When the insurance industry makes a mistake it simply closes the book and starts over.
The leaders (using the term loosely) in Washington don’t see eye to eye on much, but they do agree that the exploding cost for Social Security, Medicare and Medicaid is the number one culprit triggering the burgeoning federal budget deficits and the mushrooming national debt. What they don’t agree on is how to solve the problem.
At the outset, these programs were intended to be just like private insurance programs, calculated to be actuarially sound. Initially, that was the case, but over time the programs have been corrupted by the influence of politicians, not errors on the part of the actuaries. Politicians are like insurance marketing people; they want whatever sells – whatever sizzles – while insurance actuaries want whatever works: namely, solvency. As a consequence, Social Security, Medicare and Medicaid have morphed into programs the people love – especially those who depend on or benefit from them – but are dragging the country down the path to insolvency.
The federal budget deficit has been running north of $1 trillion dollars for the past four years, and there is no sign of a meaningful reduction in the near term. A trillion here and a trillion there and soon you are looking at a significant long-term national debt; like more than $17 trillion dollars. The exact figures are difficult to come by, but conservative estimates are that the mandated benefits for Social Security (20%), Medicare (12%) and Medicaid (8%) take up 40 percent of the entire $3.4 trillion federal budget. Since mandated promises are required by law to be paid, if Congress fails to enact meaningful changes to these programs their costs could rise to 66 percent of the annual federal budget, by mid-century. That is not exactly a tenable financial equation, even in the best of times.
FDR’s New Deal Legacy
When Social Security was introduced in 1935, it was designed as a form of insurance that would provide a “safety net” for senior citizens; 50 percent of whom had fallen into poverty when the Great Depression wiped out the value of their retirement savings. The objective was to provide a modicum of monthly income to retirees, so that the elderly would not become dependent on government relief (paid by taxpayers) in retirement.
What is important to take note of is that the Social Security Act signed into law by Franklin Roosevelt was not intended to be a government welfare program. No, it was an “income insurance” plan that people would be mandated (forced) by the government to buy. Like a private insurance company, government actuaries calculated the anticipated cost of future benefits and divided that cost among those covered by the plan. The participants paid their “premiums” in the form of a “tax” on their income; known as Federal Insurance Contributions Act or FICA. An important distinction was that these FICA payments were not to be comingled with other government funds or expenditures, but held in reserve – like real insurance companies do – in a “trust fund” that would be used to pay for the benefits as they came due.
Initially, Social Security was so soundly designed that by the 1950s and ‘60s, significant surplus funds had accumulated in the trust fund. That’s when the marketing people (the politicians) took over and the actuaries were sent back to their cages. Rather than reduce the premiums (FICA) – as the actuaries recommended – the politicians, in full marketing mode, chose to use the surplus to increase benefits and expand the number of individuals covered; which just coincidently made them look good for the next election. Using Social Security as “voter candy” soon became addictive for the politicians. While FICA taxes were regularly increased, they were never increased by the actuarially equivalent cost of the new benefits. (The politicians also raided the FICA trust fund to pay for other government programs; causing the fiscal stability of Social Security to be further corroded.)
The upshot of the politicians taking over for the actuaries led to easily predictable results. Over the decades that followed, the surplus in the Social Security trust fund was wiped out and the gap between the costs of the benefits promised and the funds available to pay for them, widened into a virtual chasm that now not only threatens the solvency of Social Security, but the fiscal stability and credibility of the federal government itself. Since FICA taxes are not nearly enough to cover the cost of promised benefits, the federal government has to make up the difference with taxpayer funds; which contributes to an increasing budget deficit and debt.
Ditto: Medicare and Medicaid
The history of Medicare and Medicaid is much the same. Medicare was created in 1965 as a “social insurance” program that would assure the availability of health insurance coverage for Americans age 65 and older and for younger people with disabilities. As with Social Security, the intention was to spread the cost of benefits by collecting a “Medicare tax-fee” levied against employees and employers. In general this tax was intended to cover about half the cost of the benefits, with those receiving them making up the difference with monthly premiums (deducted from Social Security payments) and co-pays when benefits were received. Medicaid, though not technically insurance, was implemented to provide health benefits to low income families on a “means-tested” basis. Like Social Security, Medicare and Medicaid started out as fundamentally sound programs that have been degraded by the promise of increased benefits that exceed the funds available to pay for them.
What Would Insurance Companies Do?
When an insurance company discovers it has sold a “book of policies” that is not profitable – because the benefits are higher than expected or the premiums too low – it stops issuing new policies and puts the existing ones in what is called “run-off” mode. Those who purchased the policies in good faith and paid the premiums due, receive the benefits promised; but by ceasing to issue new policies, the insurance company stops the bleeding and prevents the problem from mushrooming into a situation that could threaten the very existence of the company.
The insurance company still has to take its lumps for the unprofitable business it issued. It cannot go back on the promises to the policyholder or increase premiums to cover the losses, but by isolating this business as a “closed book,” the company can quantify the potential loss, reserve for it and ultimately – either by surrender or death – this business will “run-off” and cease to be a problem. (Insurance companies can increase premiums on most health insurance policies, but doing so is often self-defeating. Raising premiums drives away healthy people, leaving the company with higher claims and losses.)
A Common Sense Answer to the Problem
This is the type of approach the government should take with Social Security, Medicare and Medicaid. If an insurance company were in charge of these programs it would take two actions: Isolate the existing programs by not accepting new entrants and allow the existing liabilities to “run-off.” The company would design new, actuarially sound, programs with the cost of future benefits matched by new premiums collected.
In the case of Social Security and Medicare, the government could close the programs and put them in “run-off” mode by cutting off those who are more than five years away from retirement. These individuals could be given credit for “premiums” already paid and then be enrolled in the new programs.
Those currently receiving Social Security and Medicare benefits would continue to do so – with no change in the promises made – for as long as they live. But over time these participants will age and die – causing the liabilities to constantly decline and eventually end. Tax payers will have to cover the current deficiency between promises made and premiums collected, but this cost would be materially less than the rampant increase in costs that would be caused by allowing millions of new participants to benefit from clearly defective plans.
The “new” Social Security and Medicare programs would be designed on an actuarially sound basis with the future benefits balanced with the anticipated premiums (tax) paid by the participants. The benefits offered by the new programs and when they are received, may be different, but unlike the uncertainties of the existing programs, they will be there when needed – and as promised. The participants may have to wait longer to receive benefits and pay more of the cost themselves, but the big advantage is that they will have time to plan and have the certainly that the plan will be there. And, it will not bankrupt the country.
And the Moral of the Story …
In principle, Social Security, Medicare and Medicaid are much like private insurance policies. As such, they should be priced and managed the same way insurance companies manage their business; but they haven’t been and that error is at the core of our deficit and fiscal crisis.
When insurance companies discover that a block of policies is not actuarially sound and is throwing off unsustainable losses, it cordons off that block of business and allows it to run off the books. The company does not continue to sell the same new policies, but rather it isolates the “bad business” so that losses do not continue to grow and eventually overwhelm the entire company. The existing policyholders receive the promised benefits, but the problem is not compounded by continuing to make the same promises to new policyholders.
Then, using the experience gained from the old policies, the company designs new plans. Plans that offer needed and attractive benefits, but based on actuarially sound principles that prevent the company from making promises it can’t deliver and in many cases allows them to deliver more than they promise.
If an insurance company does not follow this formula when it discovers it has written a bad block of business, it will soon find itself swamped in loses that will threaten its very existence; and then what good are any promises? It is a lesson our politicians would do well to learn from the insurance industry.