Who Really Bears the Insurer's Risk?

Though among the largest companies in the world, insurance firms are also among the most misunderstood.

This is no accident. The insurance "industry" has carefully planted and nurtured a widespread misconception of the true nature of insurance.

In fact, the insurance industry does not produce at all; it is an insurance services industry, with companies acting as bookkeepers for the redistribution of wealth among policyholders.

By presenting themselves as insurance producers -and defending their presumed prerogatives as such-insurance companies have misled, and mistreated, consumers around the world. From this basic issue spring the problems of insurance redlining, the unavailability (or unaffordability) of compulsory automobile or other essential insurance, unfair discrimination in the underwriting, classification, and rating of risks, and the failure-or refusal-of insurers to give proper benefit to policyholders for the gains won on investments made with their income.

Consider two Caribbean brothers who finished an eight-family apartment in Brooklyn. One, an electrical engineer, had carefully minimized fire and crime risk. Yet they couldn't get insurance, or even an inspection to ascertain eligibility for normal insurance Eventually they were forced to accept the FAIR plan, a pool made up of bad risks unable to insure elsewhere. They had to pay $8,000 rather than $800.

There is no doubt that insurance is a big, and multinational, business. Risks and groups of risks are shunted back and forth across the oceans through intricate reinsurance arrangements. Major insurance holding companies such as INA, the American International Group and the German-based Allianz Insurance Companies conduct their operations on a worldwide basis.

The funds and assets controlled by insurers are staggering. In the U.S. and Germany, about 10 percent of all disposable income is under the control, of insurers. U.S. insurers possess assets 2.5 times greater than those of the oil and gas industry; fire and casualty companies alone have assets nine times greater than the auto manufacturers. In the most recent year for which figures are available, fire and casualty companies were the second most profitable industry in the United States, averaging a return on equity of 22.3 percent. The median U.S. profitability was 16.7 percent.

And so it goes around the world. Allianz in Germany is also remarkably profitable. In March of this year, Allianz stock was valued at 724 DM; by October it had jumped in value to 1,150 DM.

It has only been in the relatively recent past that the ancient institution of insurance has been portrayed by the insurance industry as a "risk business" in which the risks of economic loss borne by the insured have been transferred to the insurers for a price-the premium.

Insurers now contend that since they assume large risks for policyholders, they are entitled. to commensurately large profits. The fallacy here is that there is no risk transferred to the insurer.

The individual risks of the policyholders are pooled through the creation of a common fund; the risk is eliminated by redistribution through this fund. Indeed, the only risk borne by an insurer is that their profits in one year may not be as extravagant as they were in the previous year.

An often-made distinction between insurance and gambling illustrates the difference between the industry-promoted version of insurance and reality. Consider: gambling creates a risk that formerly did not exist, while insurance eliminates a risk that formerly did exist.

This distinction is crucial. When insurers say they have taken on their own shoulders the risk that the policyholders formerly assumed, they are saying that the company is gambling that the policyholders will remain claim-free and that the premium is a wager. If they win, needless to say, they believe they are entitled to win big. And the insurers dictate the odds. Even so, the profits are state guaranteed, because supervisory authorities have to care for the solvency of the insurance firms. Thus, the premiums must be permanently set too high to guarantee that even the final claimant could collect.. Studies of the fire and casualty business over the last 25 years indicate that the industry has never lost even one dollar on a cash flow basis.

Insurance, then, consists simply of a common fund established by those exposed to loss-a tool to eliminate risk. The insurer only manages the common fund.

This, view of the common fund is not new. As far back as 1825, a select committee of the British House of Commons reported, "Whenever there is a contingency, the cheapest way of providing against it is by uniting with others, so that each man may subject himself to a small deprivation [premium] in order that no man may be subjected to a great loss."

So insurance is merely the redistribution or pooling of risk among policyholders, not a business or an industry it all. Insurance does not produce anything, , as the economists who calculate the Gross National Product in both Germany and the U.S. recognize.

The fact is that the sole service performed by the insurance company is the management of the common fund on behalf of the policyholders. It is only the expense of collecting premiums and settling claims that is recognized in the GNP. In a $100 premium that divides into $60 for the common fund and $40 for the insurers' overhead and profit, only the $40 enters the GNP. The accounting for insurance in the GNP constitutes nothing less than a complete refutation of the insurers' contention that insurance is a product and that the premium represents the price for that product.

According to James H. Hunt, former Insurance Commissioner for the State of Vermont, the industry's false claim of ownership of the policyholders' money provides them with a powerful incentive to unfairly minimize their losses. It is this urge, he says, that leads them to redline-to deny insurance to millions of people, thereby forcing them to obtain mandatory insurance (such as auto) through assigned risk plans which offer poorer coverage and inferior service at higher premiums.

"The incentives provided by this false view of insurance inevitably lead insurers to engage in competition for `good books of business': groups of insured with lower than average claim expectancy," says Hunt. "The fallout from this selection competition is that many good risks find themselves in the unwanted groups; the selection process identifies these groups in an arbitrary fashion. It encourages competition-solely through selection of risks, which is harmful to the insurance consumer and creates chaos in the insurance marketplace. It also shields the industry from price and service competition on the expense part of the premium dollar, where competition would be beneficial. Policyholders are reluctant to shop the marketplace knowing they may be cancelled without cause. This freezes the market."

Government insurance regulation has solidified these practices. Regulators have concentrated on the adequacy of premium dollars to meet potential losses. Far too little thought has been given to the notion that the common fund belongs to the policyholders. Insurance regulators should ponder the example set by the system of compulsory auto insurance in Japan. There, for the purpose of establishing a nationwide risk pool, all insurers must compute premiums by internally adding their expense and profit margins to a government-approved price for the claims portion of the premium that is applied to all companies. No profit or loss from the claims portion of the premium accrues to insurers. Thus, competition occurs among insurers only with respect to prices they charge for their services as well as. the quality of those services and their roles as managers of the common fund. Insurers vie to service the whole market for insurance, not just that segment they deem worthy of their attention. Since their profit comes not from arbitrarily minimizing losses but from maximizing coverage, firms are motivated to serve as many customers as possible.

The true nature and function of insurance ought to be exemplified by the nonprofit mutual insurance companies which are ostensibly owned by their policyholders. But the mutual insurers have become creations of their managements, who in practice-though not in law-own them.

Mutuals now have become no less profit-oriented than the stock companies - and no more responsible. During recent U.S. Senate hearings on the mutuals, attorney Gary Kreider testified: "I think this committee has found America's forgotten investor, the mutual owner who contributes, but does not control, his capital; who owns, but does not order, his enterprise; who provides but does not participate in the profit and who, through it all, is left ignorant and impotent by present law."

The supreme irony is that the intense lobbying and propaganda efforts of the insurance industry which sustain this regulatory protection are funded primarily by the policyholders themselves. Of all the billions of marks, dollars, rupees, drachmas, and coins of all nations supplied by the policyholders, only a pittance goes toward advancing their interests-and that only in a handful of farsighted jurisdictions that insist some small portion of premium dollars be devoted to the protection of insurance buyers. In the state of New Jersey, for example, the Office of the Public Advocate represents the public at insurance rate hearings with funds from a tiny fee on insurance companies.

Where do insurance consumers go from here?

The goal is clear: to work toward a legal separation of the claims part of the premium from the service and profit part. Then, the forces of competition will work to lower the costs of insurance services provided by the managers of the common funds, rather than toward profit maximization through selection competition.

This goal is obviously a long way off. To begin, consumers should seek consumer checkoffs, with the aim of gaining at least as much funding for consumer representation before insurance regulatory officials as the companies devote to lobbying these same officials through their trade associations. Such checkoffs are, now used by students in the U.S. and other countries to form PIRGs, and Wisconsin utility consumers to fund a Citizen Utility Board. Further, the U.S. National Insurance Consumer Organization and Zeller Kreis, a German insurance consumer group, have agreed to seek an international conference on insurance in late 1981 or early 1982.

Hans Deiter Meyer is an insurance attorney with Zeller Kreis, an insurance consumer group based in Zell, Germany. Robert Hunter is former Federal Insurance Administrator in HUD and a casualty actuary. He is President of National Insurance Consumer Organization. Howard Clark is a director of NICO and former chief insurance commissioner of the State of South Carolina.