The End of Insurance as We Know It

by Rob Galbraith

  •billing options including payment plans, account balances and payment status

  •account reviews to ensure adequacy of coverage and protection gaps

  •general inquiries related to coverage and many other items

  These activities are performed using a mix of channels including (but not limited to) a licensed agent, a customer service representative (CSR) in an agent’s office or call center, via an automated phone system, on a website or mobile app. These activities in total represent a large volume of transactions for agents, brokers and carriers, and beyond physical documents and the ephemeral “piece of mind” they represent the majority of value to policyholders. However, these “services” are not equivalent to a service that, on its own, is worth paying hundreds or thousands of dollars for. Rather, these services are a function of the insurance product itself: they are utilized by consumers to access, retain and customize their insurance product. Unlike claims service, servicing a policy in an insurance context represents a means to an end, not an end in itself.

  So it’s settled: insurance is a good whose largest benefit is great claims service. Confused yet? If it were a relationship status on Facebook, we’d have to classify insurance as “It’s Complicated.” On top of the good vs. service debate, there is the element of time that makes insurance complex. For most products and services sold for a profit, businesses first determine how much the good or service is going to cost. Businesses then decide on a price to charge that covers their costs plus a profit margin. Sure, there are complex pricing algorithms for things like hotel rooms, airline flights, rental cars and the like, but the costs are still well known to those companies beforehand. Not so in insurance where the largest product cost are paid claims (losses) and the accompanying loss adjustment expenses (LAE).

  Insurance carriers do not fully know the “cost” of the product until after the policy period is over, all of the claims have been reported and adjusted and all of the losses have been paid. This entire process is known within the insurance industry as loss development. Depending on the line of business and type of coverage, the loss development process can take months or even years after a policy term is up before the ultimate losses are known.

  Insurance carriers rely on loss reserving actuaries who use a variety of statistical techniques to estimate what ultimate losses are expected to be and ensure that carriers are retaining enough loss reserves to pay all claims on policies written in a given policy term. However, the fact remains that until every last claim is paid and closed, the true cost of providing insurance coverage is not fully known. At the point that ultimate losses (i.e., product costs) are fully known, it is well after the premium has been collected from the policyholder. Carriers, regulators, rating agencies and others are relying on the accuracy of those actuarial techniques to ensure that the premiums charged are more than sufficient to cover the associated losses from the policies that are sold.

  GO ON, TAKE THE MONEY, AND RUN

  From the policyholder’s perspective, a cost versus benefit discrepancy of sorts exists as well.Policy premiums are usually due, partially or in full, at the inception of the policy. Rarely does anyone get “free” coverage in insurance! It’s not an unusual scenario that a policyholder pays their annual premium in full up front but not incur a loss until almost a year later near the end of their policy term. What’s to guarantee that the insurance company will even be around to settle your claim when a loss occurs? A disreputable insurer could be off with the money collected as premium and getting any sort of recovery is highly unlikely, even if you were to sue them and win a settlement in court.

  This possibility of insolvency has been a reoccurring challenge throughout the long history of insurance. This prospect has led to the need for regulation and guaranty funds provided by the government to cover any insured losses that should rightfully be covered by an insurer who is unable to pay the claim due to insolvency. In response to prodding by the federal government in the late 1960s exploring the establishment of an insurance equivalent of the Federal Deposit Insurance Corporation (FDIC) which supports bank deposits for consumers in the event of a bank failure, the NAIC developed a model law which led to all U.S. states having a guaranty fund by 1982.[35] However, the 1980s saw a large rise in the number of insurance insolvencies which led to additional model reforms by the NAIC including risk-based capital (RBC) standards, financial regulation accreditation standards and progress towards codifying statutory accounting standards.

  Even if an insurance carrier is not intentionally committing fraud through a Ponzi-scheme type setup, insolvencies can still occur due to a lack of adequate loss reserves being set aside to pay claims. A noteworthy example is the impact that Hurricane Andrew had as a Cat 5 making landfall in south Florida in 1992. The total damage was over $15 billion in insured losses, an amount that exceeded all of the insurance premiums ever collected in Dade County. Eleven insurance carriers went bankrupt. The impact could have potentially been even more devastating if Miami had been hit worse - it could have bankrupt the entire industry.[36] Afterwards, it became common practice in the insurance industry to use rigorous statistical catastrophe models to simulate the financial losses from large catastrophe events such as hurricanes and earthquakes to incorporate an appropriate catastrophe load into rating rather than solely relying on historical losses within a 3-5 year time horizon.

  A more recent example of the potential for insolvency and how opaque the business of insurance can be is the bailout of AIG that occurred during the Great Financial Crisis of 2008. A notable difference for the AIG bailout as compared with banking institutions is that AIG was a large and international insurance company that did not make bad loans but rather provided an unregulated product called credit default swaps (CDS) as a side part of their main insurance business. These credit default swaps were highly complex financial derivatives bought for the purposes of “insuring” the value of assets contained within collateralized debt obligations (CDOs) that are securities based on underlying assets such as auto loans and home mortgages. Specifically, the credit default swaps on subprime mortgages were held by a number of financial institutions and AIG’s failure would have made those assets worthless, causing a chain reaction. Because of AIG’s interconnection with innumerous counterparties, which in turn were also connected with many other counterparties, the Federal Reserve and the U.S. Treasury orchestrated a bailout of AIG that totaled $182 billion in the end. Fed Chairman Ben Bernanke noted that AIG had operated like a hedge fund using the money it received from its clients’ insurance policies.[37]

  PARLEZ-VOUS LEGALESE?

  In addition to the introduction of insurance regulation, insurance has been a formal, legal contract between two or more parties (regardless of century or country):

  an insurer, who assumes the responsibility for paying economic damages due to a covered loss

  and

  an insured, who pays a fixed premium amount for the life of the contract in return for the promise of this downside financial protection.

  Early agreements may have been settled on a handshake, but for centuries, insurance has been a binding legal contract that is ultimately enforceable through the judicial system. This ability to hold insurers accountable in a court of law provides insureds with a strong incentive to buy into the insurance system by instilling faith and trust that otherwise would be extremely hard to build in a relationship between insurer and insured. Furthermore, the legally binding nature of insurance along with a strong regulatory environment provides enough trust in the entire system that consumers can shop around with insurers who are competing with each other on price, features and service - not whether they will pay a legitimately covered claim or not.

  This trust in the guarantees made to each other in the insurance contract and reliance on the legal system to remedy any disputes was hard-earned. Typically, contracts represent a mutual understanding negotiated by both parties. By contrast, when it comes to insurance, the legal contract does
not (usually) represent a unique agreement between the insurer and insured that is unlike any other agreements. That would be a highly inefficient way for the insurance marketplace to work, and most consumers would have no clue where to begin to even negotiate such an agreement even if they wanted to.

  Instead, insurance is considered a contract of adhesion, essentially meaning that the insurer (as the “expert” on insurance) is responsible for drafting all of the terms and conditions within the insuring agreement and the result is a “take it or leave it” proposition for the insured. Even in cases where an agent or broker is involved on the part of the insured, the insurer will generally make the final call. Brokers and agents can help to “translate” the contract and the needs of the client, but they are often selling a product that they are unable to modify. There may be some options or endorsements to the standard contract language that can be selected, but for the most part the insured does not have a lot of say in the drafting of the contract language.

  One implication in the legal system for contracts of adhesion is that because the insurer was solely responsible for drafting the contract language, there is an imbalance of power that favors the insurer when it comes to interpretation of contract language. To address this, any ambiguities in the contract’s provisions are resolved in favor of the insured. Because of this, insurers attempt to draft contract language that is clear and unambiguous. How successful are they? The answer is worthy of an entire Insurance Nerds book on its own. Thankfully, one exists! To find out and learn a whole lot more about what goes into an insurance contract and claims disputes, I highly recommend the educational and entertaining book When Words Collide by Bill Wilson.

  While writing legal contracts in precise and technical language may be advantageous for resolving legal disputes, it is far from ideal for ordinary consumers attempting to understand whether they have appropriate coverage or not. Insurance contracts are long, dense documents that are hard for insurance professionals, including agents and claims adjusters, to understand, much less the typical consumer. Contracts often have to be filed and approved by regulators, and many contracts have been standardized for ease of business by third parties such as the Insurance Services Office (ISO, now a part of the Verisk corporation) or the American Association of Insurance Services (AAIS). However, carriers do compete on contract provisions and features, and many have their own proprietary agreements, so consumers should follow the advice of Bill Wilson and RTFP - Read The Full Policy.

  STOP BEING SO NEEDY

  As a consumer faced with the daunting task of understanding their insurance policy and making sure it sufficiently covers all of their exposures, can you simply trust that the insurer has included everything you’ll need in their standard contract? Ideally the answer would be “yes” but the true answer is “often no”. For some basic risks such as an auto or renters policy, it is possible that a standard policy covers the vast majority of consumers to a satisfactory degree. In the abstract, the more likely answer is that not every exposure that a consumer has is fully covered in the event of a loss.

  There are several reasons why this could be the case, including that the damaged item or items are:

  Got that? The point is that insurance is a legal contract, with precise language to avoid ambiguity. This results in a contract that is difficult for non-insurance professionals to understand. It’s like building furniture from IKEA; simple in theory; complicated in reality.

  Based on how complicated insurance contracts are, even professionals need rigorous training to understand them. Insurance agents and claims adjusters both require training to obtain and maintain their licenses. While it is common for more complicated sales roles to require training, rarely do sales professionals also require a license. Perhaps the most similar occupation is a real estate agent who must take classes and pass a licensing exam in order to sell homes. The fact that insurance, which costs far less than a home and is more commonplace, requires a licensed agent to sell the product demonstrates how complex a product it is.

  BUT WAIT - THERE’S MORE!

  Due to the product’s complexity, the marketplace for insurance today is geared toward selling a compulsory product. Consumers are not seeking to purchase and may avoid reviewing their coverage. For personal lines (auto and home insurance), market penetration is exceedingly high. (Note, however, that there are still a large number of uninsured motorists despite legal requirements that make it mandatory to have coverage, so this is not even an ironclad guarantee that everyone who needs insurance coverage has it - even when mandated by law.)

  Throughout this book, the focus is on personal lines products because virtually everyone has at least a basic familiarity with them as a consumer if not also an insurance professional. However, commercial lines are also a major component of the P&C insurance industry and there are specific products in this space that are distinct from personal lines. These include:

  •a Business Owners Policy (BOP) that provides both liability and property coverage for small businesses

  •a Commercial General Liability (CGL) policy to cover many liability exposures

  •Workers’ Compensation (WC) coverage to pay for workplace injuries for employees

  •Errors & Omissions (E&O) and Professional Liability coverage for liability arising out of a specialized duty of care such as an agent, financial professional, doctor or lawyer, among others

  •Directors & Officers (D&O) coverage for boards of directors and senior management of a corporation that covers any liability that may arise in their obligations from overseeing a firm’s activities

  Many of these coverages are sought because there is some requirement, usually a legal one or a requirement to receive a loan or a license, that mandates proof of insurance as a prerequisite for purchasing an item (such as a home or business) or to conduct some activity (such as drive a car or practice medicine). When insurance is not compulsory, the market penetration rates drop considerably even though an exposure to loss and the need for coverage may strongly exist for perils such as earthquake. There is a saying in the industry that “insurance is sold, not bought”.

  Bottom line: insurance is complex, so people do not always look to acquire coverage unless they have to. Part of the reason is a mismatch between the perceived risk of loss and the actual risk borne out by statistics, but another reason is the sheer complexity of the product itself dissuades people from purchasing it if they are not obligated to. Put another way, if insurance was easier to understand and acquire, most people would purchase coverage.

  MIND THE PROTECTION GAP

  In theory, a consumer is fully protected when any possible claim that could be submitted for coverage from the policy is paid; in other words, they never have a claim denied. In reality, some exposures that consumers are (or should be) concerned with are likely not covered by any of the insurance policies they currently own. As a consumer, you can increase your odds of obtaining the level of coverage you need by reading your policy and becoming familiar with its provisions, working with your insurance agent to identify your exposures and assessing whether they are adequately insured, and shopping around. The reality is, however, than even by doing all of these things, you are likely to still have some exposure to loss that won’t be covered by your insurance. This is either because no carrier will insure the risk to the level that you are seeking and/or the cost of obtaining such coverage is prohibitively expensive relative to the benefit you receive.

  When a consumer does not have all of their exposures covered by insurance, this is referred to as the protection gap or coverage gap. Helping consumers narrow or, ideally, close their protection gap is a major area of opportunity for insurtech. This gap can exist for a number of reasons:

  1.Consumers are not aware they have coverage needs beyond compulsory purchases such as auto or home insurance.

  2.Agents do not do a proper job of uncovering a client’s exposures and insurance needs.

  3.Consumers are unable or unwilling to
pay for all of the insurance products they need to cover all of their exposures.

  4.Consumers decide not to insure at sufficient limits to provide full coverage.

  5.Consumers decide not to add coverage endorsements that would provide more complete protection.

  6.Agents and consumers are unaware of coverage options that exist in the marketplace.

  7.Carriers are unable or unwilling to write coverage for certain exposures.

  A classic example of a common protection gap is flood insurance: anywhere it rains, it can flood, yet most people in the United States are not covered by the National Flood Insurance Program (NFIP) offered by the federal government via FEMA. For the last 50 years, NFIP has essentially had a monopoly on flood insurance because the private insurance industry considered flood to be uninsurable due to large problems of adverse selection. Only those most at risk of flooding would purchase protection and those with a slight risk would opt not to. Recently, however, through the use of technology to build detailed flood inundation maps and more precisely measure elevations, a burgeoning private flood insurance marketplace is emerging to offer consumers choice in this market. Another coverage gap example is the rise of the gig economy and new exposures such as ride sharing that are, by traditional definitions, excluded on a personal auto policy. Carriers have worked hard to innovate in this space over the past few years to develop both personal and commercial policies to cover the risks for both drivers and passengers engaged in ride sharing.

  PERSONALLY, IT’S CLEAR AS MUD

  If it wasn’t problematic enough to definitively answer the basic question of whether a consumer’s insurance products can sufficiently cover their exposures, the insurance industry is forced to introduce a lot of technical concepts that are difficult for many insurance professionals to understand and explain, much less an average member of the public. For auto insurance, there are several coverages that together “make” an auto policy: Bodily Injury Liability (BI), Property Damage Liability (PD), Medical Payments (Med Pay), Personal Injury Protection (PIP), Uninsured Motorist Bodily Injury and/or Property Damage, Underinsured Motorist Bodily Injury and/or Property Damage, Collision (which covers colliding with another vehicle but not an animal?!) and Comprehensive (which does not cover everything?!) a/k/a OTC - Other Than Collision.