I currently work for an insurance company. Not a great big one, but a leading one in its niche, and one that seems to treat its clients pretty well. And I get to see firsthand the impact of heavy regulation on the company. Some people look at this impact and argue that business would be much more efficient without it. But that won’t work in this case. I will explain here why the insurance industry needs this regulation.
Let’s assume that some insurance company executives are more ethical and principled, and others are less so. Let’s consider the incentives acting on the latter group. Getting high premiums is good, but drives away new customers. Advertising lower premiums brings in new customers, allowing total revenue to go up by more than enough to compensate for the loss of margin on each. So the incentive is to compete with other insurers with a low price.
Paying claims is bad. It not only loses money right away, it forces the raising of premiums. The more claims you can avoid paying, the more competitive a rate you can offer to new customers.
Now, the revenue of premium payers is steady, but the cost of claims is not. One year might be twice as expensive as another. This means you need a cash reserve. But this needs slightly higher premiums, so the incentive is to keep it smaller. Plus, there’s the all-too-human itch, when looking at a big pile of money, to start spending some of it. So it’s all too easy to talk oneself into underestimating the degree of variability of claims — to assume that the exceptionally bad years won’t happen.
The cash reserve can earn money through investment. Some investments pay more than others, but the ones that pay more also pay at a less predictable rate. So the incentive is to underestimate that variability and invest in overly risky opportunities for capital growth.
Whenever a company has a few good years in a row, the amount of saving they’re doing for future claims starts to look excessive, and the incentive is to think that it’s now safe to cut back on savings, and lower premiums.
Put all this together and what you get is a situation where market forces push insurers toward being underprepared for major claims. If some companies prepare well and others prepare poorly, the ones making poorer preparation will tend to get customers away from the ones preparing well, by offering lower prices. This can force the companies that are reluctant to do so, to also shave their premium prices. So the number of poorly prepared companies has to increase. And because the rewards of underpricing are immediate but the negative consequences are uncertain and may not occur for many years, it’s very easy for people to convince themselves that they’re not underpricing at all.
Eventually, a crunch will come — the investments may go south, and at some point the big claims will hit. If the investments do poorly enough, even routine claims may suddenly be too big. Once this happens, the company can either exhaust their capital, or cheat their customer, coming up with some technicality as a grounds to refuse to pay a claim. The latter might work, or it might make them liable to a costly lawsuit. Either way, it’s not sustainable. Eventually, you either have to give up the money, or lose your reputation so customers won’t trust you with their money anymore.
Now a free market apologist might argue that the market will eliminate these bad companies eventually, thereby leaving the good ones behind. But once some companies turn bad, competitive pressure forces the others to either get down in the mud with them, or shrink and become minor niche providers. This means that the majority of customers buying insurance end up being not really insured. Legally they’re covered, but in practice they aren’t — they’re still subject to the risk they tried to eliminate by insuring themselves. The result of this is that the entire industry ceases to function; no real insurance is being provided except to a select few who are willing to pay a top-shelf price for it.
As a result of this, the only way to have an insurance industry that really insures people is, firstly, to force them to expose their financial data so that everyone can see if they are at risk of failing to pay claims. And to test those findings against some standards of financial preparedness.
But that’s not the only issue. Even when all the insurers are financially healthy, each one still has an incentive to resist their obligations to pay claims. There’s always an immediate reward for finding ways to deprive a customer of coverage when they make a claim. And if some companies do so and others don’t, those companies gain a pricing advantage in the short term. This can mean that the whole industry, again, can be dragged toward failing to really cover their customers. This isn’t theoretical: a situation like this did happen in the pre-Obamacare health insurance industry. It became the norm to cheat and rob many customers through legalistic trickery. (We shall see in time how much difference the new law manages to make.) The auto collision insurance industry has allegedly also showed tendencies in this direction, when the regulatory climates of particular states allowed it.
Again, the free market does not weed out the bad apples — or rather, it doesn’t weed them out quickly enough to discourage their proliferation. Instead, it pushes the good ones to emulate the bad. And even if you clean out all the bad ones, the least good of the ones remaining will still exert a slight downward pull, which increases with time.
The only way to overcome this steady downward movement is to put a floor under it, which means setting and enforcing minimum standards of dependability in paying claims. Our current regulatory environment, unfortunately, is spottier in this area than it is in the financial one. But when and where it’s done properly, the insurance industry can function pretty well, providing a valuable and necessary service. When it doesn’t, the industry can gradually shift from useful to parasitical. If that shift becomes complete, one might as well never have bothered to start insuring oneself.