Notes From a Native Son: Insurance Companies Are a Licence to Print Money: Who Insures the Insurers?
All financial firms should by law be compelled to submit an annual business model to the regulator and supervisor for assessment if they are to continue to trade. This should be a basic condition to provide adequate consumer protection and the integrity of the financial supervisory and regulatory systems.
As has been stated before, the business models of insurance companies and banks, the two major financial sectors, are totally different. While banks borrow short and lend long, a flawed business model if ever there was one, insurance companies are often compelled to have a capital adequacy of at least 110 per cent of its likely liabilities. And, of the various branches of insurance – unemployment, health, home, motoring, disaster, etc. – the greatest moral hazard is motor insurance; it is the low hanging fruit, in that it is the easiest for insurance companies to make lots of money while paying out a relatively low percentage of claims.
First, unlike life and health insurance, or even unlike home and contents insurance, motorists are compelled by law to have insurance. Unlike life and pensions insurance, for example, there is no need to base actuarial assumptions on a continuous mortality investigation report and the one in two hundred event assumption is in many ways only theoretical since there is no longevity risk. Generally, there are two broad kinds of insurance regulation: firm-specific and industry-wide. Firm-specific regulation and supervision is when the authorities are focusing on a single firm, going through its books, interrogating its staff, and talking to a sample of its customers. This may arise out of a formal complaint, market rumour, suspicion or a randomised stress test.
It is fair and legitimate that the financial regulator should expect that all legally registered financial firms should operate within the spirit and letter of the law. Market integrity is at the root of sound consumer protection and a transparent and fair financial system and firms with opaque policies or operational shortcomings cloaking their flawed management and actuarial risks. The first and most important of these risks are the design and distribution of financial products; their suitability for customers’ needs, affordability, and that they are not complex, opaque and over-priced. Marketing literature must be accurate, limited with no restrictions on exit; terms and conditions must not be over-burdensome, complex and must be written in simple English, and not legalese. There should also be a cooling off period. In other words, consumers must fully understand what products they are buying, their purpose and their features. What they are told they are getting is what they should get. Providers cannot hide behind the myth of caveat emptor – let the buyer beware. The second most important regulatory requirement is customer relations: are they treated fairly with transparent and object underwriting.
Understanding Insurance Companies:
To understand the viability of insurance companies, apply some of the analytical tools used by financial journalists and financial analysts. Look at the company’s annual report, especially the auditor’s assessment of whether it is a ‘going concern’ and the chairman’s report for a view on how s/he sees the immediate future of the company. Look at its re-insurance provisions, if any, in particular its reasons for reinsurance, types of reinsurance, its reinsurance assets and liabilities. You also need to look at its operating cycle, its accounting methods (statutory versus GAAP), asset valuation, liability valuation, capital and surplus, including its risk-based capital. Look also at its capital adequacy analysis, risk management and hedging, its financial forecasting and, most important its credit rating agency’s rating. Crucially, look at the members of the board, the senior executives, the key decision-makers and make an assessment of them, professionally and morally. Are they people you would trust? Look also at its legacy book and how it is managed. This will give a good clue to the firm’s culture and controls: i.e. internal systems and controls, making sure all employees know what is expected of them and how customers should be treated.
There is also a need for risk management to be transparent to all staff, from the very top to the bottom.
Suitability of advice and procedures for managing any potential money laundering attempts are also important. Customer outcomes are very important.
The capital reserves an insurance company holds – or its re-insurance provisions – tells us a lot about its viability. What makes the financial health of an insurance company so central to macroeconomic policy is that the central bank, i.e. the taxpayer, is the lender of last resort. If any insurance company cannot meet its liabilities government cannot stand idly by and tell the insured that that is bad luck; those insurance obligations must be met, although the post-crisis history of the regulatory failure surrounding Clico sends a totally different message. I believe, and I may be wrong, that this is the mistake made when the Mutual was being demutualised. Most of the arguments were political, including the makeup of the board, and to my mind the concentration should have been actuarial. I believe carefully analysis would show that members of the Mutual in reality paid to get rid of the society.
What makes insurance companies, compared to banks, so central to long-term planning and family protection is that most people take out cover – from motor insurance to life to an annuity – and tend not to read t he fine print until they reach retirement, there is a disaster or a motor accident and they want to claim on the policy. That is why it is so important that all insurance companies should, as a regulatory requirement, be compelled to publish on its website its claims records: how many claims it has had over the past year, what were these claims for, how many were met without further query, how many were rejected and the reasons for the rejection. With motor insurers, one fairness measure is to abandon the smoothing mechanism, in which good drivers pay for the accidents of the bad, and underwrite the insured individually. In this way, the claims record of the individual motorist will be the deciding factor in deciding the amount of a premium, plus inflation. So, if over the duration of the cover the motorist has a no-claims record, then the premium should increase only by the rate of inflation.
Another way of individualising motor insurance is by mileage, by attaching a black box to the vehicle the insurer would know the number of miles and times travelled by the motorist and can charge as relevant. Again, in that way, the motorist who only makes essential journeys will not be penalised for the high-risk journeys made by the leisure motorist. There are other important questions that Barbadian consumers should ask: what are the minimum capital requirements for banks and insurance companies in Barbados? What are the financial assets and financial liabilities of the firm? And, how are these managed?
There is nothing to convince ordinary people that the banking and insurance regulators and supervisors are fully aware of the state of the global financial sector in which they operate. They seem to operate in their own little world. Nothing apparently has been said, or done, at least publicly, about the statutory solvency requirements for insurance companies, nor has there been anything about the regulatory conditions surrounding how these companies can use debt.
By definition, insurance companies are pre-funded, by that I mean that premiums are paid before claims are made. So, any founding capital an insurance company has serves more as a buffer than for risk-bearing. I believe there are only two acceptable business models for a bancassurers – a mutual or listed company. No bank or insurance company should be privately owned. This is a risk too far.
In the final analysis, there is an urgent need for a more serious debate about insurance generally, and motor insurance in particular, including its impact on public health. In the United States, the biggest motoring insurance market in the world, over 40,000 people are killed each year in road traffic accidents. In total, uninsured drivers cost the US insurance industry about US$250bn a year. Although the ratio in Barbados may be lower, road traffic incidents have a huge impact on public health and policing costs. Every victim of a road traffic accident in Barbados who has to go to hospital cost the public purse a large sum of money, which should be reclaimed from motor insurers; it is a scandalous abuse of public funds by these companies.
Apart from passing the costs on to the motor insurance companies, a no-fault liability clause in insurance legislation will remove the need for police to be called out to every motor accident, no matter how small. The other insurance scam, of course, is in the life and pensions sector with lapsed policies, what the industry calls lapsation. People who take out life insurance policies and allow them to lapse simply hand their money over to the insurance companies. To give an example, between 1991 and 2010, US$29.7trn of new life policies were issued in the US, during that time, $24trn policies became lapsed (many were taken out before 1991, which accounts for the discrepancy). In other words, American citizens simply handed over $24trn to insurance companies in return for nothing. (see: Narrow Framing and Life Insurance, Daniel Gottlieb and Kent Smetters, National Bureau of Economic Research, working paper 18601). Good regulation should force insurance company to handover all lapsed funds, with the exception of modest administration costs, to a national wealth fund to be invested on behalf of the entire nation. The equivalent of lapsation in motor insurance is to refuse claims or continually raising the premium.
Finally, the regulator should be able to impose unlimited fines on financial services firms as a penalty for breach of the rules. If such penalties have not been written in to the primary or secondary legislation, then it ought to be since this is one tool that the regulator needs in order to control bad behaviour by firms and to reimburse customers for lost investments, and compensate them for hurt feelings and general damages.
For further reading, see: Risky Business: Insurance Markets and Regulations, by Lawrence S. Powell
The Economic Theory of Insurance, by Karl Borch