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Insurance Risks and Government Interventions

Dwight M. Jaffee

University of California, Berkeley

Presented to SIFR Conference on “Insurance Economics: New Risks, New Regulation, New Approaches”, Stockholm, August 24-25, 2015.

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Three Principles of Insurance Regulation

1) Governments are regularly asked to intervene in insurance markets in main part because risk sharing is an intrinsically important and societal activity.

2) Government interventions can be welfare enhancing:a) When private markets fail to operate effectively;b) To enforce contract structure and disclosures;c) To maintain safety and soundness.d)

3) Government interventions can also reduce welfare:a) Price controls can cause private markets to fail;b) Government insurance plans commonly include

subsidizes, especially on higher risks, providing incentives for policyholders to take greater risks.

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Capital Regulation of Insurance Firms

The need for, and specification of, regulatory insurer capital rules is complex and controversial.

The case for no government insurer capital rules:– In a friction-free world, policy holders and

insurers could agree on the desired capital level.– Premiums would discount for any insurer risk.– Industry structure such as mutual, multiline, and

monoline insurers, would also affect capital.– Laissez faire optimal could be 100% capital, with

the “Names” of the original Lloyd’s an example.

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Insurer Capital Requirements in a World With Frictions

Frictions include double taxation at corporate level, principal agent issues, and adverse selection.– The result is an excess cost of capital for investors

placing capital in an insurance firm.– The implication is that insurers have incentive to

conserve capital (below the friction-free level).– Policy holders should receive proper premium

discounts to offset the insurer default risk. The case for a laissez faire equilibrium carries over

to friction worlds, although insurer capital is limited.

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The Case for Government Imposed Capital Requirement for Insurers

Worldwide, regulators impose capital requirements, accepting it as the government’s responsibility to ensure safety and soundness of insurance firms.– When insurers default, policyholders inevitably

ask why government did not take prior action.– Policyholders unable to accurately measure risk.

But setting capital requirements is highly complex:– Natural conflict between insurers and regulators

given varying risks and the excess cost of capital. Comparison with Basel III bank capital rules.

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Risk-Based Capital Requirements (RBCRs)

U.S. has long used RBCRs, Solvency 2 will soon too. Some U.S. RBCRs failed during 2007/2008 crash:

– Rules required large mark to market MBS losses;– Insurers successfully argued unfair to suffer both

capital loss and RBCRs on the same securities.– Basically, this was instrument to bailout insurers.– U.S. insurers now have very low MBS RBCRs.

Must improve RBCRs, for risk ratings, systemic risk, shadow insurance, and buffer capital/Basel III.

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Further Insurance-Capital Issues

U.S. states historically regulate insurance, but…– 2010 Dodd-Frank Act created Federal Insurance

Office (FIO) to make international agreements. – Financial Stability Oversight Council (FSOC)

now has power to identify insurers as SIFIs.– Most regulatory power still at states and NAIC.

Solvency 2 creates standardized EU regulation.– International negotiations are underway to

synchronize U.S. and E.U capital regulations.– Reinsurance collateral is one key issue.

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Auto Insurance in U.S. and California

Proposition 103 passed in 1988, requires premium prior approval and created new rating factor rules.– CA went from least regulated to most regulated.

Regulators must approve the rating factors and weights insurers apply to set premiums:– Three factors are required: (1) driving record, (2)

miles driven, and (3) years of driving experience.– Certain secondary factors are allowed: e.g. gender,

marital status, and auto location (within limits).– Other factors are not allowed: e.g. FICO scores.

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Current Auto Insurance Regulation Formats by State

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Change in Average U.S. Auto Insurance Expenditure: 1989 to 2010

Source: Consumer Federation of America, 2013

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Average Insurance Expenditure vs. Traffic Density, by States, 2010

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What Caused California Auto Premiums to Fall Significantly relative to Rest of U.S.

The decline in California premiums surprised many economists, but the trend is undeniable. Factors:– Insurers must provide “safe driver” discounts;– CA introduced and enforced strict seatbelt rules;– Fraudulent claims in CA fell dramatically;– Uninsured motorists declined significantly,

Claims declined significantly, allowing insurer profitability and competition to be maintained.– One interpretation is that Prop. 103 pushed CA

from a “bad equilibrium” to a quite good one.

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Competition in California Auto Insurance

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Further Auto Insurance Issues

Residual Markets—Assigned Risk Pools– Auto insurance is legally required, so government

must ensure its availability.– Assigned risk plans, joint underwriting, etc…

Uninsured motorists:– States range from MA (4.5%) to NM (25.7%);– CA (15%) illustrates politics vs. economics.

GPS record (pay as/how you drive; pay at pump). No fault insurance.

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Market Failures for Catastrophe Insurance

I refer to natural disasters (floods, wind damage, earthquakes), terrorism, and large industrial events.

Private catastrophe insurance markets regularly fail:– The excess cost of insurance capital makes it

difficult to acquire and maintain sufficient capital.– Cost of capital to cover tail risk is extremely high.– Concerns apply to insurers and reinsurers alike.– Spread between required premiums and consumer

expectations becomes unacceptably large. There are both market and government remedies.

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Insured-Linked Securitization (ILS)as Market Solution

Insurance risks, especially catastrophe risk, could be sold to capital market investors:– Investors diversify: small holdings in many risks;– Cat risks: low Beta and asymmetric information.– ILS provides a security to transfer the risks.

Catastrophe bonds are a main ILS instrument.– Investors receive risk-free rate + premium, but– If scheduled event occurs, all funds go to insurer;– Problem: a cat bond with 1% expected loss has

often required a risk premium 3 to 5%.

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USAA Cat Bond Issues, 2000 to 2014Multiples = Issue Spread/Expected Loss

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Cat Bonds Issued Q2 2014/Q1 2015, by Peril(Source Lane Financial)

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Total ILS Issuance(Source: Lane Financials)

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The Varying Forms of Government Intervention

In many cases, the government simply bears 100% of the risk, although insurers mays still run the market.– The U.S. National Flood Insurance is an example.– Commonly, the high risks are subsidized, so the

government actually encourages risk-taking.– Complex question whether government cost of

capital < private insurance cost of capital. In other cases, the government provides reinsurance,

including deductibles and coinsurance. Government role in terrorism insurance varies widely.

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Government Intervention in Insurance: Conclusions

It is inevitable that government will intervene, quite often significantly, in insurance markets.

Dysfunctional regulation must, of course, be avoided.– Price ceilings are among the worst offenders.– Failure to apply risk-based premiums is in same

class and may be even more harmful.– They both preclude mitigation and risk-avoidance.

Functional regulation does exist, but as my examples show, it is a delicate and complex enterprise to get it right.