What is (re)Insurable?
By Sam Gutterman
Reinsurance News, September 2021
Editor’s note: By invitation Reinsurance News is reaching out to past presidents of the SOA as thought leaders of the industry. Sam Gutterman was president of the SOA from 1995 to 1996.
We spent half a semester in my insurance law class at the University of Michigan (several decades ago) addressing the question “what is insurance?” An integral aspect of that question continues to be “what is insurable?” I have encountered both of these questions repeatedly throughout my career in risk and insurance. The issues involved are often both significant and nuanced.
There are two key different but related ways to view insurability—the practical and the conceptual. Practically, an insurable risk is one that an insurer is willing to provide insurance coverage at a specified price that the potential applicant is willing to pay. In contrast, the conceptual approach incorporates a wide range of factors that are usually considered in the context of the insurance process, such as an insurer’s capacity and willingness to manage uncertainty.
Under either view, the availability of relevant and reliable information about current conditions and future expectations is of fundamental importance. If the insurer cannot obtain relevant information regarding the exposure(s), a sufficient meeting of the minds may not develop to consummate a contract. This also applies to a reinsurance situation in which the direct writer does not provide relevant information, for whatever reason. In any case, a lack of information regarding the risks involved or related externalities is a major reason for being uninsurable.
Practical
I used to think that an actuary (or an underwriter) could come up with a price for any insurance risk, although the applicant may decide the benefit of having a specific insurance coverage is not worth the price. I looked to Lloyd’s of London, famous for providing financial protection against almost any peril for a price.
However, the ability and willingness to insure can differ widely from context to context, from time to time, and from person to person. It is driven by both supply and demand, with a fragile boundary between offering insurance and not offering it, depending on the extent of hardness/softness of the market, the uncertainty inherent in the coverage and portfolio of risks, and the information/data available. The insuring process can also be influenced by herd or peer risk.
A practical consideration for a potentially covered individual and the insurer is the affordability of the quoted price or assessment of value to be provided. These involve personal/corporate decisions amid their contexts—economists attempt to assess these decisions based on utility functions, while actuaries consider alternative financial demands and risk aversion/appetites.
Focusing on supply and demand, as well as needs and expectations, described in an early chapter of all basic economics textbooks, may be the most important factors to start with.
Conceptual
Although it is usually best to start an insurability process by considering fundamental principles and concepts, it is not always easy to do so. Factors to consider in determining whether an (re)insurer should offer insurance coverage mainly relate to the uncertainties involved. And whenever there are significant uncertainties, information is at the heart of the decision-making process.
This gets to a fundamental yet related question that may need to be addressed: what is the objective of (re)insurance anyway? For a direct writer, this includes providing financial stability and peace of mind to its customers, while for a reinsurer this can include such purposes as enhancing the income stability and capacity of the direct writer, reducing the insurance protection gap, and furthering the sustainability of the industry. The spread and diversification of the risk portfolios are essential to satisfying all of these objectives.
In view of these objectives, the considerations that can drive the decision to insure can include:
- Sufficient information. Determining what constitutes the minimum amount and type of information that can facilitate becoming or remaining insurable can be subjective. To illustrate inadequate information, I recall the first time I analyzed the cost of a P&C reinsurance treaty—I noticed that there were no reported paid claims or case reserves for what was labeled as including mostly automobile liability insurance written on a quota share basis. That looked odd. I asked for more information. Sure enough, there was indeed a problem—it turned out that the treaty was about 80 percent general liability with quota share coverage between $1 million and $5 million. Uh-oh! Sure enough, within another two years, the loss ratio skyrocketed above 1,000 percent. Or the case of an annuity rate quote in which it was unclear whether the employees of a coal-mining company to be covered included only its office workers or only current and former miners.
- Symmetry of information. An insurer would like to have at least as much information about the insured exposures and perils as the applicant. I remember a situation in which a block of business was labeled as containing “environmental risks,” which initially raised all kinds of alarm bells. But this turned out to include a couple of gas stations that had the potential for underground gas storage tank leaking risks not near water; not necessarily good insurance risks, but certainly ones that could be underwritten with appropriate controls in place with an adequate inspection.
- Time. How long of a time period can a price guarantee cover? That is, for how long can the uncertainties that may arise from inevitable changes in circumstances be covered by guaranteed insurance rates? This is the reason some contracts or guarantees have a one-year term. In some cases, the extent of uncertainty increases with time, resulting in limited coverage or guarantees. These can also arise from changes in subsequent experience, the accumulation of long-term mortality trends, or mortality disruptions such as pandemics or medical breakthroughs.
- Anti-selection and fraud. To the extent an insured has a choice, information asymmetry, anti-selection, and moral hazard are all possible sources of increased uncertainty. It is not good business practice to rely on a post-claim inspection to understand the real exposures involved.
- Trust. For a direct writer, how long has the relationship with the agent/broker and the applicant existed and what type of credit rating does the applicant have? For a reinsurer, the quality and stability of the direct writer and its management are important to consider in managing uncertainty.
In any case, the (re)insurer’s reluctance to offer insurance protection is increased when the premium for uncertainty appears insufficient compared to the extent and perceived financial consequences of the certainties involved.
Quantitatively Speaking
I recently came across a quote in Kay and King’s book titled Radical Uncertainty: for a risk to be (re)insurable, “it must be possible to quantify the probability that the insured event will occur.”[1] Although this is an oversimplification and reinsurers employ tons of actuaries and modelers, probabilities cannot be developed for all circumstances. Even in mortality reinsurance, there are a lot of short- and medium-term changes in mortality that can emerge unexpectedly.
Yet as Frank Knight, a noted early 20th-century economist claimed, “if you cannot measure, measure anyhow.”[2] In most instances, even though precise answers cannot be derived, a sufficiently accurate estimate can be made. Nevertheless, the best method to address this challenge can sometimes be unclear.
Actuaries know that there are many ways to derive such quantities or estimates. They can be based on technical actuarial models incorporating numerous random variables based on historical mortality experience of similar risks. Or they can be based purely on professional judgment considering expectations of changes in risks or conditions. Where practical, it may be best if both approaches were used.
To test the level of uncertainty, catastrophic exposure, and concentration risk the insurer is willing to undertake, a rigorous scenario analysis may need to be undertaken.
To help achieve an optimal amount of insurance is available, more protection of the insurer may be needed. A well-designed regulatory regime can help ensure that policyholders are protected. In part, insurers are required to hold reserves to meet more than the present value of their expected best-estimates of their likely commitments. They may have to hold capital to meet something like at least 95 percent of likely adverse events or conditions, with the business required to be transferred to a third party if needed. Ultimately there is the backstop of state guarantee fund coverage. These mechanisms are all linked, with costs borne by policyholders or other stakeholders.
For some risks, joint private/public insurance programs can be developed to address exposures that insurers are not willing to handle themselves, especially at a premium level deemed to otherwise be unaffordable.
Catastrophic and Concentration Risk
The possibility that the insured or portfolio of insureds suffers extreme losses can not only increase the incentive to insure, but at the same time can discourage an insurer from offering coverage at an unaffordable price. The availability of reinsurance (from multiple sources, where possible) is essential in helping insurance premiums to be reasonable in relation to the coverages provided. Such risks can involve a wide range of uncertainties, the cost of which can differ by the risk preferences of an individual or company.
This can be the case, for example, for a pandemic that can affect a high percentage of an insurer’s risk portfolio. In addition, providing homeowners insurance to houses in a flood plain in which many homes have been built (or rebuilt), regardless of historical flood history in the area. An increased number of people are moving into such areas—this type of catastrophic risk is not improving, resulting in challenges to the (re)insurance industry.[3]
Mitigation, or the Role of the Reinsurer
But all is not lost—uncertainty will always exist and the contingent risks that insurance can cover never seem to go away, and sometimes seem to be growing at an exponential rate. The needs for insurance protection, opportunities for insurers, and opportunities for actuaries will continue to exist. Which brings me to a discussion of what can be done to help make these risk more insurable.
One of the objectives of a reinsurer should be to facilitate the placement of direct insurance (insurability, thereby providing more business to the reinsurer). To be successful, the considerations described above and risk quantification need emphasis. Managed and lowered cost and premiums are key elements of affordability, which require, whenever possible, insured-motivated mitigation.
A primary value an insurer can be to provide insurance is risk control advice and objectively determined underwriting rules for acceptance of risks and reasonable premiums. Where practical, incentives to lower costs will enhance both the willingness of an insurer to provide coverage and the insured to purchase insurance. Examples include premium discounts for good health or healthy behaviors for life & health insurance, loss prevention action and risk management for property & casualty insurance, and land use zoning and minimum building standards for flood insurance. By promoting healthy and safe living conditions, such incentives can benefit policyholders and the insurance industry.
A personal example is my townhouse in Utah, a state that has suffered from drought and fire risks. Only one out of 80 insurers contacted was willing to insure my homeowners’ association for fire insurance protection. This seems like a consensus for uninsurability. Yet the following year, after a new roof was installed, rates decreased substantially and many more insurers were willing to quote on the coverage. The steps taken by the homeowners’ association reduced expected costs and thus enhanced insurability.
Conclusion and Final Message
There is no bright line between being insurable and uninsurable. In reality, this line is often a somewhat squishy boundary. It benefits the insurance industry to expand the extent of their insurance protection as much as practical. Despite the seeming expansion of catastrophe risks, insurance can provide significant benefits to those covered. It is desirable for both the insurance industry and individual insurers to expand insurability and availability of insurance globally, nationally, and locally.
Statements of fact and opinions expressed herein are those of the individual author and are not necessarily those of the Society of Actuaries, the newsletter editors, or the respective author’s employer.
Sam Gutterman, FSA, CERA, FCA, FCAS, HonFIA, MAAA, is a past president of the SOA (1995 to 1996). He can be contacted at sam.gutterman1@gmail.com.