Insurance And Private Defense In Chaos Theory

I’ve recommended
Bob Murphy’s Chaos Theory
as a book that will stimulate readers to think about free market alternatives to
government. But I have serious reservations about Murphy’s overall scheme for a market
based society because it relies on insurance to do things that insurance won’t do. From
cover to cover Murphy offers insurance as the glue which will hold a free society
together.

The idea that insurance can provide market
solutions to certain crucial problems goes back at least to The Market for Liberty written
by Morris and Linda Tannahill in 1970. In the second half of Chaos Theory Murphy offers
essentially the same market solution for defense that the Tannahills do. In the first half
of his book he spins even more elaborate insurance schemes, but I believe his interest in
market solutions insurance could provide probably had it’s origin in consideration of
proposals for defense like those offered in The Market For Liberty. So I will begin my
critique there.

Insurance is central to defense in the society
Murphy envisions:

"In an anarchist society committed to
the sanctity of private property and contract, insurance companies would most likely
oversee defense services."

It’s certainly natural that people will seek
to be insured against the damages of foreign invasion, and Murphy sees this as the first
step toward the solution to the problem of defense.

"Like natural disasters, wars bring
widespread death and destruction. In market anarchy, insurance companies would provide
coverage for these losses too, and would thus have a great financial interest in deterring
and repelling military attacks."

Murphy then asks us to consider a society that
starts with no collective defense. People will want to be insured against invasion, but
the price of insurance will be very high, and insurance itself will do nothing to protect
the people.

"In this bleak situation, an executive
at the Ace insurance company has a brilliant idea. He can undercut his rivals and offer
the same level of coverage for only, say, 5,000 per person – half the price charged by his
competitors. He can afford to do this by spending some of his revenues on military
defenses, and thereby lower the probability of foreign conquest. For example, he might pay
private defense agencies $40 billion per year to maintain helicopters, tanks, trained
personnel, etc. and be on the constant alert to repel any attacks. If these preparations
reduced the chance of foreign invasion to only, say, one-half of one percent per year,
then they would "pay for themselves." The innovative insurance executive would
reap huge profits and capture the market for military liability, while the residents would
enjoy increased security and lower premiums. With property safe from foreign
expropriation, investment and population growth would be stimulated, allowing greater
economies of scale and further rate cuts."

This "brilliant idea" is in fact a
recipe for driving the Ace insurance company into bankruptcy. Producing defense will not
enable Ace to charge lower prices than it’s rivals, quite the opposite is true. If Ace
produces defense which lowers the chance of public invasion all of Ace’s competitors will
cut their prices to take full advantage of the new situation. And they will be able to
charge less for insurance than Ace, because they don’t have to pay for the overhead of
actually producing defense.

David Friedman explained this in The Machinery
of Freedom in 1972:

"This is the problem of Morris and
Linda Tannahill’s idea of financing national defense through an insurance company or
companies which would insure customers against injury by foreign states and finance
national defense out of the money saved by financing the customers. Such an insurance
company, in order to pay the cost of defense, would have to charge rates substantially
higher than the real risk justified, given the existence of it’s defense system. Since
people living in the geographical area defended would be protected whether or not they
were insured by that particular company, it would be in their interest either not to be
insured or to be insured by a company which did not have to bear the burden of paying for
defense and could therefore charge lower rates. The national defense insurance company
would lose all it’s customers and go bankrupt, just as it would if it were simply selling
national defense directly to customers who would be defended whether or not they paid.’

As Friedman points out, defense is a hard
problem in the free market because it is a public goods problem. In a free market
producers of defense cannot easily control who receives the benefit of the defense they
produce. There is no magical quality of insurance that enables insurance companies to
profit from producing public goods.

Murphy is aware of the public goods problem.

"Does the above system really avoid
the perennial problem of private defense? That is, can it overcome the free rider problem?
After Ace Insurance entered into long-term contracts with defense agencies, what would
stop a rival firm, such as Moocher Insurance, from undercutting Ace? After all, the
likelihood of property damage would be the same for Moocher’s clients as for Ace’s, yet
Moocher wouldn’t spend a dime on military expenditures. This reasoning is perfectly valid,
yet the case for private defense remains strong."

The reasoning is perfectly valid, which means
that no case has been made. It means that such a plan would result in bankruptcy for any
company that attempted to implement it.

Murphy goes on to talk about factors which may
tend to make the public goods problem easier to solve, but they have nothing in principle
to do with insurance. He says that the market of defense is "lumpier" than
generally assumed which really means that a small number of agencies have the ability to
afford national scale defense even with free riders. That’s nice if it’s true, but it has
nothing to do with insurance. He talks about offers the defense producing agency cold make
to get enough subscribers to make defense profitable. Such offers might well work in
certain circumstances, but again they have nothing to do with insurance.

If two companies are offering to sell defense
to you, why should it matter to you that one of them is your insurance company? The
defense will only be produced if it is profitable to produce in and of itself, and if it
is produced you’ll be able to get a better rate on your insurance regardless of who
produced the defense.

There is no good argument in Chaos Theory to
support Murphy’s assertion that insurance companies would most likely oversee defense.
Some other points he makes on defense are plausible enough, but it is unfortunate that he
chose insurance as the lynch pin of his scheme because it really has no bearing on the
hard problem of defense.

Murphy asks a great deal more of insurance in
the first part of his book; I will address that in another piece.

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