Panic Blinds Reason

It is a myth that insurance companies assume risk. Insurance companies earn their stripes (and profit) by managing the risks of others, not assuming them.

All Americans, but especially those of us in the financial services industry, have been rocked by roiling financial markets. There are many reasons for and much blame to be assigned for the turmoil, but this column focuses on the problems as they relate to the insurance industry.

In one way or another, all of us are impacted by the crisis at AIG. As the only American insurance company capable of standing toe-to-toe with the European giants, there was much to be proud of at AIG. While it does appear that all AIG liabilities will be met, the fallout from the mistakes of AIG management will be painful for the entire insurance industry because the confidence of the consumer has been damaged.

Up to this point, insurance companies have benefited from a well-deserved reputation for impeccable safety and security. This high repute was earned by being boringly conservative. However, during the past two decades, as the regulatory supervision of the financial services industry (implemented to prevent another Great Depression) began to be eroded and repealed, the insurance companies found it increasingly difficult to compete with the expanding powers of banks and investment firms.

Unfortunately, many insurance company executives chose to compete in this new financial world by moving away from the proven philosophy of risk aversion. They did so to follow in the footsteps of banks and investment firms by beginning to accept unmitigated risk. Now, the fallacy of this philosophy has come home to roost.

It is a myth that insurance companies assume risk. Insurance companies earn their stripes (and profit) by managing the risks of others, not assuming them. Life insurance companies do not assume the risk of an individual dying; they cobble together thousands of other individuals who are worried about the economic cost of dying. The premiums collected from the entire group are managed by the insurance company and paid out on behalf of those who do die. For that service, the insurance company receives a fee, which is called profit. Only when an insurance company ceases to manage risk and actually assumes the risk does it encounter problems.

The truth is that insurance companies do best when they are boring. AIG grew to become one of the largest and most successful insurance firms in the world, yet, until the current crisis, very few people outside the insurance industry had even heard of the company. The successful long-term management of an insurance company boils down to three simple but critical rules.

The first rule is that a company must never put itself in a position against which it can be anti-selected. Companies underwrite a risk because they need to know what the risk is and how it can be managed. If the underwriting is deficient, then there is the potential for anti-selection that will lead to losses. And if there is the potential for anti-selection, it will happen.

Second, insurance companies should never assume a risk that cannot be managed. For example, if a company issues a product that exposes it to the risk of financial disintermediation (the movement of interest rates and liabilities), it is vulnerable to a risk that it cannot manage. And that is a recipe for disaster. This is exactly the mistake that the management of AIG made.

The final rule that companies must abide by is to have the interests of all those involved in the transaction be parallel. This goes for the company, the insured, agents, employees, and shareholders. If a product is offered that favors one interest group over the other, the parallel is lost and trouble follows. Being out of parallel is a mistake many insurance companies have recently made, and this has led to the current problems with distribution, litigation, and regulation.

History has shown that when insurance companies fall into trouble, it is because of a violation of these very basic rules of management. The good news is that they are simple rules and work wonders when applied.

(This article bylined by Bob MacDonald was originally printed in the final edition of Insurance Marketing, the premier source for marketers of life, health, and financial products. The publication ceased operation following its Oct. 2008 edition, a victim of the economic recession, not as some suggest that it failed because Mac was a columnist.)

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