The End of Insurance as We Know It

by Rob Galbraith

  Credit cards have a lot of popular features as a product, and one common use by consumers is to cover “losses” for non-insured items when they break, such as iPhone repairs or replacements, a new television, auto maintenance, etc. Some people no doubt budget for and save money (often at rock-bottom savings interest rates) to cover these unexpected expenses, but most people do not these days in advanced economies. Why do consumers not buy insurance for these types of losses? First off, insurance products are not easily found to cover these risks (extended warranties are more common and act as an alternative to traditional P&C insurance). Another reason are that credit cards provide a lot of convenience compared to insurance. Consumers have shown a willingness to pay the associated (high) interest rates in exchange when they do incur a “loss.” Why? One reason: they value the use of their cash for other purposes during most periods when they do not have a loss. That is, their cash is valuable and provides for a higher lifestyle on a monthly basis than would be possible through increased savings or purchasing insurance.

  Credit cards provide an instructive lesson in another sense: they are easy to understand and use by consumers. Like insurance, credit cards are a financial instrument. Like insurance, credit cards come with a lengthy list of terms and conditions. Like insurance, most people do not read these terms and conditions and rely upon their financial institution (in this case, a bank or credit union) to answer their questions and service their account. However, if you compare the terms and conditions that come with a credit card account, they are simpler than a standard insurance policy. There are fewer variables for consumers to understand as well: the credit limit, the interest rate, the minimum payment due and any points or rewards that can be earned.

  LOST RESERVES

  Turning now from the consumer side to the carrier side, what happens with all of those premiums that policyholders pay? When premiums are initially collected, they are received as written premium and, in essence, “held” in the form of reserves on behalf of that policyholder. The money cannot be immediately recognized as revenue. A policyholder may pay their entire annual premium at the time of policy inception, but if they later call back to cancel after 3 months time, the carrier has earned premium equal to one-quarter of the policy’s annual premium. The carrier keeps the earned premium as revenue they have earned for the coverage afforded over the 3 months. The remaining balance of the written premium is “unearned” and must be returned from the reserves to that policyholder as it is their “unused” money to reclaim. Insurers hold lots of money as unearned premium reserves at any given time as a liability on their balance sheet.

  More broadly, a large portion of the premiums collected by insurance carriers are held in the form of loss reserves. These are a also reflected as a liability on the balance sheet and represent the total amount of money needed to pay all past, current and future claims obligations. The size of the loss reserves is determined through advanced actuarial techniques and involves some subjectivity; there is a reasonable range between what a company can select to set its loss reserves at. As estimates for loss reserves fluctuate up and down based on the loss development patterns of incoming claims being reported and payments being made on existing claims, reserves may be:

  •increased, which raises the amount of liabilities, lowers profitability and can lead to a need to raise rates to collect more premiums in order to cover all losses

  or

  •decreased, which results in a “release” of reserves that gets recognized as income to the carrier (and is subject to taxation).

  The business model of collecting money up front for “pooling” and holding it in the form of loss reserves until claims come due to be paid is almost as old as insurance itself. These reserves help keep premiums cheaper for consumers by earning a modest return on investment during the time period from when it is received by the carrier to when it is paid back out. The time lag between when premiums are received and losses are paid varies widely based on the line of business and coverage - literally whether we are discussing the P or the C in P&C insurance:

  •For property coverages, the time lag is generally weeks or a few months

  •For casualty coverages, the time lag is generally months or even years based on the extent of injuries sustained by third parties, medical expenses incurred and/or legal proceedings

  Insurance lines of business can be classified across a spectrum based on this time lag between short-tail lines and long-tail lines.[49] Here are some examples:

  Short-tail (property) insurance lines

  Long-tail (casualty) insurance lines

  Auto non-injury

  Medical malpractice

  Homeowners

  Employment discrimination

  Renters

  Environmental pollution

  Business property coverages

  Occupational disease

  For longer tailed lines, the increased time held translates into higher investment returns (typically) and lower premiums relative to the losses paid as compared with short tailed lines. Insurers can make significant profit in any given year from investments off of this float; in fact, it is how Warren Buffett has used insurance to become one of the richest men in the world![50] However, there are regulatory limitations on how loss reserves can be invested. Insurers typically attempt to match the duration of their investments to the timeline their expected claims payouts will occur. This can be problematic depending on how the markets are performing, and carriers may be forced to divest at times that are not ideal. More importantly, carriers often invest in a conservative portfolio primarily made up of bonds, with some exposure to the stock market and other asset classes. Within their large holding of bonds, many are low-yielding but highly liquid and secure government bonds.

  Let’s return to our compare and contrast exercise with insurance and credit cards. Insurance collects cash upfront and holds the money in a reserve until it is needed to pay a claim. In the interim, the premiums received (float) are invested in a portfolio that is primarily made up of government bonds that is focused on the preservation on principal as opposed to growth. The benefit to consumers is provided if they have a covered claim during the policy term; otherwise, the insurer recognizes the premium as revenue and it is kept for internal operations. Credit cards, by contrast, do not require money upfront at all - consumers only pay when they use the card and decide to carry a balance. The benefit to consumers is the tangible products or services they acquire in return for using the card, which may include covering economic damages from a loss event. Credit cards charge a high interest rate to consumers in exchange for their flexibility and banks earn money on the spread between the interest rate they charge consumers using their credit card and the interest rate they pay on bank deposits and/or interbank lending rates.

  In short, from a consumer perspective insurance and credit cards offer two different business models for providing financial resources to help in times when an unexpected financial loss occurs. One business model (credit cards) preserves liquidity but a higher cost is incurred in the form of interest payments if a loss event occurs. The other business model (P&C insurance) saps liquidity but provides significant downside protection in the rare event a loss occurs. Importantly, credit cards have limits that are typically lower than the limits on a standard insurance policy; therefore, for larger risks (such as the cost of paying for medical care for someone who is injured in an auto accident), P&C insurance does not face competition from credit cards. (Potentially another banking product such as a home equity line of credit could be used to cover this sort of loss but this is uncommon.) Each business model comes with advantages and disadvantages: however, when P&C insurance is compulsory the choice is removed from consumers, creating a forced drain on liquidity.

  SHOP TALK

  To summarize, insurance is a significant portion of the monthly budget of most households and is a drain on liquidity. The good news is that, unlike utility companies, there are a number of insuranc
e companies to choose from when purchasing a product. Even better news, insurance premiums vary widely from carrier to carrier so consumers can potentially acquire the same coverage at vastly different price points. This potential for savings is embodied by ad campaigns that promise “you can save 15% or more on car insurance” or “customers who switched saved an average of $300 on their policy”. Bottom line: there is a large financial incentive to shop around for your insurance coverage needs.

  Shopping behaviors and brand loyalty vary greatly by country, making it hard to make blanket assertions in this realm. However, in the United States, JD Power reported a record-low volume of new insurance shoppers in their 2018 Insurance Shopping Study.[51] Consumers do not shop around as much as you might guess based on the strong financial incentives to do so. Why don’t consumers comparison shop more? The reality is that it is hard to do so for several reasons including:

  •the complexity of the product

  •it’s exceedingly time consuming (in the US) as comparative raters have not been as successful as in other countries (see previous bullet on the complexity of the product)

  •customers who do switch later regret doing so due to rate increases[52]

  •branding is relatively strong in the US - the top 10 writers hold 72% of the total market share, up from 64% in 2000[53]

  Is there truly a difference between insurance providers? The answer to that question is yes and no. Different carriers charge different premiums and many have contract differences from each other in their policies, some of which are material and others that are not. Differences exist in the quality of service from the agent as well as the claims service. There are also different distribution channels (i.e., direct writer, exclusive agent or independent agent) that also affect the policyholder experience. However, despite the differences, JD Power reports that customer satisfaction with U.S. auto insurers is at an all-time high in 2018 despite rising premiums.

  DEADPOOL

  At its core, insurance is a risk transfer mechanism. Policyholders agree to pay a certain amount of money to a carrier in exchange for protection in the event of a wide range of potential losses that could occur (though, critically, not all scenarios). The premiums that are paid are pooled together and held in reserves to be invested according to the insurer’s needs for liquidity and capital preservation. Losses are paid from this pool of money when they occur, and the value proposition for policyholders occurs when the amount of the paid claim is greater than the annual premium paid for the policy. But losses, while often costly, are infrequent and rare occurrences. The vast majority of policyholders each year do not file a claim and therefore receive no direct benefit from their insurance product (other than the ability to prove that they are covered to meet compulsory requirements).

  Is this the most efficient risk transfer mechanism that can be designed? Credit cards offer one alternative for smaller dollar losses that are typically not covered by standard insurance products and do not have the same restrictions on what types of losses are covered. There are other times where, while a loss might be covered by an insured’s policy, policyholders actually choose to cover the cost on their own through savings, use of a credit card or other mechanism in order to avoid having to make a claim on their insurance policy. This is usually done to avoid incurring a higher premium from losing a claims-free discount and/or incurring a claims surcharge and, sometimes, to avoid having their coverage dropped at renewal for having an excessive number of losses. Extended warranties are another way that people choose to cover losses; they work very similar to insurance in terms of making a known payment for unknown benefits in the contingency of a covered loss event. However, extended warranties often involve a one-time payment up front for a multi-year agreement and the cost can be combined with the overall cost of the asset being acquired if financed.

  Bottom line: P&C insurance represents a significant drain on the cash flow (liquidity) of the majority of people who live paycheck to paycheck and must abide by a monthly budget. The downside protection against loss can provide a significant economic benefit - but the need for this is relatively rare over the course of a single policy term. The opportunity cost of losing their liquidity is, by contrast, relatively large. This presents a market opportunity that might be exploited in the way that the popularity of credit cards and extended warranty products have grown over the previous 2-3 decades.

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  CHAPTER 7 - IN THE RED ZONE

  OPEN AND SHUT CASE?

  In football, an open receiver is one that is not covered by a defender. If you are a defensive coordinator, an open receiver is your worst nightmare. Left uncovered, a receiver could potentially catch a football thrown to them by the quarterback and score a touchdown, causing your team to lose the game. To avoid a loss, you want to make sure each receiver is covered by a defender. Defensive coordinators work long hours during the football season with the position coaches and defensive players to ensure that, on game day, as few receivers are left uncovered as possible. The better the coverage, the more likely your team is to avoid losing games and have a successful season. In games, when the other team is close to your end of the field, their chances of scoring a touchdown go way up. This area is generally know in football as the “red zone” and the team on defense has to be extra vigilant not to leave any players uncovered because the likelihood of getting scored against is much higher here.

  Unsurprisingly, insurance terminology is its own language and often counterintuitive. A perfect example is the term open perils which generally means that, unless specifically excluded in the policy, a loss from any peril (hazard) is covered. So, unlike football, having open perils is a good thing: it means as an insured you have better protection in case of a loss By contrast, the term named perils means that a peril is not covered unless it is specifically cited as covered in the policy. From an insured’s perspective, they are generally unaware of this distinction even if their agent has walked them carefully through their policy contract. So knowing what perils you are covered for and which you are not is far from an open and shut case. In fact, it’s a fair bet that the majority of insureds cannot articulate which perils they are covered against versus those that they are not. This is why it comes as a shock to insureds when they suffer damage and file a claim with their insurance company, only to have the claim denied because the loss is not due to a covered peril. Statistics on the percentage of claims that are denied are hard to come by, but anecdotal evidence suggests that it is not uncommon. What is the point of paying all this money each month in insurance premium if you can’t even use the product when you need it?

  This chapter explores some specific examples of how confusing it can be to determine what perils are and are not covered. As mentioned in the previous chapter, when consumers use credit cards as a financial product to cover unexpected losses, the type of loss and proximate cause is irrelevant: credit cards are agnostic about what happened and why. The same is not true for P&C insurance products. To be deemed a covered loss, losses must meet the following requirements:

  •The damaged item or items must have been covered by the policy.

  •The damage must have resulted from a covered peril.

  •The policy must have been in force during the time that the damage occurred.

  From an insured’s perspective, it is logical to assume that the most common and costly causes of loss are covered by their insurance policy. Unfortunately this is not the case. For example, flood is a common peril caused by severe weather that can easily cause damage in the tens or hundreds of thousands of dollars, but is not covered by most homeowners policies. According to the National Centers for Environment Information (NCEI), from 1980 to 2017 the most frequent causes of natural disasters in the United States costing $1 billion or more are severe storms (42.4%), tropical cyclones (17.2%) and flooding (12.2%).[54] Are damages from these perils covered by a typical homeowners policy? It depends: the specific facts matter a great deal. Another recent example arose f
rom the eruption, fissures and lava flow from Kilauea in 2018. Damage to homes was not always covered: in some cases, damage caused from a resulting fire was caused while damage from the lava itself was not - but even resulting fires were not always considered a covered peril.[55]

  BAD UX

  The P&C industry is at an all-time high for auto and property insurance in 2018 over the years, according to the annual Claims Satisfaction Surveys by JD Power. However, customer dissatisfaction is a primary reason that consumers shop around: according to a Facebook.com analysis of auto insurance,[56] 14% of respondents cited unhappiness with their current provider and 12% of respondents cited wanting better coverage as reasons prompting their decision to shop around. P&C carriers know that the faster claims are resolved, the lower the related expenses (and generally the lower the loss costs) and the higher the customer satisfaction is in general. However, resolving a claim quickly is not the primary driver of customer satisfaction according to JD Power: in their 2018 Property Claims Survey, the time to settle a claim is the lowest-rated attribute. One in seven respondents indicated that their claim took longer than expected to resolve; however, claims satisfaction scores did not drop when expectations were properly managed. By contrast, when customer expectations on the timing of claims settlement were missed, satisfaction scores were lower even if the overall time to settle the claims was relatively short.[57] Insurance falls into a category of customer expectation that is extremely difficult to deliver on. If you settle a person’s claim in a timely manner for the full amount they are expecting, you are simply doing what they expected when they bought the policy in the first place. Anything short of that leads to disappointment and disillusionment.