Why The Government Will Lose Money By Insuring Toxic Assets


When the government proposes to insure troubled mortgage related assets on the balance sheets of banks, it will almost surely downplay the eventual payments and overplay the value of premiums the bank will pay.

“The taxpayers could actually make money on this insurance,” some will say.

But the truth is actually the opposite—the insurance premiums will likely be too low, and the payouts much higher than expected.

A big part of what makes insurance an attractive idea is that people confuse how private insurance companies make money and how the government operates.  But a government can’t run itself like an insurance company, and the differences mean the government will almost always lose money on insurance schemes.

First, let’s review how insurance companies make money.

It’s often thought that insurance companies are just placing bets against their customers. So, for instance, when someone buys life insurance that person seems to be betting that they’ll die early enough that they won’t have paid out in premiums the full value of the insurance settlement. This is more or less true.

Where people screw up is assuming that the insurance company is taking the opposite side of this bet. They think the insurance company only makes money if the customers live long enough that they’ve paid more in premiums than the settlement. But that’s not how insurance companies work. In fact, almost all premiums are set low enough that if the insurance company were entirely dependent on those, they’d lose money on every policy.

So why aren’t insurance companies broke? Because they invest the money they get as premiums. Insurance companies sell insurance policies but their real business is investing. Think of an insurance company as an investment company that raises money in a peculiar way—by offering to pay people large sums when they die in exchange for a piece of their current income.

The plan to provide a government backstop for the value of troubled assets will also have to charge low premiums. No bank would buy insurance if it were priced to cover the expected sizes of the losses. In fact, doing so would be insane. They’d be handing over a solid asset—cash—for a guarantee, which will be discounted against the idea that the government may not make good on its promise. Why not just take the losses when they come and use the money in the meantime to make investments? The premiums will have to be low because no matter what level the expected losses are, it only makes sense to buy insurance that is cheaper than that.

Unlike an insurance company, however, the government is not an investment company. It will simply spend any premiums it collects are part of the general revenue. Even if it did somehow attempt to invest the premiums, there’s no reason to think the government would get a return high enough to make up for the shortfall.

No matter how you cut it, the government will almost certainly see a loss on this insurance portfolio.