Is the Insurance Business Viable?

The insurance business is fraught with problems for which, in many insurance lines, a solution that is acceptable to consumers and leaves the insurance business viable is not likely. We analyze the factors that create this situation. Consumers often view economically viable premiums as too high. In these cases, the tendency of private insurers is to abandon those lines to avoid failure. Pressure then mounts for government to provide insurance at “affordable” premiums or for government to force the insurance companies to do so. The results of the availability of such affordable insurance are not in consumers' interests. The insurance business is subject to problems that have no obvious solutions. Much criticism of the business focuses on unscrupulous insurance companies or unscrupulous consumers, but although these problems are serious, they are not the fundamental problem. All that is needed for the viability or acceptability of an insurance line to be problematic is that insurance companies and consumers act honestly in their own apparent self-interests. Similar to the “problem of the commons,” individuals doing what seems right for them can destroy the benefit to all.The problem is the system itself, but several factors are important contributors to this conclusion. They include inadequate information about probability densities, asymmetrical information about risk, political pressure, political campaign strategies, and downward-sloping demand curves.We analyze the factors that affect the viability of many insurance lines and illustrate the principles with numerical examples that are meant to be realistic. These examples reinforce the theoretical concerns. We also describe how the principles apply to what is going on in windstorm insurance and medical malpractice insurance.The insurance business is not likely to be viable in a realistic world of heterogeneous risks and preferences. Such a world requires creating and pricing by risk classes, which can lead to charges of unfairness, profiling, and discrimination. Indeed, pricing by risk classes is profiling—profiling by claim history, credit history, geographical location, neighborhood, income level, wealth, and so on. When risk classes are created, many lower-income people and minorities find themselves in classes with above-average risk and, therefore, above-average insurance premiums in relation to coverage. When insurance premiums are unacceptably high for a group, outcry can arise from the media, activists, regulators, and politicians proclaiming that the profiling is unfair. This possibility prevents the delineation of many useful risk classes and the establishment of sufficiently high premiums in high-risk classes to make the insurance business economically viable.For example, windstorm (hurricane) premiums that make the insurance business economically viable in this line are likely to be so high that a substantial proportion of homeowners in each risk class choose not to buy the insurance. These homeowners say that they “want to buy insurance, but it is too expensive.” Homeowners, activists, the media, and politicians tend to conclude that the insurance companies are unscrupulous. Insurance companies may then be forced to reduce premiums. This process significantly increases the probability that, eventually, the insurance companies will fail or need to be bailed out.Insurance companies try to protect themselves by writing policies that exclude events that either are not insurable (such as acts of war) or cannot provide a profit (such as expensive experimental health care). The enormous personal tragedies associated with these events, however, create well-intentioned pressure by consumers, activists, regulators, and politicians to force insurance companies to cover the events. Two possibilities result. Either the insurance premium is raised to cover losses from these events or it is not. If it is raised, less-risk-averse homeowners will drop their coverage and some relatively risk-averse homeowners will be forced to buy coverage that they would not otherwise buy. If the premium is not raised, homeowners will receive an apparent free lunch but the insurance companies will fail, will need to be bailed out, or will abandon the market.Forcing coverage can benefit politicians. Most voters do not understand many of the issues. They do not understand that, barring bailouts, if insurance companies neither fail nor abandon the market, policyholders must end up with higher premiums. Because of this lack of understanding, many voters, nonpolicyholders as well as policyholders, believe that politicians did them a favor by forcing coverage. If the insurance companies do fail or abandon the market, the politicians can (and may be forced by the electorate to) step in and provide coverage through the government. This action is also viewed favorably by many voters.But none of these alternatives is socially optimal.