While I was busy with real work, as well as developments in my family’s own adventure into being disgruntled health insurance consumers, a couple of blogs I follow (Point of Law and RiskProf) pointed to the latest propaganda from the Center for Justice and Democracy regarding the industry’s record profits in 2007.
Like most folks in the industry…I don’t mind the record profits. As the underlying exposure grows, you’d expect to regularly see increasing nominal profits, particularly in years where few catastrophes occurred. If we didn’t have good years every so often, who would want to invest in an industry where a trillion-dollar disaster is just waiting to strike. (Think New Madrid quake or a Cat 4 hurricane barreling up the Hudson.)
But never fear, the market cycle turns and virtually all of the products I work with are very concerned about the emerging soft market and increased competition. This is the free market at work, despite perhaps doing so a bit inefficiently and while overly-burdened by psychology-driven irrational behavior on the part of investors and reinsurers.
Buried in the discussion, however, is a fascinating question—is the insurance industry overcapitalized?
I’ve been through the exercise, for example, of setting a target loss ratio given the need to generate an expected return on equity given an allocation of capital to my program. (”I’m getting how little investment income on how much capital? My ROE hurdle is how high? But that means….”)
I’ve also been through the exercise of simulating the capital required for a program to maintain certain ratings with organizations like A.M. Best. (”You mean, if we dividended out capital to the point where it isn’t dragging the apparent return of my program, our ratings will drop down where? No producer would place business with us with that rating.”)
As long as the insurance industry is expected to be able to pay all claims after a mega-catastrophe, and as long as the industry is regulatorily restricted in the amount of risk we can accept in our investment portfolios, we are going to be sitting upon large investment portfolios earning ho-hum returns. And if we are going to be beholden to investors who require an expectation of better-than-ho-hum returns…there will be a nontrivial profit load in our rates, and we will periodically have record years.
If you could change any of those built-in loads or assumptions that drive the nature of our capitalization and profit goals…well, you could have an all-new ballgame.
If consumer advocates really want to put a cogent argument together about insurers making “too much” money, perhaps their efforts would be better expended testing some of the underlying infrastructure of the industry’s funding assumptions.
Rather than railing against a couple of good years’ profits, maybe there ought to be some challenge given to the rating agencies’ methodologies, the de-facto requirement that business only be given to A-rated carriers, or the obligation that insurers not only be able to pay all claims arising from a mega-catastrophe but that they also be able to remain a viable operation post-disaster.
If the industry really is making too much money, perhaps consumer advocates ought to consider starting up their own mutual insurer or insurance exchange for the more commoditized insurance products (life, health, auto, home, small business). Without the profit demand, they should be able to under-price the players in the current market and offer an apparently better deal to the consumer.
But, it’s easier just to slam an unpopular industry than it is to actually create and run a business.
