Options and Insurance in Public Policy

Over the last fifty years, there has developed a quantitative theory of finance and financial engineering that has implications for how we think and teach in planning. In particular, options and insurance may be understood in practical terms when we think about projects, cost-benefit analysis, and so-called big infrastructure.

Option theory originally developed when it was noticed that securities’ prices seemed to move randomly from day to day. Such a “random walk” may be effectively modeled by thinking of those prices moving diffusively, moving as the square-root of time (rather than linearly, as we think of a velocity,) so that distance is proportional not to time but to the square-root of time. Diffusion is well understood by physicists, and its earliest formulation in terms of molecular motions and collisions is due to Einstein and Smoluchowski.  A securities option is a chance to buy a security at a certain price in a particular future time, and since we have a rough sense of how prices move (diffusively!), we can figure out what to pay for such an option: the so-called Black-Scholes formula. (Prices might move up or down, by the way.)

More generally, the theory of real options, for goods and for prices that might move in other ways for other kinds of goods, suggests that we might pay now for the chance to buy something in the future. So, if we are concerned about getting to work on time, we might be willing to pay extra for the HOV lane not only when we use it, and perhaps for our car being equipped with a suitable sensor, but we might be supportive of its being built even if we expect to use if rarely (to have that option)—especially if many people are willing to pay for such an option. The same might be true for transit, so if many people might want to have that choice of option in the future, if the roads break down or their vehicle is unserviceable, they might be willing to pay a very small amount now or perhaps daily so that such a transit system would be available to them. Hence when we compute benefits of such a projects, we might well include option values of the many rare-users who would appreciate such an option in the future. Similarly, if it were the case that pharmaceutical companies would only develop a medication if they could charge a great deal for it, those of us who are not ill might be willing to pay for its availability some time in the future by allowing such a high price (likely paid by insurance companies) for currently ill patients.

Such an option benefit makes sense if many non-users wish to have that option and are willing to pay (a small amount) for its being available when they need it. If the non-users are 100 times the number of the users, and they are willing to pay 1/1000 of its entry fee or ticket, say every week, it might turn out that the benefits from the option are as large as the benefits from the actual users. Would you pay a penny a week to be sure you could get to work when your car breaks down?

In effect, innovations in medicine or technology might provide insurance benefits. So, when a new procedure or medication is developed, we know that we are covered by such a possibility even if we are very unlikely to actually need it in the next decade, say.  From the insurer’s point of view, a disease (that might affect one of its insureds), one that might cost a great deal to be managed, might well be readily controlled by an expensive medication--in effect, long-term risk is mitigated for the insurer were they willing to pay for the medication when it first appears.

When we learn to think in time in planning, usually we think in terms of a discount rate. But option value might well be an enormous benefit. Of course, the actual numbers are specific to each case.

References:

Darius Lakdawalla, Anup Malani, Julian Reif, “The insurance value of medical innovation,” Journal of Public Economics 145 (January 2017), 94-102.

Julia Thornton Snider, John A. Romley, William B Vogt, and Tomas J. Philipson, “The Option Value of Innovation,” Forum for Health Economics & Policy, 15:2 (2012) Article 5.

Redfearn, C. on Luxury   to be added