Saturday, June 18, 2005

Slow boil

If you throw a frog into a pot of boiling water it will jump right out. But if you drop it in a pot of warm water and slowly turn up the heat, the frog will stay put until it perishes.

This cruel science experiment comes to mind as I think about the institutions that we have been conditioned to think are protecting us. Yesterday more evidence emerged of the frailty of our financial identities – as 40 million credit cards processed by CardSystems Solutions were hacked --
14 million of which were MasterCards.

The fundamental source of the problem, in my view, is insurance. Or more specifically, the notion of risk pooling which implies that all insured pay the same premium to cover the claims incurred by a subset thereof. How does this apply to MasterCard? If, say, 40,000 of those MasterCard holders find a total of $4 million in fraudulent charges on their July statements, MasterCard claims it will not require the cardholders to pay the charges. This statement, however, is not consistent with reality. What will happen is that MasterCard will shift the costs to the merchants whose goods are fraudulently purchased. And the merchants will raise their prices to consumers to cover the costs.

MasterCard will thus use the principle of risk pooling to shift the claims of a subset of its cardholders to all of them. According to a Gartner analyst Aviva Litan, MasterCard will not pay the price, “The sad truth is that the card companies could easily contain the potential damage by shutting down the affected accounts and issuing new cards. But of course they won’t do that because that would cost them around $10 a card. Instead, they will let retailers take most of the hit.”

MasterCard has cleverly disaggregated its functions. Processing is done by CardSystems, whose ownership includes Camden Partners, Equity Dynamics, Principal Financial Group and Edgewater Private Equity Funds. MasterCard is itself owned by its members to whom it licenses the right to issue cards or accept drafts from retailers. By outsourcing responsibilities for its business functions, MasterCard can shift the costs of its flawed security procedures – thereby eliminating MasterCard’s financial incentive to fix them.

Therein lays the fundamental flaw in applying insurance principles to institutions which hold portions of our lives in their hands.

And until society requires those responsible for such problems to bear the cost of fixing them, the incentives to keep things the way they are will continue to exceed the forces to make them better – slowly boiling our blood in the process.


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