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Not Reassuring

The news that "The Bottom May Be Close" has no reassuring ring to it. The radio this morning revised growth estimates down - according to the OECD recession lasting throughout 2009, and according to Treasury, merely no growth for 2009. On a GDP per head basis, recession either way. In the US the scale of the bailout effort seems to multiply rather than merely add up. At times like these we need friends - but look what they are up to: taxing our tourists out of the skies. If there was ever a tough time to be the new guy in charge it is now, but some people are worried about what the grand new strategy: 'jolting' the economy, according to Barack Obama means. Following up on my criticism of the dim and unthinking use of words (the day before yesterday it was 'credit crunch') I have another contender 'unprecedented'. In fact banking crises are anything but unprecedented. This article explains how things played out last time (in the US) at a consumer level, by looking at the reverse wealth effect.

Getting Out

In honour of white ribbon day - yesterday - here is a good post that typifies the situation met by many women. One of my friends says that if she comes across women who are in abusive relationships they often don't listen to the bald "get out" type of advice so often handed out - so she tries to convince them to "get ready" by talking it over with a close friend, making arrangements for children to be picked up from school by another mother, and preparing a spare set of car keys, money, and vital documents at a different location.

Dead Wrong About Home Affordability

A nice little booster piece in the Herald fails to spot that interest rates and house prices are only two of the three really important drivers of home affordability. The other is the lender's ability to lend. Take the opening paragraph:

The number of people owning their own homes is expected to rise as interest rates fall and borrowers enjoy savings of about $7000 a year on mortgages.

This may be true - eventually - but it won't be true in 2008, and it won't be true in 2009 either. The suggestion that there is a direct relationship between lower interest rates and higher home ownership wasn't even true in 2007 - as house prices were bid up and more people found they couldn't enter the market. So plainly there is more to it than just interest rates. Fortunately, we have one of the Herald's finance writers on the case - so unlike in the politics pages where we could stop here, more work has been done.

House prices have also fallen over the past six months, the business says, and 10 per cent to 15 per cent discounts are not unusual.

Yep they have. Of course, apartment prices have fallen by about 30% in places, and houses - especially entry level homes - by less than the 10% to 15% quoted. But let's take these figures as given. But has affordability improved? We get treated to a number of unchallenged press release statements such as:

"This is particularly important to first-home buyers, because each 1 per cent drop in rates means considerably more people can enter the market."

So if my purchase price is lower, and my interest cost is lower, then surely it will be cheaper for me to buy a house?

Well, no, actually, it won't.

This is because a year ago ABC bank would cheerfully lend you 95% and sometimes as much as 100%. Today after a flurry of criteria changes including servicing levels, eligible income, and maximum loan to value ratios that are too complicated to go into in detail you will be lucky if the average borrower can get more than 80% on a first home purchase.

Here is an example:

In October 2007 Jack and Jill had saved $20,000 and were looking at buying a home on the outer edge of Auckland's North Shore. Using a 95% home loan they could have just about bought a home costing $400,000 (ignoring certain other costs which family might have helped out with). They hunted around, couldn't find anything they really wanted at this price and left it...

...cheered by that Herald article they hit the streets again. During the past year they've saved a bit more. Now they have $30,000 - a near miracle given rising living costs. They actually found a house that they'd looked at for $420,000 back on the market and the desperate real estate agent has let slip that it can be had for $375,000 a biggish drop of 12% - as the owners are in trouble.

Based on what they learned last year Jack and Jill sign a conditional agreement and head back to the bank. This time they only need a 92% loan - and interest rates are much lower. The problem is that the bank won't lend them 92%. They head to the mortgage broker - who has seven fewer lenders than last year. He shrugs his shoulders - he has one lender who will do the loan, but at a rate they can't service.

To get their loan they now need to have a $75,000 deposit. They were closer to owning a home in 2007 than in 2008. Affordability for new home buyers is worse, not better. That drop in interest rates can only bring cashed up buyers into the market - if they fancy it has fallen as far as it will.

You sometime wonder whether people use the term 'credit crunch' without ever wondering exactly what that means. Well, Jack and Jill will find out - but not from the Herald.

Bad news.

Keep the computer in the back room

News from the US that Physicians that use decision support systems are perceived to be less 'physicianly' by their clients is no surprise for some of us. Despite being a big fan of technology I have come to a more nuanced view of how it should be used: it can be summed as "As much as possible" but ALSO "not in front of the client".

The question of client perception is one dimension of that. The other question is focus. Is it on the system or on listening to the client and focusing on their requirements. Link.

The question that nags away at a fair number of clients with obvious dependence on systems is - how hard can this be? Does this adviser just load the data in and tell me the answer? Heck, I could just go to a website maybe and get it cheaper...

Why Life Insurance is more popular

The following is an excellent post by Brian Lenehan at Asteron on why people tend to buy life insurance - even though it is not such a good 'bet' than, say, medical or disability insurance. I particularly appreciate the theory of risk that peopleare prepared to take small losses - but not large ones. This helps explain at the same stroke both why life insurance is preferred, and disability or medical not so. First, here is the question I posted:

Why don't people insure what's important? Let me give you an example: they insure their lives with greater frequency than they insure either their health or income. Given the greater probability of an insurable event, and the fact that the latter two have worse claims rates (meaning insurers pay out a greater proportion of the premium in claims) they are clearly the better deal. 
In simple terms my humble Lidunian view it is a matter of perceived value relative to actual value. Goods can be compared and ranked according to which good provides the most utility which is what perceived value broadly represents. The second related reason is that the shape of the utility curve varies. For large losses people are risk averse and for small losses people are more likely to be risk takers (this also explains why we have gambling and insurance)
When we spoke I said I remembered a paper by Rose Friedman related to this. Well my memory failed me as the paper was by Milton Friedman and Savage (see references below). By the way Friedman (like Warren Buffett aspired to be an actuary in his youth)
Actual value and perceived value often vary. There are some studies (http://research.nottingham.ac.uk/NewsReviews/newsDisplay.aspx?id=145serach) which show people generally underestimate their life expectancy (they overestimate their mortality risk) and as such the perceived value of life insurance may be higher than the actual value. Other things being equal these leads risk averse people to seek out life insurance which they see as having a high perceived value.
I am not aware of whether people underestimate or overestimate morbidity risk (covered by health / income insurance). If one sets as an hypothesis that morbidity risk is underestimated then health / income insurance will have a perceived value less than the actual value.
So there we have it - higher perceived value relative to actual value (reflected in price) leads to higher demand.
A second explanation relates to utility theory. This is of course the whole basis of insurance. Without wishing to teach you to suck eggs the theory is that individuals may be risk averse and as such insurance allows them to maximize their utility by reducing risk. That is simple enough. Further studies (starting off which the Friedman / Savagae paper) show that people are both risk averse and  risk takers along different parts of the curve (risk averse for large losses and risk takers for small losses). Friedman / savage used this to explain by people have demand for both insurance and gambling. Insurance (in particular life insurance) relates to the risk of a large loss (economic loss of death). For large losses individuals were shown to be risk averse and this leads to the demand for insurance. Gambling involves the probability of a small loss countered by a small chance of large gain. Friedman / savage argued that for small losses individuals are risk-takers and this leads to a demand for gambling.
Now back to your point. Both life and income protection insurance generally cover a large potential loss and for this individuals are supposedly risk averse. This means individuals should rationally purchase life and income insurance.
Health insurance is (generally) covering smaller cover levels. Following on the logic this involves a relatively small potential loss and the individual is less risk averse and potentially more risk-taking. As such the need for health insurance (in terms of a rational person maximizing utility) could be rationally explained as being less than for life and income insurance.
Brian Lenehan
Eden, Benjamin: 1977,  The role of insurance and gambling in allocating risk over time , Journal of Economic Theory 16, 228–246.
Friedman, Milton and Savage, Leonard J.: 1942,  The utility analysis of choices involving risk , Journal of Political Economy 56, 279–301.
Friend, Irwin and Blume, Marshall E.: 1975,  The demand for risky assets , American Economic Review 65, 900–922.
Markowitz, H.: 1952,  The utility of wealth , Journal of Political Economy 60, 151–158.
Szpiro, George G.: 1986,  Measuring risk aversion: an alternative approach , Review of Economics and Statistics 68, 156–159.
Szpiro, George G.: 1987, The decision to buy or sell insurance under constant relative risk aversion, The Geneva Papers on Risk and Insurance 12, 34–36.
Friedman, Milton and Savage, Leonard J.: 1942,  The utility analysis of choices involving risk , Journal of Political Economy 56, 279–301

Insurance Ninja

My son has just had his wrist put in plaster. An accident coming off the monkey bars at school. This may have something to do with the fact that when I ask him what he wants to be when he grows up, he says "Ninja". Funny how it isn't "Consultant to the Insurance Industry". Maybe he just wants to be more hands on with risk.