Insurance - The Most Misunderstood Industry

Insurance - The Most Misunderstood Industry

A new look at the insurance industry was recently introduced in a book written by Howard Kunreuther and Mark Pauly, Behavior Economics: Improving Decisions in the Most Misunderstood Industry. The following essay borrows heavily from the concepts introduced in this book and from a related article written in the January 2013 edition of Business Insurance magazine.

We are all very familiar with insurance in our daily lives. One would think that the familiarity would translate into wise insurance purchase decisions: trading a relatively small premium for protection against a large loss when the price is right. Similarly, one would expect insurers to use data on the likelihood and consequences of specific events to determine a risk-based premium. Finally, one would expect regulators to allow insurers to change premiums that reflected the risk being insured.

Why then is such reasonable behavior by these parties so often the exception?

Many consumers simply do not appreciate insurance. They often view insurance as something required by their mortgage lender or the DMV and not necessarily the prudent exchange of risk. There is often a long interval between the time one pays a premium for protection and the occurrence of an insured loss. This is especially true in catastrophe prone areas like ours. Low probability events like natural disasters are so far and few between, a consumer may never experience a loss but still be required to pay inflated premiums year after year.

When we buy an insurance policy we benefit only when and if a loss has been incurred and we have successfully navigated the claims filing and settlement processes.  There is thus a tendency to view insurance as a bad investment when you have not collected after paying premiums for years. It is difficult to convince people that the best return on an insurance policy is no return at all.

When insurers make decisions on what coverages to provide, their concern is on the impact that a catastrophic loss will have on their balance sheets. Insurers know that if many claims occur simultaneously, as in the case of wind damage from hurricanes, there could be a severe negative impact on their surplus, and in the extreme case could cause their insolvency. For events such as terrorism, floods and earthquakes, insurers have perceived those risks to be uninsurable without some backup by the public sector. This goes a long way toward explaining why so few companies willingly insure property risks in our community. It explains why some of the largest insurance companies require policyholders to accept the highest wind related deductibles. Many of our clients come to us in search of an affordable wind deductible more so than an affordable insurance premium.

Insurance probably is the most misunderstood industry, misunderstood by all impacted segments of our society. Consumers often lament over the payment of premiums but not getting benefits in return. Would this person prefer to have been the victim of a major weather event? Insurers act like occasional large losses are not to be expected. They often don't price the risk appropriately in advance to reflect this possibility and accumulate reserves to cover the catastrophic losses when they occur.  Their managers strive to increase market share and shareholder returns in hopes of achieving short-term personal rewards. Regulators often do not allow insurers to price their products to accurately reflect the risk. They believe some consumers require subsidies. But aren't there better ways to do this than restricting premiums to be artifically low? The National Flood Insurance Program provides an excellent example of property owners being in flood prone areas being subsidized by tax payers through artifically low flood insurance premiums.

One of the remedies for a misunderstood industry is increasing the general understanding of it