It’s been reported in several insurance-themed news sources that the Consumer Federation of America (and its various alternative manifestations) has released a white paper slamming the insurance industry for making excess profits in 2006.
The industry has responded, in typical fashion, by saying essentially “nuh-uh!”.
CFA’s press release about the white paper can be found on their website as can the white paper itself.
I’ve had the opportunity to skim through the white paper. Unfortunately, my unique work arrangement means I don’t have access to some of the standard resources that would be used to check/challenge some of CFA’s assertions (read: I don’t have handy access to Best’s Aggregates and Averages and the like), but I can offer a few generalized thoughts on the study’s claims and recommendations.
- <Smirnoff>In America, companies make profit. In Soviet Russia, government profits from you.</Smirnoff> Seriously folks, we live in a capitalistic society. Profit is not necessarily evil.
- While the study authors are happy to show various metrics, including loss/LAE ratios, premium/surplus ratio trends, and net income in dollar terms, I happen to notice that some other metrics I like to look at aren’t mentioned — like expense ratios, combined ratios, and ROE’s.
True, an “appropriate” across-the-board ROE is difficult to define, given differences in organizational structure / profit goals / underlying lines of business, but it’s return-on-investment that really drives the evaluation when I’m trying to look at whether a business is making “enough” money.
- Is a simple look at betas and relatively short-term stock price volatility really the most suitable assessment of the risk-load required in an investment’s return? Looking at the losses arising from 1:1000 or 1:5000 year events in model results that give the financial folks I answer to ulcers, and which impact the hurdle rates I’m shooting for. Appropriate historic stock price data doesn’t exist over a long enough horizon to encompass the full volatility that P&C insurers face. Perhaps a better evaluation would incorporate cat-modeling and the impact of cats on ROE and stock valuations, to come up with a better long-term assessment of volatility.
- The study’s authors seem to call for regulators to act to prevent insurers from making too much money upon the backs of poor insureds. While my inner consumer advocate can appreciate the sentiment, such a stance overlooks the power and efficiency potentially arising from the existence of a free market.
In a free market, if there is a perception of excess profits being possible in a given environment, that promise will attract additional capital. Eventually supply and demand will shift the equilibrium in that environment back to the level of “appropriate profit”.
That isn’t to say that regulators should be completely hands-off, relying on faith to trust the power of the free market. Regulators do have a potentially valuable role in protecting consumers from the misdeeds of a few bad actors, and they do provide a valuable service in facilitating the establishment and maintenance of the free market. I’d even agree that some regulatory participation in the creation of a buffer to insulate ordinary consumers from the chaos and instability of raw forces of free-market-ness is in order.
However, “the answer” is absolutely not to demand that insurers make no-more-than a predefined profit…unless, of course, you’re willing to balance that with a guarantee that insurers will suffer no-more-than a complementary level of predefined loss in the bad years.
- The study claims that the industry is overcapitalized, on the basis of declining premium:surplus ratios and a comparison of those levels against a regulatorily-defined maximum of 3:1, as well as the recommendation that 1½:1 might be a more appropriate level.
The thing is, while NAIC IRIS testing is important, I’m more concerned with satisfying the capitalization requirements decreed by rating agencies to attain an “A” rating, and with minimizing the risk that my rating will be jeopardized.
In certain lines of insurance, high ratings are demanded by purchasers of insurance. If I cannot attain that rating, I’m not going to be able to attract that business, and therefore it behooves me to ensure that I’m not going to slip down into the “B” ratings. While “B” may be sufficient to pass regulatory capitalization tests…such a rating would likely mean that I’m out of business, barring my securing additional capital.
A valid study would have challenged the 1½:1 threshhold that is assumed to be appropriate by the authors of this white paper.
Reality differs from theory all too often. Businesspeople, actuaries, and investors ignore that fact at their own peril.
- The study reviews companies as a whole, overlooking the fact that insurers write in many lines of business. The riskiness of their operations is a function of the relative weights of those lines, and correlation of risk across those lines of business…as well as the makeup of risk driven by the mix of business within each line of business.
An insurer that is heavily weighted towards workers comp or occurrence-based professional liability coverage is likely to be perceived as more risky (and require more profit) than, say, a company that specializes in private passenger auto or inland marine. Similarly the specialist insurer that focuses on homeowners in North Dakota is probably less risky (and requires less of a margin) than a hypothetical Florida-only homeowners carrier.
For a study such as this, a researcher ought to be looking at more discrete segments of business in setting the threshhold for “appropriate” profit. To do otherwise is to imply that subsidization within an insurance business is appropriate — that it’s OK to charge North Dakota personal auto insureds more because expected profit from homeowners business in the Florida keys could be so variable.
- Of course, a study that does many of the items mentioned above could, if care is not taken, suffer from an additional defect — the idea that different insurers carry different levels of surplus or are differently capitalized. If hurdle rates are set based on return on equity or return vs. surplus, you can create a situation where an under-capitalized insurer can charge lower rates to achieve their appropriate profit than a fully-capitalized insurer whose returns may drag somewhat due to limitations on how much they can earn with their investible assets.
This would suggest, to me at least, that an evaluation of whether a line of business or group of businesses is “too profitable” needs to incorporate some sort of notional capital/surplus to support the business, rather than the actual figures allocated by the insurer.
&nsbp;
The appropriateness of the level of capitalization, and of the returns being earned on invested capital therefore perhaps should be a different conversation than evaluating whether insurers are reaping “too much profit” by charging excessive premiums.
- I’m essentially repeating myself, but the study’s authors are under the premise that there is such a thing as “too much profit”. That’s a premise I have to disagree with, assuming a free market exists. If profits are in excess of the perceived level of risk, there will be new entrants attracted. If prices are too high, customers will either choose to not buy…or will be served by another insurer who is willing to accept the lower rate.
The public is better served, I think, by facilitating the free market, than trying to clamp down, introduce inefficiencies, and discourage participation.
Just look to Massachusetts to see why this is the case.
Bottom-line — my impression of the white paper is that it is a clever way of arranging numbers to appear to support an anti-business cause. Although I can certainly think of several things that could be cleaned up within the industry, the market’s alleged excess profit is certainly not on that list.