Insurance: Insure or self-insure? Public or mutual?

In a nutshell

Are you getting good value for your insurance dollar? Some are wondering why things seem to have deteriorated over the past decade.

Why are load-factors (the percent of premium not paid out in claims, typically 10-55%) so high?

Insurance: how it used to be historically and recent changes in ownership structure from mutual (policyholder owned and having fiduciary duty to policyholder) to stockholder/public (stockholder owned having fiduciary responsibility to policyholder) insurance companies; would the public interest be better served if we reverted primarily to mutual insurance companies?

To insure or self-insure? The cost of insurance (the premium) is always higher than the expected benefit, the difference being the ‘load factor’. How to get better value for your insurance dollar? Consider not just higher deductibles, but also mutual insurance companies and at times even self-insurance.

Some recent observations

Recently some people have been wondering if they are getting good value for their insurance dollar.

In a recent Bloomberg article by Drew Armstrong, entitled “Rockefeller says insurers don’t spend enough on medical care”, he indicates that large/small U.S. health insurance companies are spending less than the required (in the U.S.) 85%/80% on medical care. Among large companies only Cigna spent 80%, while others spent much less; e.g. Aetna 76% and Humana 68%. “Wellpoint “reclassified” more than half a billion dollars of administrative expenses as medical expenses when it was defining its medical-loss ratio.”

Another example  of U.S. insurance companies not giving expected value to the policyholders is in The truth about the insurance industry where Ezra Klein reports on the practices of health insurance companies to reduce “medical-loss” (policyholders would call that an insurance “benefit” resulting from a claim) whereby they “rescission” (i.e. “look carefully to see if a sick policyholder may have omitted a minor illness, a pre-existing condition, when applying for coverage, and then they use that as justification to cancel the policy”) and “purging” (i.e. “where insurers rid themselves of unprofitable accounts by slapping them with “intentionally unrealistic rate increases.””)

In Canada, the Globe and Mail’s Rob Carrick, in “Looking for a better deal on home insurance? Good luck”, complains about the rising cost of his home insurance, averaging an annual increase of over 10% over the past five years. He adds that “The problem isn’t just that my insurer is raising its rates. It’s that all companies are doing it to one extent or another, and it’s near impossible to find a better deal.” (Not surprised; the property portion of my home policy increased last year alone 100%, while the coverage only increased by 6%!This is in spite of having been claim free for over 30 years with the same company! As the old saying is, you might not want to buy their product, but you should consider buying their stock.)

Load factors in insurance

A common definition of “load-factor” in insurance products is the percent of insurance premiums collected that is not paid out in claims (i.e. the percentage consumed by marketing/administrative costs and insurance company profits). Load factors differ by insurance company and insurance product type. In the health insurance example in the Bloomberg article mentioned at the top of this page, the load factors among companies ranged from a low of 20% (Cigna) to a high of 32% (Humana).

It’s difficult to get an accurate picture of load factors for different types of policies but some references suggest the following numbers: long-term care insurance (LTCI) at 18%, but separating by gender it is 44% for men and -4% for women, annuities at 20-55% using general population mortality and 6-40%  when accounting for better mortality experience of annuity purchasers, group health insurance at 6-10%, while individual health insurance at 25-40%, property and casualty insurance at 40-60%, critical illness insurance (CI) at 55-65%, and I failed to find load factors for life insurance. (These are all U.S. figures; it is safe to assume that Canadian numbers would be similar or higher given the relative levels of competition in the two countries.)

Insurance: Some historical background

Niall Ferguson in his recent book “The Ascent of Money”spends some time discussing risk and the recent history of insurance. Here are some snippets extracted from the book:

-insurance is one of the means of dealing with risk and uncertainty. Americans’ risk of death is one in: 3288 by force of nature, 1358 by fire in a building, 314 being shot to death, 119 by suicide, 78 by fatal accident and 5 by cancer.

– past approaches used for protection were: “saving for a rainy day”, safety in numbers, burial societies, insurance (death, old age, sickness, and accident)

-life insurance started out as a form of gambling; then it was based on probability, life expectancies, certainty, normal distribution of longevity, and utility. Life insurance was formalized in Scotland (‘Law of Ann’ and evolved into Scottish Widows company) in the form of an annuity for widows and children of ministers and it was the first insurance fund to operate on the ‘maximum principle’ (i.e. capital accumulated until interest and contributions are enough to pay the maximum amount of annuities likely to arise)

-in 1906 Alfred Manes defined insurance as an “economic institution resting on the principle of mutuality, established for the principle of supplying a fund, the need for which arises from chance occurrence whose probability can be estimated”

-insurance premiums today are around 10% of GDP! Britain 12%, US 9%, Germany 6% (the difference is explainable by the protection offered by the welfare state and cultural differences.)

For those interested in the subject of Insurance Wikipedia covers many other aspects of insurance as well as some of those covered here, very thoroughly

Public/stock vs. mutual insurance companies 

As indicated by Ferguson, Alfred Manes defined insurance in 1906 as “economic institution resting on the principle of mutuality, established for the principle of supplying a fund, the need for which arises from chance occurrence whose probability can be estimated”.

Mutual insurance companies are “owned” by their policyholders, thus lower premiums or higher company profits benefit policyholders. Managers of public stockholder owned insurance companies have a fiduciary duty to maximize the return to shareholders within the context of the market for insurance product. If shareholders/owners of a public insurance company are unhappy with the performance of the company management then they can choose to sell their stock or whereas policyholders/owners of a mutual insurance company can choose to buy insurance from another company. Irrespective of the type of insurance company, the company needs to be able to cover the losses of policyholders, have provision for reserves against unexpected negative outcomes and cover the administrative/marketing expenses of running an insurance company. In case of a stockholder owned company, profits must also be delivered to the shareholders.

The reality is that, in the case of a mutual insurance company, the management responsibility is to the betterment of outcomes to policyholder; in the case of a stockholder owned company, it is the fiduciary responsibility of management to act in the best interest of the shareholders.

In the 1990s stock market frenzy there was tsunami of insurance companies which demutualized (transformed themselves from a mutual to a stockholder owned company). At that time there were many who spoke out against the demutualization trend, which ultimately largely prevailed. Objections to demutualization included: (1) company being run in the interest of shareholders instead of policyholder (i.e. eliminates the historical mutuality and likely more expensive insurance), (2) self-dealing by management to receive higher compensation (stock and options), (3) cost of demutualization (investment bankers, lawyers, accountants actuaries- but this is sunk cost for already demutualized companies), (4) reduction in company’s financial strength due greater risks being taken to improve short-term profitability, and (5) company’s focus shifts from providing secure (life or annuity) benefits 20-40 years in the future, to making next few quarters of financial numbers demanded by analysts. (You might be interested in reading “Demutualization is a bad idea for policyholders” which includes reasons why New York Life remained a mutual company. Wikipedia has a good description of Demutualization covering not just insurance companies, but also other types of cooperatives/associations, if you are interested in additional reading on the subject.)

Policyholders can influence future direction of the insurance industry, by giving preference to mutual insurance companies when all else is comparable. There is a U.S. based National Association of Mutual Insurance Companies (NAMIC)which according to their website underwrite 40% of the P & C business in the U.S.

To insure or self-insure (not insure)?

If there were no administrative/marketing expenses and no profits to be delivered to shareholders, then premiums associated with a risk would be equal to the probability of the adverse event’s occurrence multiplied by the size of the loss. This would be called actuarially fair price for the coverage. Clearly, in all realistic situations there are non-zero administrative/marketing costs and, in addition, an expected profit to be delivered to stockholders in a (demutualized) public company. So realistically, the cost of insurance (the premium) is always higher than the expected benefit, the difference being the ‘load factor’. Therefore buying insurance is always a losing proposition, and likely more so in a demutualized/stock/public company, unless it is much more ‘efficient’ than mutual companies, all else being the same. So one could argue that one should never buy insurance; especially when one could reasonably bear the cost of the loss (i.e. self-insure; self-insurance could take the form of purely paying for losses from available income/assets as they occur or taking a more pro-active step of setting up an insurance account where one regularly deposits the equivalent of the premiums that would have been paid). One could even go further and argue that in cases when one self insures, the individual will act with greater care to prevent or reduce both the size and the probability of a loss, and vice versa.

However, in circumstances when the loss would have catastrophic effect on one’s financial situation, insurance still has significant risk management role and in fact is required for the proper protection of a prudent individual and his/her family(e.g. to cover catastrophic losses like in life/disability insurance to protect human capital of a/the family’s breadwinner, liability coverage in case one gets sued, or emergency travel health insurance for Canadian travelling to the U.S. to cover potential costs of hundreds of thousands of dollars.)

In a recent Globe and Mail article “The lowdown on insurance salesmen and warranty peddlers” Moshe Milevsky writes that you should “Insure only events that have a potentially disruptive impact on your lifestyle and only if they have a relatively low probability of occurring”. He very sensibly argues that insurance is for very low probability catastrophic events. So life insurance is something you should buy to protect your ‘human capital’ (remaining earning power until retirement), whereas extended warranty on your $110 phone is a waste of money. “When you are retired, for example, it is hard to justify the payment of large (life) insurance premiums to protect human capital that has a low value. “ He also discusses ‘self-insurance’, or how to deposit the premiums that one would have paid to insurance companies into “risk-free investments only and no dipping into the cookie jar (except to cover a loss)”. He also reminds his readers that with insurance “you can’t make money “on average,” and the insurance company makes money “on average” at the same time.” You must decide for yourself what risks you’ll self-insure and what risks you’ll pay an insurance company to cover. (You might be interested in a similar discussion on the self-insurance option for Canadians’ health insurance in my blog Individual health insurance in Canada)

Bottom line 

All else the same, try to deal with a mutual insurance company. Insure only low probability very high impact (catastrophic) events, and self-insure when you can bear the potential loss. Buy life/disability insurance during working years to protect human capital. Buy liability insurance to protect against getting sued in event of an accident that you might be involved in. Also buy emergency health travel insurance if you are a Canadian traveling to the U.S. or if you have a (relatively) new car that you’d have trouble replacing in case of a serious accident. However when you do buy insurance consider higher deductibles to reduce premiums.

You might want to consider self-insuring an older collision, critical illness, long-term care (especially Canadians). If you do self-insure, make sure you set up an insurance account that you pay the equivalent premium to yourself, so you’ll have the funds available when needed.

When you are considering buying or you are being sold insurance products, you’ll need to look at each case and test against “low probability and high impact” and of course factor in your own risk tolerance.