Insurance Transparency Project

Right now, the industry’s problems with its customers (really, customers’ problems with the industry) stem from the fact that buyers don’t have enough information to reward good actors and punish the bad. Economists would call this an asymmetry of information. My current funder and favorite Hungarian billionaire , George Soros, would call it: a far-from-equilibrium situation. (Ever wonder why two of the all-time best Big Board performers have been A.I.G. and insurance-heavy Berkshire Hathaway?)

Specifically, as things stand now, insurance buyers can’t see two important things: price and performance. It is difficult to know and compare the price of insurance — whether for a policy for homeowners or medical malpractice coverage. More importantly, it’s impossible to know which insurance company is more likely to pay a claim. It’s also hard to know which insurance company is more likely to terminate a disability policyholder’s claim, drop a health insured, deny a homeowners’ claim, be sued by its customers, or pay less on a claim than its policyholders have demanded.

It’s as if you had to buy a mutual fund (not optional; you have to buy it) but couldn’t see the past performance. I know past performance is no guarantee of future results, but, crimminey, it’s not nothing.

Katrina offers a useful illustration and will become, I think, an insurance laboratory. (Put it this way, if Katrina had happened on Long Island, N.Y., or coastal Maryland and Virginia, I’d have plenty of competition on this story, as opposed to none.) Insurers have said they expect to pay $45 billion in Katrina related claims. By any definition, that’s a big number and an important one. But there is another number the market can’t see. That’s how much policyholders think they’re owed and have demanded of insurers. Trust me, it’s bigger than $45 billion. How much bigger? The outside limit is $135 billion — that’s the total economic damage, insured and uninsured, caused by Katrina, according to my friends at Swiss Re, the world’s largest reinsurer and a font of important industry research. If we allow that the federal flood program (aka, taxpayers) is paying about $20 billion in Katrina claims, that still leaves $70 billion paid either by — there are only two possibilities — taxpayers or policyholders themselves.

Now, I’m just a history major, but if $45 billion is a big number, mathematically speaking, $70 billion is bigger. Put it this way, on a stretch of beachfront in Slidell, La., six homeowners I surveyed (a small and problematic sample, I know) believe they were paid an average of 10 cents on the dollar for their wind claims.

Now, you might ask, don’t policyholders have an interest in inflating their claims? Of course, just as insurers have the opposite interest in minimizing them. Both the insurers’ number of total insured losses and the policyholders’ number of the total amount claimed (it doesn’t even have a name yet, but let’s call it that) are equally bad numbers. But at least we can see the insurers’ number. We don’t see the policyholders’. So, there is a gap between insurers payments and policyholders’ demands, but we can’t even see the gap, let alone know how big it is.

Taking it a step further: what if we could compare the gap between amounts paid and amounts demand — I’ll call it the “payout ratio” — between Allstate, State Farm, Chubb, Lexington and the rest. Wouldn’t you, as a buyer, be better able to make an informed decision about which policy to buy? If one was cheaper but paid out less on the dollar — – oh, let’s say, Allstate’s, to take one at random – you might want to roll the dice and buy that one. Or you might want to pay more for the higher ratio, say, from Chubb, to take another one completely at random.

But, an inquisitive reader may ask (why am I starting to write like Sigmund Freud? hmm), if an insurer has a lower payout ratio, doesn’t that just mean that it is more unfortunate in its pool of customers — that is, more of them either misunderstood their policies or are actually cheaters? Two things about that. Insurers are known as underwriters; their job is to decide which potential insured is the better risk. If one company has more stupid people or cheats, that just means it did a poorer job underwriting than its competitors. You’ll want the superior underwriter, anyway, right?

On the cheaters question, policyholders actually have a greater disincentive to willfully inflate (grammarians: sorry for the split infinitive) claims than insurers have to deliberately underpay. A policyholder who deliberate inflates a claim is guilty of insurance fraud. That’s a crime, son. Indeed, there are whole wings of police departments and prosecutors’ offices devoted to tracking down crimes against the insurance industry. Deliberate underpayment by an insurer, however, is known as “bad faith.” That’s not a crime and is subject only to civil penalities. And after recent U.S. Supreme Court decisions, punitive damages are limited, generally speaking, to less than 10 times compensatory damages. In other words, insurers can afford it. The case, by the way, featured State Farm as the defendant (See Campbell v. State Farm, SCOTUS 2003)

But if insurers had to pay all they owed, wouldn’t they go broke and would chaos then not ensue? Well, that’s why they call it underwriting. You took the premium and accepted the risk, Mr. Insurer. That was the deal; not only is that the deal, that’s why you exist. You can’t not pay just because it hurts.

But allow me to put worried minds to rest. The year 2005 was the most calamitous year ever in terms of insured losses; insurers said they will pay $60 billion in damages, mostly related to Katrina and other storms (whether they will is a subject for another day). Paradoxically, the year 2005 was also the most profitable year in the history of insurance, going back, as my loyal readers know, to the days of Lloyd’s Coffee House on the London docks. The industry reported 2005 net income of $43 billion. That net income is about what Iran received from its oil revenue that year. Sorry, my mistake :actually 2005 was the most profitable year until this year. In 2006, a year without big storms, insurers are expected to post net income of $60 billion, a rise of 39%.

Are those profits excessive? Please. To us free marketeers, that’s an oxymoron. There’s no such thing. Does the industry have an “ethics problem,” as someone I admire put it? Nah. Insurers do what I would do if I owed $60 billlion. I’d try to pay a little as possible. And, keep in mind, many insurers have duties to shareholders, too, plus all have duties to remain financially solvent, which is no small thing.

But, there is what economists call an asymmetry of information. Basically, sellers have the data, buyers don’t. I say, let the market see which policies — homeowners, auto, health, workers’ comp, medical malpractice, commercial, directors’ and officers’ liability — are cheapest and more likely to pay, and the market will drive down prices and squeeze out the inefficient and the non-performers.

And if you think insurance only matters if your house sits on the shores of Bay St. Louis, Miss., dear reader, I have two words for you: health insurance.

And here are a few facts about insurance that I bet you didn’t know.1. Insurance is 12% of GDP, a rise of 50% from 7.9% in 1960 (My economist friends wil lknow the meaning of that). That’s not good for competitiveness, to put it midly.

2. Insurance is the third biggest consumer expense after mortgage and taxes. The average family pays $7,000 or more for it.

3. Insurance is one of two industries exempt from U.S. anti-trust laws. Yes, that’s right, State Farm and Allstate can talk to each other on price, territory, policy language, claims practices, you name it. Only Major League Baseball is similarly exempt, and you can always go to the movies instead, if you see what I’m saying.

4. Insurers have steadily withdrawn from bad risks, leaving those to taxpayers. Ever wonder why we call it the National Flood Insurance Program? Because, since 1968, it’s been underwitten by the wildly inefficent and stupid ol’ government (and in fact, it is, but we’ll get to that). And have you noticed that a state agency backs up coverage for earthquakes in California, writes more and more coastal wind policies in the gulf, including 90% of the riskiest parts of the huge Florida market) and that the federal goverment backs up terror risks? You haven’t? Dang. I have.

5. Insurance is a fascinating business with an amazing lore and history. It is also highly cyclical. These cycles depend to a high degree on, yes, losses, but also on investment cycles. That is, when stock and bond returns are high, capital pours into insurance and prices drop, as they did in the 1990s, sometimes to uneconomic levels. When returns fall, capital goes elsewhere, and insurance prices rise, as they have since the tech bubble crash of 2000. The terror attacks of 2001 were what some observers call a signaling event that cleared the ground politically (long story there) for insurers to raise rates. The subsequent bad hurricanes did the same. You are no doubt familiar with the ritual of insurers almost masochistically trumpeting the huge “losses” they “suffered” (more to say on those misnomers) in Katrina and other events. No doubt, some of that anguish is heartfelt. Some of the anguish is not.

6. Since 2001, insurers have used big catastrophes (Katrina, the 2004 hurricane season and of course, 9/11) to raise prices dramatically, and the business leaders in the Gulf openly worry about an “insurance crisis,” that is, coverage — which is not optional, by the way — that costs too much for too little. The Miami Herald ran a series under that title, “crisis,” and got flooded with emails from business owners.’

–Cindy Hertz , a managing general partner of Adhesive Tape Products, with 34 employees, said that before the company’s hurricane policy was canceled, the annual premium was $19,256. Her only quote so far: $187,943. ‘’We do not know where to turn,'’ she wrote.

– Harvey Trautenberg is with a nonprofit, the L.D. Pankey Dental Foundation. He said hurricane premiums have soared from $100,000 in 1999 to almost $1 million today.

– Dr. Geoffrey James said the insurance crisis is just one more issue driving physicians out of Miami-Dade and Broward.

7. Insurers are big big lobbyists, both in Congress and in 50 state houses — not to mention state departments of insurance, their regulators. They have a big impact on how our democracy works. I’ll leave it at that.