Peter Gosselin, a staff writer for the LA Times, has written a provocative piece on the future of insurance. It's a must read for anyone interested in risk.
We all know that insurers want to sell insurance to people who are not likely to use it. In the rapidly disappearing "old days" of risk transfer, insurer actions were premised on the law of large numbers: if you sell relatively similar insurance policies to a large enough pool of insureds, the losses will be spread out. In effect, those less likely to file claims subsidize those more likely. Because rates up until recently have been pretty much the same for all, the coastal homeowner pays relatively less for insurance; the secure inland homeowner, less at risk, pays a relatively higher rate for insurance.
This is no longer the case. Insurers are backing away from coastal exposures. The price of insuring coastal homes goes up and up, limited only by the intervention of state regulators. Often, the state itself has to create a risk-bearing mechanism so that coastal homeowners can be covered. Meanwhile, property insurers, having identified what their actuaries have determined to be low risk prospects, go into their death spiral of cutting rates (and paying higher commissions to agents) to secure the business. They're no longer interested in big pools. They want to limit their writings to prime risks only. In effect, they are easing their way out of the risk transfer business.
The Hazards of Mining
We are already deep into the brave new world of data mining. Insurers can develop a much more specific and detailed profile of each risk. Armed with geographic, climactic, economic/credit history, education and other data, they isolate the factors that might indicate a direction toward filing a claim (bad risk) or never filing a claim (good risk). In the predatory world of insurance, this translates, of course, into highly favorable (discounted) rates for the good risks; and higher and higher costs for those identified as bad risks. State regulators look upon the increasingly sophisticated pricing models with alarm, because they know that lower and middle income people often bear the brunt of higher costs.
Katrina opened the eyes of its victims to the fine print in insurance policies: water damage simply wasn't covered. Now property owners whose homes have been totally destroyed by any cause (fire, tornado, etc.) are confronting not-so-subtle changes in the wording of their insurance policies. No longer providing "guaranteed replacement cost" - ie., rebuilding the home as it was - insurers now offer "extended replacement cost" - which limits payments to a specific dollar amount. Homeowners who built in the 80's and 90's might assume that there is a built-in escalater clause to cover the higher cost of rebuilding in 2006. They are dead wrong. And I'd be very surprised if anyone has bothered to tell them about the changes.
The End of Insurance?
We may be seeing a fundamental change in the nature of insurance. Insurers have always been risk averse, but now they have the tools to limit their risks dramatically. As the concept of pooling evaporates, as insurers begin to slice and dice prospects into dozens, even hundreds, of categories, the number of losers is likely to exceed the winners. For one reason or another, a very large number of people who have been identified as "bad risks" will be faced with exponential hikes in the cost of insurance. (If health insurers try to base their pricing on genetics and family history, all hell will break lose!) Meanwhile, those identified as good risks will be able to choose among highly discounted products. Brand loyalty will disappear in the proverbial New York minute.
Peter Bernstein, author of the highly readable and entertaining Against the Gods: The Remarkable Story of Risk, thinks the new insurance strategies are doomed: "Insurers who look at each risk individually at the expense of broadly diversified pools are going to end up in the soup. Diversification, not flyspecking one risk at a time, is the insurers' optimal form of risk management."
We'll see. The insurance industry is undergoing a paradigm shift of enormous importance. The new model will probably generate some hefty profits, but the party may not last very long. There will be howls of protest from the millions who, for one reason or another, have been deemed to be "bad risks." Then the rhetoric will explode: "Bad risks of the world, Unite! You have nothing to lose but your (coverage) chains!"