RiskProf

RiskProf takes the dare

I could be wrong about a number of things, but I try --in this forum --to be correct in applying economics to situations involving risk and insurance.  My opinions are based upon economic theory which includes the theory of how insurance is priced.  In a comment to a previous post on free insurance someone said,

"No one is asking for free insurance. Compare the expected losses to the premiums. I dare you."

So, I take up the dare.  Except I punt a little.  I do not have access to expected losses.  So I looked at past performance.  

One of the problems with this incredibly simplistic assertion is that it is based on the assumption that everything works with in a one year period.  Firm's are in business for the long run, thus they expect to make profits in the long run.  In fact, they do not have to make a profit every year, just in the long run.  Otherwise they will leave the market.

In the figure below I plot the loss ratio (losses incurred in a given year to premiums earned).  Thus this is actual losses rather than expected.  Florida has the big swing in 2004 and 2005 due to the hurricanes in those years.  If we look at the average of these ratios over time Florida's is 72.77.  That means that for every dollar of insurance premium paid, the state's customers received 72.77 cents in loss payments.  Kansas (one of those middle states without any hurricane risk) has a relatively stable loss ratio and an average ratio of 62.64.  That means for each dollar of premium paid, the state's customers received 62.24 cents back in loss payments.  Finally, in the U.S. overall, the average loss rat is just a bit above Kansas'.

So, Florida's customers already get a better deal than the average customer in the U.S. given that they receive more back in terms of loss payments.  They would like an even better deal (as would I).  To get this better deal, they would like Kansas and the other states to chip in. 

The data come from the NAIC and are available from them if the commentator wants to check my work.  To be fair, maybe no one wants free insurance.  Maybe they just want less expensive insurance.  Either way, someone else who doesn't share that risk has got to chip in to make it so.

Insurance is not socialized risk sharing.  It is sharing of risks where everyone pays their risk based price. And for the record, I was (and still am) against federal programs like TRIA.  I also believe that the private market could cover flood insurance.

(Note this post was updated slightly from the previous version because I meant to save it and I inadvertatnly published it before it was finished).

Observations on Insurance Related Consumer Advocates I

I just saw a post by Claire Wilkinson at the I.I.I. about the 2008 property-casualty industry profits.  It made me think about past disagreements with the Center for Justice and Democracy and other consumer advocate groups.

Profits are down... substantially from an all time high the previous year. While the industry eked out a slightly positive profit, it is just a hair above zero according to the ISO.

Because the dramatic change in profitability, should we not expect the consumer advocates to claim that the industry needs to raise prices?  Of course when profits were high we saw claims of price gouging. If the industry is now just breaking even does this mean that it is no longer price gouging?  Did it become a saint in just a year?  Were are the forty page reports demanding higher insurance prices?

I also saw claims that the industry was holding too much capital. Capital is expensive and its costs are passed onto the premium.  But, substantial capital holdings implies that the firm is safer from bankruptcy. Were the consumer advocates arguing that the industry was too safe and that consumers did not benefit from that safety? I never saw it put that way.  it was always in terms of prices.

In fact a well known consumer advocate, Mr. Robert Hunter stated

Another major conclusion of [his] report is that the property/casualty insurance industry has inflated the surplus [capital] it holds, by as much as $100 billion beyond the level needed to back up the underwriting risk they face.

Others argued that capital levels should be reduced to the bare minimum required by law.  This would have put the industry in a precarious position.

There was never an explanation as to why insurers held capital in the first place.  Making capital evil was a way of making the industry look inefficient and bloated.  I think many consumer advocates would agree with me and wish banks were better capitalized.

Georgia Deregulates (mostly) Auto Insurance

Yesterday, Governor Perdue, singed a law recently passed (SB 276) by the legislature that would allow insurers to set prices in a free market for automobile insurance.  My colleague Rich Phillips and I made a couple of presentations to legislative committees on the issue.  Our main point was that Georgia was not in a crisis mode right now, so it would be easy to allow market competition to commence.  Our second point is that the research shows that price regulation in the states over the last 30 years or so does not yield consistently lower prices compared to competitive states.  So, if price regulation does not do a superior job at keeping prices low, why have it? 

For an influential set of papers on auto insurance deregulation, see the Brooking's/AEI Joint Center book here.  Here is our presentation for the talk we gave to the legislative committee.

What is interesting about this bill is that the mandatory coverage (minimum levels) required by law are still subject to price regulation, but the additional coverage are subject to competitive pricing.  Further according to the AJC, the consumer group, Georgia Watch, seemed to be ok with the new law.  However, their website suggests otherwise.

Another Look at Insurance Profits

Ted links to a CJ&D complaint that insurers are making profits.  It is hard to believe that we are talking about this.  Under our economic system profits are good thing.  Profit attracts capital, firms enter, and competition is enhanced.

What many people seem to think is that profits are an extra and that this extra is an immoral extraction of money from consumers.  Of course, it is possible, that collusion among the providers might lead to extraordinary high profits.  In that case the extraction of “extra” might be immoral. However, this is not the case in the insurance industry.  No one has made the case that there is collusion and many have made quite a bit of noise about it.  Perhaps the Florida insurance commissioner will find some secret memo among the subpoenaed documents that says something like this memo I recently received.

 

To all in the insurance industry and selected bloggers:   Our regularly scheduled secret meeting will not be held tonight because Debbie has a Girl Scout meeting tonight.  She just forgot about it when she originally scheduled the  secret meeting and she is the cookie coordinator.  Debbie suggests that we  postpone the secret meeting until next Tuesday.      Also, Debbie wanted to remind everyone, especially Ed S., that while smoke filled rooms might have been de rigueur in the past, smoking will lead to immediate banishment to the corridor C hallway where a special close circuit video connection will allow smokers to watch the secret proceedings.     Oh, by the way our head number cruncher suggests that we should overcharge every household   by $950 up from $870 this last year. We can talk about this at our next secret meeting.      Finally, Progressive Allied Indemnity of Secaucus also volunteered to bring the donuts.      Thanks guys,         Mickey Secret Insurance Cabal Coordinator

I suppose that if this memo existed, I’d change my mind about collusion, but this is a canard that keeps being repeated without any type of proof.

There are numerous firms competing for our insurance dollar expect in those states that won’t let the industry compete.  In those states we see insurers leaving the state.  All one has to do is look at the automobile insurance markets in New Jersey, South Carolina, and now Massachusetts.  In each case the state regulated prices severely.  This caused companies to leave the market and prices ended up rising because of massive subsidization schemes that rewarded high risk drivers at the expense of the low risk driver.  In each case, deregulation occurred because the state had to throw its hands up in defeat.  It could not manage the market through increasingly hostile regulation.  Insurance is a voluntary business and at some point, companies will just leave.  After de-regulation each market responded with lower prices for many consumers and more insurers were willing to write in the state.

This week we saw a number of things which are consistent with this market based view.  First, State Farm threw up its collective hands in Florida. In addition to deciding to write no new polices it cut 50 thousand policies. 

Alex Sink the CFO of Florida is worried about the effect of upcoming surcharges on the policyholders of Citizens Property Insurance (the state owned insurance company).  There could be serious (double digit) increases for these customers in the company of last resort.  Citizens is the fifth largest insurance company in the US in terms of exposure (which is not a typical way of measuring insurance company size, but because it is owned by the state, its asset base is essentially the borrowing ability of the state.

Florida looks like a tremendously mismanaged risk exposure. Therefore it is going to be more costly for everyone involved including both private and public participants.

In addition, a study came out this week in Natural Hazard Review that said hurricanes were no worse in terms of severity than in the past.  What has changed is the economic harm that they can cause.  This is because people are putting property and other assets into high risk zones.  By itself, this causes an annualized real economic loss from hurricanes of about $10 billion per year. Over the past 7 years (2000-2006) the combined homeowners and commercial property premium volume in 2006 dollars averaged 4.2 billion.  This does not include Citizens’ premiums which are currently about $1.6 billion.  So if we expect to have $10 billion in annual losses we do not take in that much in terms of insurance premiums.  While the $10 billion dollar annualized loss includes both insured and non-insured losses, if we assume that 50 percent of the losses are insured losses then our premium volume is pretty close to the expected annual losses.  This leaves no room for profit, underwriting or claims costs.  It is no wonder that firms are reluctant to operate in Florida.  There is no profit opportunity because the state has chased out the private market, allowed increased concentration of risk on the high risk areas, and subsidized the state’s own rates by using its power to tax all residents of the state to cover losses by Citizens.

Finally, the NAIC, the group of state insurance regulators publishes an annual document called the “NAIC Profitability Report”. In the 2006 edition there is a table on page 36 which compares the insurance industry with a fortune All Industry (Finance and Industrial) average return net worth.  The highest return for the insurance industry was in 2006 with a return on net worth of 12.2 percent.  The highest year for the All Industry net worth was also 2006 and the return was 15.4 percent.  Over the last 10 years (see graph below) the insurance industry averaged 7.2 percent and the All Industry average was 13.5 percent.  Further the return for the insurance industry has a standard deviation of 3.8 compared to the All Industry return standard deviation of 1.86.  Thus, the insurance industry’s returns are volatile compared to the All Industry returns.  Now, one can quibble about the proper definition of profit, but most definitions will give similar results in terms of relative profitability and volatility.  So, profits are good.  Regulatory mismanagement is bad!  Demagoguery is beneath the pale, but par for the course!

(click to see a bigger image)