people in the world who could join. But in any case, a Ponzi scheme is based on a lie. If someone gets away with a lie and lives out his entire life and goes to his grave without his lie ever being discovered, he's still a liar.

Answer 8

Possibly useful: Think of insurance as being more like the fire department than like an investment. The ideal case for any given year is that you get absolutely no return in your money. When a disaster hits, though, is too late to go out and create a fire department, so you pay in advance against that risk.

And you pay a relatively small surcharge for the overhead of running the system. Including profits if it's a commercial business, because without profits they wouldn't be there to offer the service. So overall it is expected to be a net cost. You're paying for an extended warranty, not buying something that will make a profit.

(In fact there was a time when fire departments were run by insurance companies. Only those who bought policies would be protected; if you didn't subscribe they would let your house burn while protecting your insured neighbor. Society decided that it made more sense to move that to taxes and nonprofit status and protect everyone, but the comparison is more valid than you might have expected.)

Answer 9

In addition to @DStanley's answer: insurance companies actually invest their premiums. That's why insurance isn't a Ponzi scheme.

(Replace "Insurance" with "Social Security" and then you've got a Ponzi scheme.)