Max Scherzer and the Incentives to Self Insure by Dave Cameron June 9, 2014 Over the winter, Max Scherzer turned down an offer from the Tigers that would have paid him $144 million over six years, and instead, decided to play out his final season in Detroit and then see kind of offers he will get as a free agent. Given pitcher attrition rates, Scherzer was certainly taking on a significant risk to pass up that kind of contract. Jeff Zimmerman’s research pegged Scherzer as having a 31% chance of landing on the disabled list at some point in 2014, and a significant injury likely would have forced Scherzer to forego pursuing any kind of long-term deal this winter. By turning down the offer, Scherzer appeared to have made a big bet on himself and his future health. However, as Scherzer noted to Tom Verducci over the weekend, he actually hasn’t taken on nearly as much risk as we might have thought. Instead, he sold the risk to an insurance company for what was presumably a better rate than the one the Tigers offered. And I fully expect this to become a trend, with third-party insurance agencies stepping in to correct a market imbalance in Major League Baseball. As I noted back in February, the outcomes on recent long-term extensions have skewed very heavily in the favor of Major League teams. There have been a handful of pre-free agent contracts where the player made out better than they would have had they not signed the deal, but most of the time, the players have ended up leaving money on the table. And often, quite a lot of it. The argument in favor of these deals — and one that is trotted out every single time a player signs a team-friendly extension — is that the marginal utility of the first few million to a player dwarf the utility of all subsequent millions. By guaranteeing themselves $10 or $15 or $20 million in future income, the player no longer has to worry about finding a post-baseball career, and can live comfortably without fear of an injury or other factor derailing their career before they get to arbitration or free agency. This argument has merit, as the value of a dollar certainly has some diminishing returns once you get into the kinds of paychecks that Major League players make. The hundredth million isn’t worth the same as the first million. But that argument fails to capture the nuances of the risk/return market, and ignores the fact that MLB teams themselves are not the only party willing to buy risk. The options for a player are simply not limited to taking a long-term deal from an MLB team or personally carrying all of their own risk until free agency. And as long as Major League teams are making offers to players that put too low of a price on the risk that the player is buying, players like Scherzer are going to be incentivized to look for secondary risk-purchasing markets. And that’s what insurance companies specialize in. We might not think of it in these terms, but each of us sell personal risk to insurance companies every year. Auto insurance is required by law, but odds are, you probably have more than the minimum coverage on your vehicle, so you have willingly sold some of your risk of getting into a car accident for some percentage of your monthly income. The same is true with homeowner’s or rental insurance, health insurance, life insurance, and even pet insurance. As human beings, we generally have a desire for stability over the unknown, and we’re willing to trade some of our income to hedge against disaster events. Large corporations fill the market with products that essentially transfer risk from an individual to an investor, and these companies are very good at pricing risk so that the aggregate of their premiums collected return a higher rate than the policy claims they pay out. From an investor perspective, there is little practical difference to selling someone insurance versus buying stock in a company or a fund; they are essentially looking for a return on their investment that outpaces market averages or brings a lower rate of risk for that same level of return. There are billions of dollars being invested every day, and everyone is after the same goal; the best possible return for a given level of risk. Of late, Major League teams have been buying the risk of future injury or performance decline at severely discounted rates, and that kind of market inefficiency begs for competition. The prices that players have been selling their risk for have to look very appealing for risk-seeking investors, and third-party insurance companies are drawn to any market where risk and reward are not in balance. Since Scherzer is the most recent player to publicly note that he self-insured, let’s look at how the risk-pricing calculations might work. Let’s create an outcome probability matrix based on Scherzer’s profile. Outcome Occurance Percentage Expected Future Contract Stays healthy, performs better than 2013 15% $200,000,000 Stays healthy, performs same as 2013 20% $190,000,000 Stays healthy, performs worse than 2013 25% $160,000,000 Stays healthy, performs much worse than 2013 10% $100,000,000 Minor Injury, performs well when healthy 10% $150,000,000 Minor injury, doesn’t perform as well 10% $80,000,000 Major injury, value tanks 10% $30,000,000 Weighted Average 100% $144,000,000 Since this is more of an object lesson than a break-down of what Scherzer should sell his risk for, these numbers are made-up, but I think they have some basis in reality. And, not coincidentally, the weighted average comes out to $144 million, the amount that Scherzer turned down from the Tigers; these are the kinds of outcomes you can get when you make up the numbers. We could say that perhaps the Tigers calculations looked something like this, even if they didn’t lay it out exactly this way. This matrix gives Scherzer a 70% chance of staying healthy all season — with various outcomes relative to his 2013 performance within that range — and then a 30% chance of getting injured, with different levels of injuries and performances requiring differently sized discounts. I set his base level pay in the worst case scenario outcome at $30 million, as even if Scherzer’s elbow exploded tomorrow, there’d still be a long line of teams lining up to pay for his rehab as long as they got a few discounted years after he got back from surgery. Short of death, Scherzer isn’t really at any risk of not getting paid some significant amount of money this winter. The only question is how much he’s going to get paid. So let’s say that Scherzer wanted to sell the risk of the negative outcomes occurring, guaranteeing himself a minimum payout of $100 million, with the insurance company agreeing to make up the difference between the $100 million and the amount he is guaranteed in his next deal. Based on this matrix, there’s a 10 percent chance that the insurance company would have to pay him $70 million, a 10% chance that the company would have to pay him $20 million, and an 80% chance that they wouldn’t have to pay anything. Thus, a $100 million guarantee would be a break-even proposition for the insurance company with a $9 million premium. Of course, there’s no incentive for the insurance company to just break-even, as they’d need a significant return on their money in order to invest in Max Scherzer instead of just parking their money the market. At a 15% return on their money, they’d ask for $10.35 million. So, using our totally made up numbers, Scherzer could agree to pay just over $10 million out of the total value of his next contract and have no risk of earning less than $100 million. The policy would reduce his top-ending potential from $200 million down to $190 million, but as everyone always argues, what’s the practical difference between $190 and $200 million anyway? This way, Scherzer gets to test free agency, pick where he wants to spend the rest of his career, and have no concern that an injury is going to cost him the monstrous payout he’s in line for. Obviously, the risk profile and future expected dollars are going to be different for every player, but policies like this are almost certainly cheaper than taking the kinds of long-term deals that MLB teams have been offering of late. Players who have not yet made enough money to support their family for the rest of their lives should be incentivized to sell a portion of their risk, but the prices MLB teams have been putting on that risk simply doesn’t reflect a balance between risk and return. MLB teams aren’t the only ones with money who want to buy risk. Until teams start making offers that are more aligned with the actual risks the players are selling, there’s going to be a market for third-party insurance companies to step in and take advantage of the inefficiency. The market for buying and selling risk is very well established, and the prices that outside parties will pay to relieve a player of his risk-burden are likely much cheaper than the discounts MLB teams have been offering players in order to sign long-term contracts. A long-term deal with a team can come with some ancillary benefits beyond just guaranteed money — no-trade clauses being a big one — but the primary reason players have been taking these deals is to rid themselves of disaster risk. But you don’t have to sell six, seven, or eight years of future incomes at discounted prices to divest yourself of disaster risk, and neither should Major League players. If the teams themselves aren’t going to offer competitive prices for the risk carried by a player, then perhaps third-party insurance companies will correct the market for them.