Insurance companies and regulators are in bed again, but it is the consumer who could get screwed
In a recent front-page article in The New York Times headlined, “Seeking Business, States Loosen Insurance Rules,” writers Mary Walsh and Louise Story effectively brought to light the dark actions of insurance regulators and companies that could lead to financial turmoil in the insurance industry even greater than that experienced in the Great Recession of 2008 and 2009.
The Times article revealed that states – desperate for revenues – are allowing insurance companies to establish “captive subsidiary companies.” With the promise of lighter regulation and less stringent requirements for reserves needed to cover potential losses, these states are allowing (encouraging) the insurance companies to transfer huge risks off the books of the primary company – making them appear more profitable and less risky – and allowing the companies to shield their true financial strength from scrutiny. If that high-risk accounting strategy seems faintly reminiscent of Enron’s ill-fated “Raptor” and “LJM2” subsidiaries, it should.
As the Times exposé pointed out, “This has given rise to concern that a shadow insurance industry is emerging, with less regulation and more leverage than policyholders know, raising the possibility that in the future, insurance companies might find themselves without enough money to pay claims.” Some of the companies taking advantage of this “look-the-other-way, see-no-evil” type of regulations are the very same companies – MetLife, Hartford Financial, Swiss Re, Aetna and AIG – that found themselves in a precarious financial position or needed government help to survive the last time around.
This collusion among some state regulators and insurance companies is the classic “I scratch your back, you scratch mine” type of mentality that mocks the very concept of state regulation of insurance companies. The states receive a needed boost in revenues based on premium taxes collected on business moved into the state. In exchange insurance companies are allowed to operate in the shadowy world of financial wizardry and tricks. Unfortunately, the ones who could end up paying the price for this abdication of regulatory responsibility and financial chicanery will be those who look to insurance companies to protect them against risk. (That is, if we don’t have another government bailout.)
How Insurance Companies (should) Make Money
Insurance is all about risk, but not the type of risk that most people think. There is the general assumption that insurance companies are in business to assume the risks of others, i.e. dying, being injured, experiencing a fire, but that is an incorrect assumption. Insurance companies are in the business of managing not assuming the risks of others. Insurance companies manage risk by pooling those who face a risk, i.e. getting sick, together in a single group and charging a fee (premium) from each member of the group. These collected premiums are held by the company in a reserve to pay for the costs of those who actually experience a loss.
So, it is not the insurance company that takes the risk. Instead, savvy insurers use their expertise to spread the risk among a large group, so that those at risk of loss share that risk with others. For this service the insurance company earns a fee. If the insurance company manages the risk efficiently and effectively, then the fees collected become their profit.
As we have seen in the past, well-run insurance companies can turn these fees for managing the risks of others into billions of dollars of profit; creating huge financial institutions. However, when insurance companies are poorly run or when greed enters the picture, the risk is that these companies will assume the actual risk and ultimately fail. The result will be real losses for shareholders and those who contracted with the company (policyholders) to effectively manage their risk of loss.
A good, but certainly not the only example of this type of scenario is the American International Group (AIG). For decades AIG was a well-run company that efficiently managed a multiplicity of risks worldwide. For its efforts, AIG earned billions of dollars in profits and became one of the largest and most respected financial institutions in the world. Then greed set in causing AIG to change its business model and violate the most basic precept of insurance by starting to assume, rather than manage risk. Instead of spreading the risk of “credit default” or the risk of mortgage failures, AIG assumed the risks inherent in these activities. In short order this great giant of a company AIG was teetering on the cliff of bankruptcy—only to be saved by a $100 billion dollar lifeline from American taxpayers who wound up owning 80 percent of the company.
A similar bailout occurred when the management of Hartford Financial – seeking to increase sales and bonuses – began to assume the investment risk for customers who had purchased variable annuities from the company. By promising to cover investment loses within the policies, Hartford lost hundreds of millions of dollars. Only a $2.5 billion charitable investment by Allianz SE and $3.4 billion in government TARP funds saved the company from bankruptcy.
The Fatal Flaw of Permissive Regulation
Insurance companies begin to fail when they begin to assume, rather than manage risk. And the most effective counterbalance we have to protecting ourselves from insurance companies that forget that simple formula is effective regulation.
The purpose of state regulation is to protect the consumer by preventing companies from taking risky and stupid actions, which they seem to have a proclivity to do. One of the primary functions of insurance regulators is to make sure the companies are safely putting aside enough of the collected premiums (called reserves) to pay claims when losses occur. (From the standpoint of the company, the smaller the reserves required to be established, the higher the profits; at least in the short term. Of course, in the long term, to the degree that these reserves are insufficient to pay the claims when they arise, the company will fail.)
For the past decade, as insurance products have become more complex and the financial structure of insurance companies more obscure and convoluted, state regulators have been criticized for lacking the resources and expertise to effectively protect the consumer and determine the financial integrity of insurance companies. Consumer groups have sought to rectify this weakness by proposing federal regulation of insurance companies, but strong lobbying by the National Association of Insurance Commissioners and many of the companies has blocked the proposal.
Now, with states attempting to increase revenue by promising even less regulation of reserves and financial overview for companies that move large blocks of risk into their state via captive companies, the very concept of regulation – not to mention protecting the consumer (most of whom are not in the state accepting the business) – is made a mockery.
This attitude and approach is something that we can expect from the greed of insurance company executives, but for state regulators to get in bed with the insurance companies and sacrifice their responsibilities on the altar of short-term revenues, boarders on criminal. But, what else is new?
And the Moral of the Story …
Insurance companies are in the business of managing not assuming risk. When they stick to their knitting, it is an easy business and they can make enough money to keep most potentates happy. But when enough is not enough and the insurance companies begin to stray from what their business should be, it is the responsibility of regulators to keep them on the straight and narrow.
However, when the line between risk and regulation is blurred or even erased as is happening in the current environment of loosened insurance rules, then a new risk emerges—one is destined to repeat rather than learn from the mistakes of the past.