Risk Management Reports

Can the commercial property/casualty insurance business in the United States be in a death spiral? Economists Richard E. Stewart and Barbara D. Stewart suggest just this in an explosive article entitled “The Loss of the Certainty Effect” in the Fall 2001(just published – late) issue of Risk Management and Insurance Review. In the past seven months I’ve commented on some of the disturbing signs of self-destructive behavior (see “The Unraveling” in the December 2001 RMR and “Oh Insurer, Where Art Thou?” in the April 2002 RMR). My fears are now confirmed by this masterful exposition, complete with references, footnotes and historical perspectives by two knowledgeable and experienced executives. Dick Stewart served as Superintendent of Insurance in the State of New York, President of the National Association of Insurance Commissioners, General Counsel of Citibank and CFO of Chubb. Barbara Stewart was Chief Economist at Chubb. Both are now with Stewart Economics, in Chapel Hill, North Carolina.

Their thesis is that large claims are unlikely to be paid promptly and willingly by commercial insurers, a situation that will inevitably lead to a failure of buyer confidence. They point out that the keystone of insurance is the assumption by buyers that their claims will be paid. If that trust disappears, then insurance is of no value. It is a mechanism based on trust: a premium is paid now in the confidence that, should a future loss occur, the insurer will have both the resources and the willingness to pay.

The Stewarts list nine changes that increase the probability of insurer denial of large claims.

1. Price competition replaced tariff and cartel rates that existed prior to 1975 and has become increasingly cutthroat and volatile in the ensuing quarter century.
2. The “risk management” movement persuaded buyers to retain smaller and more predictable losses, removing an area of profitable business.
3. Insurance brokers wield more power, especially with their consolidation into three or four major global firms, larger than many insurers.
4. Insurers are now more oriented toward stockholders than policyholders.
5. The insurers’ traditional emphasis on being well capitalized is being replaced by more leverage to produce higher returns on equity.
6. Insurers are turning to securitized property catastrophe reinsurance.
7. Insurers now recognize explicitly the value of earnings on funds reserved for claims, their “float.” It is a significant value, especially as they seem to be unable to make any kind of profit on underwriting.
8. Unexpected catastrophes have surprised insurers. Add to the mounting calamities of earthquakes, floods and windstorms the liability disasters of asbestos, environmental claims and medical malpractice, and we see an industry that doubts its ability to predict losses and price its products.
9. And finally, the “birth of a sophisticated, aggressive, and expensive coverage bar serving both insurers and policyholders” adds millions to loss costs.

I can add to that list the deliberate under-pricing of insurance to garner market share, the high overhead costs, and the gradual raiding of reserves to bolster share prices. All reduce the financial strength of insurers and accentuate their willingness to become slow or no payers on claims.

The Stewarts conclude: “All the changes point in the same direction. From an insurer’s point of view, resisting large claims has become an effective, perhaps even necessary, competitive strategy. From a policyholder’s point of view, the cost of collection has gone way up and reliability has gone way down.” The problem is pervasive in large general liability, D & O. and all-risk property losses.

The authors then review these changes in light of option, asymmetric information and prospect theories, all of which, they suggest, mean that the loss of the certainty effect (on behalf of buyers) “would be very expensive for insurers, perhaps disastrous.” They go on: “This process of disproportionately devaluing commercial insurance as it is seen to lose its certainty also has the potential to become a spiral in which insurers can profit at the reduced price levels only be getting even tougher on claims.” If the belief that insurance will “perform” slips away, like the Cheshire Cat’s grin, then much of commercial insurance is irrelevant. History describes prior instances of irrational insurer behavior that created responses to redress the balance. The Stewarts cite the adoption of the “incontestability clause” for life insurance after the Civil War, the enforcement of the New York Standard Fire Insurance Policy in the late 1800s, the new “standard” form for accident and health insurance in the early 1900s, and restricted cancellation provisions for automobile insurance in the late 1940s. Each instance was triggered by a decline in public confidence, leading to an imposed remedy supported by government.

For the current crisis, the Stewarts suggest four possible answers: (1) greater disclosure by insurers of their overall claims practices, (2) treating liberal claims practices as a competitive advantage, (3) increasing the use of securitization of both property and liability exposures (so long as external and independent “triggers” can be found for these claims), and, (4) motivating insurance brokers to pay more attention to performance at the point of claim. I have my doubts about this last suggestion. As long as brokers continue to receive “profit commissions” from insurers, they will have an inherent conflict of interest. Will all or any of these changes be adopted? Will government intervene yet again? The authors are not sanguine.

Failing change, the Stewarts suggest that the only insurers to make money will be those who adopt the hard-nosed approach to claims payments, driving out of the market more liberal insurers and further reducing the buyers’ trust. If this death spiral starts, can it be stopped?

For a copy of this article, contact Blackwell Publishing, in Malden, Massachusetts, USA, or Oxford, UK, at subscrip@blackwellpub.com, or go to the Stewart Economics website, at www.stewarteconomics.com.