Shit happens: the rise of the insurance industry

Insurance: An ingenious modern game of chance in which the player is permitted to enjoy the comfortable conviction that he is beating the man who keeps the table.  Ambrose Bierce

What the insurance companies have done is to reverse the business so that the public at large insures the insurance companies.  Gerry Spence

The Act of God designation on all insurance policies; which means, roughly, that you cannot be insured for the accidents that are most likely to happen to you.  Alan Coren

There are worse things in life than death. Have you ever spent an evening with an insurance salesman?  Woody Allen

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Insurance plays a central role in the functioning of the modern world. Shit happens and we want to be prepared for adversity. The idea of saving for a rainy day is a basic financial impulse. The largest share of the insurance cake is for cars. We also insure our homes our pets and our lives. Then are those celebrities who insure body parts. I get the impression that many of these celebrity body-part insurance contracts, such as Tom Jones and his $7 million chest hair policy are just urban myths or publicity stunts. Insurance has also been the subject of many films: Double Indemnity, The Apartment, Memento, The Thomas Crown Affair and The Rainmaker to name but a few.

The rationale behind insurance is to transfer risks to where they can be borne at a lower cost. The insured pays a small premium in order to receive benefits should an unlikely but high-cost event occur. As they insure millions of homes, insurance companies are able to play with the predictability of large numbers. They are able to set aside resources more efficiently. This actually benefits the economy as a whole as  resources are freed up to be used in other areas.

As long ago as the 3rd and 2nd millennia BCE the Chinese Babylonian traders were transferring or distributing risk. The Chinese would use a large number of ships to limit the loss due to any single vessel’s capsizing. If a merchant received a loan to fund his shipment, he would pay the lender an additional sum in exchange for the lender’s guarantee to cancel the loan should the shipment be stolen. The Greeks and Romans had guilds called benevolent societies which looked after the families of deceased members, as well as paying funeral expenses of their members. This kind of institution was also typical in Medieval Europe. The first insurance contracts date from 14th centuryItaly, but it was not until the invention probability theory and actuarial science in the 1600s that insurance really began. Before these great intellectual developments offering insurance was a gamble. Now the insurance companies would become the casino.

After the great fire of Londonfire insurance began to be sold and marine insurance was available at Edward Lloyd’s coffee house. In 1744 acouple of hard-drinking Scottish Presbyterian ministers Robert Wallace and Alexander Webster set up the first true insurance fund in 1744. They created The Scottish Ministers’ Widows Fund to take care of the widows and orphans of deceased ministers. They soon realised that merely collecting premiums that it as also necessary to invest the money wisely. They based their calculations on an accurate projection of how many beneficiaries there would be in the future, how long ministers might live and how much money could be generated to support their dependants after they died. Now Scottish Widows plc is a Financial Services company, whose assets under management were worth £145.5bn in September 2010. In the 1840s in the United States Morris Robinson, the head of Mutual Life of New York had the idea of employing highly-paid life insurance salespeople. He wanted them to form long-term relationships with their clients. Now insurance is multi-billion dollar industry. In developed countries it accounts for around 10% of GDP.

The problem of asymmetric information between the seller of insurance and the buyer creates what economists call a problem of adverse selection. Those high-risk individuals, who know more about their risk profile than the insurers, will create a mix of clients which is adverse to the insurer. Insureds who eat poorly or who engage in high-risk professions or sports have an added incentive to take out insurance. Companies attempt to get around these problems. They can try to investigate potential clients. For example, if you want a life insurance policy, you will probably have to undergo a medical exam. But you can never find out everything. The use of predictive genetic tests in setting premiums for life insurance would be extremely controversial and is not an option at the moment. Instead, insurance companies tend to set high rates to make up for this adverse selection. This however is a disincentive for ordinary-clients to take out insurance and fewer of them will, exacerbating the problem

Once an individual or family is insured, new problems emerge. In particular, the insured now has less incentive to avoid the risk of a bad outcome.Moral hazard says that the more you feel insulated from risk, the more temptation you have to engage in risky behaviour. Insured people respond to incentives and undertake actions they would otherwise avoid. And if the insured value is worth double, then the insured actively has an incentive to cause an “accident”. This does not mean that everyone will do – there are moral norms and we are also afraid of being caught – but there will undoubtedly be some who will. We are talking about a continuum here. On one end of the spectrum you have those who are complexly honest. Then there are those who may subconsciously relax forgetting to take all the necessary precautions. At the other end you have those who will provoke a fire in order to claim the insurance. A person with automobile collision insurance, for example, is more likely to go driving on an icy night. Subsidised flood insurance can encourage people to build homes in areas prone to flooding. Insurance companies can try to counter this risky behaviour. They can refuse to insure people in dangerous areas and insurance policies often stipulate that their clients have to pay a fixed amount of the damages incurred before the insurance company pays the remainder. However, given the impossibility of monitoring everything that their clients do, insurance companies just have to accept that once policies are issued more claims will be made.

Insurance often raises question of what is fair. I have already mentioned genetic profiling of clients. One fascinating case is that of driving and gender. The insurance industry’s data actually shows a statistically significant correlation between gender and increased risk.  If women as a whole are less likely to cause accidents, shouldn’t they benefit from lower premiums? Is it legitimate to group people in this way? After a ruling by theEuropean Courtinsurers will now have to charge the same price to all their customers. The effect of this is to punish people who are statistically less likely to claim on the insurance. For the Court the insurance companies were breaching a fundamental human right equality between men and women.

We are all familiar with the insurance contracts and their small print designed to bamboozle their customers. We feel that insurance companies are trying to get out of paying what they should be paying as in The Onion’s spoof headline, “Earthquake-Insurance Provider Suspects Client Of Deliberately Shifting Earth’s Tectonic Plate.” In The Stuff of Thought Steven Pinker talks about the problems about the insurance of theWorldTradeCenter. The disputed centred on exactly how many events took place inNew York on that morning in September 2011. Silverstein’s insurance policy stipulated that he receive $3.5bn for one event and $7bn for two. Swiss Re wanted to argue that it was one incident took place Pinker summed up the dilemma facing the court very well:

“It could be argued that the answer is one. The attacks on the buildings were part of a single plan conceived in the mind of one man in service of a single agenda. They unfolded within a few minutes and yards of each other, targeting the parts of a complex with a single name, design, and owner. And they launched a single chain of military and political events in their aftermath. Or it could be argued that the answer is two. The north tower and the south tower were distinct collections of glass and steel separated by an expanse of space, and they were hit at different times and went out of existence at different times.”

The meaning of the term event became very contentious during the trial. Swiss Re’s attorneys framed it in mental terms – there was one plot. Silverstein’s legal representatives defined it in physical terms –two collapses. In the end Silverstein lost as the court confirmed that the destruction of the WTC in the September 11, 2001 terrorist attacks was a single event.

It is not always the insurance companies who try to hoodwink their customers – insurance fraud is an important cost. We have those extreme cases like John Darwin. The former teacher and prison officer faked his own death. He was reported as “missing” after failing to report to work following a canoeing trip on March 21, 2002. He reappeared on December 1, 2007, claiming to have no memory of the past five years. In reality he had been living under a false name and they ended up inPanama. After returning to England John and his wife Anne were found guilty of fraud and both were sentenced to six years in prison. Charles Gavett fromPike County,Georgia. told authorities that his wife, Cynthia, had died in the attack on theTwinTowersinNew York. He claimed more than $600,000 in life insurance money — but Cynthia was actually alive and well back home. A local deputy sheriff even testified that the Gavetts had invited him over for Thanksgiving — more than two months after her supposed death. Gavett was the first person to be arrested for fraud related to the Sept. 11 attacks. These are exceptional cases but on a smaller scale many ordinary people engage in insurance fraud. When consumers report losses on their homes and cars, they creatively stretch their claims by about 10 percent. Insurance companies then retaliate by raising their premiums.

With the evolution of the financial system the distinction between insurance and other forms of risk management is beginning to get blurred. The bailout of AIG showed how intertwined the two sectors are. And now the insurance industry is facing new challenges. There seem to be more hurricanes and we have also seen the rise of catastrophic terrorism. The future promises to be even more uncertain and eventful.

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