What Is It With Insurance Companies, Anyway?

February 9th, 2010

A film about insurance companies could aptly be titled Rashomon. Commentators and public figures each paint a different picture of insurance companies, each one viewed through a special-interest lens.

 Politicians cast insurance companies as characters in a morality play. The companies are villains who earn monopoly profits at the expense of their customers. Only the efforts of idealistic lawmakers and well-meaning regulators prevent the insurance companies from defrauding their policyholders.

 Internet savants portray insurance companies as clever malefactors who profit from knowledge denied to the rest of the world. Fortunately, the savants are on the job telling us the “things the insurance companies don’t want you to know!”

 Consumer advocates claim that insurance companies make money because they deny coverage to applicants who have pre-existing conditions. Their remedy for this evil is to require insurance companies to accept all applicants on equal terms.

 Unlike moviegoers, we aren’t stuck with somebody else’s subjective version of reality. We can arrive at our own conclusions about insurance companies based on rational thought.

 Insurance Companies Are Profit-Motivated Businesses

An insurance company is not an organic unity, like a person. It is a business organization populated with individual human beings, classified as executives, managers and rank-and-file employees. We can treat it as monolithic only insofar as all these people pursue the common goal of profit.

 Accepting this gains us the privilege of reification. We can talk of “the company” saying this, doing that and feeling the other. But this hypothesis has certain implications. It means that an insurance company is not a charitable institution giving goods and services away. It is not a public utility with statutory limitations on profit and an obligation to serve. It is not a non-profit institution serving “social” goals (whatever those are).

 The beneficiaries of insurance-company profits are its owners. These are mostly separate from its executives and managers, who are hired to represent the owners’ interests. Most large insurance companies are publicly owned. Its shareholders are typical of the investing class. They are rich, middle-class and even poor. They are fat cats, retirees, widows, orphans and members of nearly all strata of society.

 The profits earned by insurance companies are not unusually large, relative to company size or to those of companies in other sectors. They can be gauged accurately only as a rate of return on investment, not by their absolute amount. (Don’t we gauge our personal-investment success by the rate of return on our yearly mutual-fund, brokerage or bank statement?)

 Insurance Companies Serve Their Customers’ Interests

Insurance companies strive to serve their customers, because profit-making businesses cannot survive, let along thrive, without customers. They discover or infer what their customers want and give it to them. They do not ask whether the customers should want what they want. That would be not only presumptuous but futile. They simply satisfy their customers’ wants, but they do that in the way that best serves the interests of the insurance company’s owners.

 Whole life insurance did not originate as a collective plot to divert customers away from term insurance. It began in direct response to customer complaints that they “got nothing out of” term-insurance premiums unless they died. Various specialized uses evolved for whole life insurance. When consumers insisted upon misusing it, insurance companies shrugged and complied.

 Insurance Companies Provide Insurance, Not Something Else

Offering policies to all regardless of pre-existing conditions is not insurance. It vitiates the actuarial basis of insurance. It is something else. Since insurance companies are in the business of providing insurance, not something else, it is not surprising that they resist this initiative.

 The organic way of coping with the problems caused by preexisting conditions is to issue rated policies and/or exclusions. When activists reject these market-oriented adjustments, this calls their good faith into question. Is the objective to help consumers or to hurt insurance-company owners?

 Insurance companies do not earn revenue by denying coverage to applicants – they simply avoid a reduction in profits. If the companies are profitable, they must be serving customers in the lines they offer.

Insurance Companies Offer Products that Reduce Risk, For a Price

Confronted with a medical problem, a pharmacist will suggest medication. A surgeon will suggest surgery. A lawyer will suggest litigation (or settlement). Is it surprising that insurance companies react to consumer demand by offering insurance-oriented products? Those products substitute cost for risk. They reduce risk, for a price.

 Financial planners quickly learn that their clients want high returns at low risk. In other words, they want contradictory things. Faced with this attitude, insurance companies respond by trying to give their customers what they want – for a price.

 Living benefit riders to variable annuities advertise guaranteed rates of return, income and withdrawals. Traditional variable annuities offer tax-deferred investments yielding mutual-fund type returns, with a death benefit and other insurance features included. Indexed annuities tie rates of return to indices of equity-market performance while guaranteeing against loss of principal and negative returns. Life annuities guarantee income for life to people worried about the risk of outliving their retirement savings. While all of these products are not insurance in the strict sense, all of them are insurance in the substantive sense. They all substitute cost for risk.

 Critics of insurance companies point accusing fingers at the fees and expenses charged by insurance companies. In fact, these are the costs of providing the insurance-oriented features demanded by customers. Insurance companies incur costs associated with holding reserves, setting up and administering subaccounts, supervising investments and enduring market downturns. These costs are ultimately paid by customers. The customers could alternatively bear the risk instead of insuring against it, search out a cheaper source of insurance supply or negotiate an insurance contract without the insurance-related feature. Failure to take these actions means that the customer considers the benefits of the policy to be worth their cost.

What the Insurance Companies Don’t Want You to Know

Indexed annuities are one of the most popular insurance-company products of the last 15 years. Yet critics point to hundreds of different methods for crediting index gains to customers as evidence that insurance companies benefit from special knowledge and seek to confuse customers.

 Insurance companies developed the concept of a crediting method as a convenience; it serves the same purpose as a bid-ask spread in investment banking. Because it is the one differentiating feature of an otherwise-homogeneous product, it also provides a means of distinguishing each company’s product from its competition. When roughly fifty insurance companies strive to differentiate their competitive product, this is hardly evidence of a monopoly at work – just the reverse. Since each method works better in some market environments than others, the various approaches also enable the company to make money by successfully forecasting future markets – if it can.

 The fact that crediting methods were not created expressly to confuse consumers does not obligate the insurance company to insure they each consumer understands their workings. Does McDonald’s publish the formula for its secret sauce? Does Coca-Cola provide its formula upon request? Indeed, consumers are not prevented from penetrating the mysteries of the various crediting methods and using that knowledge in their purchase decisions.

 Epilogue to Rashomon

Insurance companies have the effrontery to behave like insurance companies, and this outrages insurance-industry critics. The products and features complained of by insurance critics are the byproduct of the insurance offered. Whether the benefits are worth the price they command is a decision made by consumers. The objections raised by the critics are not moral but moralistic. Consequently, they obscure rational analysis rather than aiding it.

 If they wished, Insurance-company critics could submit their criticisms to an acid test. They could start insurance companies that eschewed the practices complained of and better served the interests of consumers. Apart from proving their case against the insurance companies, they would also earn handsome fortunes for themselves.

 There is no case on record of this happening.

Category: Annuities, Economic Analysis, Fixed Annuities, Indexed Annuities | Tags: , , ,

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