Insurance helps the world go round! Without insurance nearly every aspect of our lives (as individuals or as businesses) would be fraught with risk and volatile experience especially from the financial point of view. That said society and regulators the world over are always concerned that insurance products are fairly priced and do not exploit ill-informed consumers.
From the UK to Australia recent regulatory effort has particularly focussed on ‘add-on’ general insurance products, those sold as a secondary part of another transaction (e.g. alongside a car sale, a new loan, or a holiday booking) as evidence suggests that those products sold under ‘forced circumstances’ can be poor value. In the UK, Consumer Duty explicitly requires that consumers pay a price that represents fair value.
The insurance industry has always argued that insurance offers peace of mind, an emotional or soft benefit, as well as hard financial value. They have argued that this point of view is legitimate and there should be a value attaching to it. (In costing insurance products there are also issues around the appropriate allowance for expenses, including the cost or reward of distributing products, but this article focuses on the peace of mind aspects of fair value.)
Objectively, insurance provides sources of value including:
1. Claims payments – combining the likelihood of making a claim and if made, the amount of the claim. Both are uncertain and for some insurance products the range of possible outcomes can be vast – e.g. a catastrophic personal injury, or a massive fire.
2. A point of help and assurance when something goes wrong - a convenience and service factor.
3. The benefits from access to bigger purchasing power – that is the supply chain management.
4. Access to the insurance company’s capital base - on economic terms, allowing a low cost of capital and the smoothing of financial experience.
5. Risk management - alongside managing the financial uncertainty, skilled support in managing underlying risks and dealing with claims issues which can often be under emotional circumstances.
Taking all these sources together can be classed as ‘risk transfer’ and they clearly represent value, and cost. Assessing the fairness of price given this value is then a challenge – the cost of claims (frequency and severity) is explicitly measurable – at least historically where the number of claims is a fact, and the total cost generally known. But how do you allow for the variation in claims amounts – the risk of very large/catastrophic claims that may only occur very infrequently, or the chance of a change in factors driving claims or events not captured in the data? The expense of providing service and advice is another element of cost providing value. These issues of themselves are relatively complex questions. Offering a product at fair value clearly needs to allow for them all. It can be said that in total they offer peace of mind, and a value related to cost of capital allowing for their inherent variability placed on them. But there is an extra element.
Peace of mind in its widest sense is difficult to define. The notion of not having to worry about something, of reduced stress and anxiety, of avoiding putting a burden on someone else (e.g. a relative if you’re injured or even your family if they’re managing your estate), avoiding anger and confrontation can be seen as having value over and above pure financial considerations.
To be clear, peace of mind may be defined either as the total of all the above, or just the extra emotional benefit. The first point in any dispute is whether a clear shared definition exists.
If it’s accepted peace of mind is the totality, then what is the extra emotional calmness worth? Instinctively it varies between individuals (we are all different psychologically and have different risk appetites and personal circumstances). So if this extra benefit exists, how can a price or value be placed on it and should the pricing vary by individual as evidently its value does? Why might someone who is of a more nervous disposition or has a difficult financial position pay a different (higher) price than someone able to absorb risk? And in any case, how on earth to measure it?
Insurance sales processes have been subject to much study and focus, and it is difficult to achieve perfection. The experience and ability of purchasers varies widely – as an actuary I understand I should be expected to know more about products than most – but I might have an off day. I may enjoy numbers, but I could get as confused by policy wordings - terms and conditions – as anybody! They may be more restrictive than an average consumer understands or expects. What in any case defines an average consumer?
Service and convenience may be worth paying for. Being able to buy loan protection cover at the point of sale for a loan, or travel insurance when booking a holiday are examples of convenience. Yet when it comes to making a claim, finding papers and evidence can be difficult, time consuming and complex. If a consumer finds that a claim they expected would be covered is declined, or that they cannot find the papers required, then there are struggles and difficulties which can almost be described as negative peace of mind!
Accepting all the above, an insurance company has legitimate interests. It needs a sustainable rate of return on its capital over a reasonable time period. This should include allowance for the unexpected, or the rare event that might not be in recent claims experience. For example, earthquakes or economic downturns or political turmoil. How to quantify this? In part it is a market assessment as much as a scientific experience-based assessment of possible scenarios.
The issue remains – what is a fair price, allowing for peace of mind which itself varies by consumer segment? Most would accept that over charging means either the insurer or the distributor may make excessive profit to the detriment of the consumer. One approach is to let the market sort this out; but what happens if a market is in some sense not functioning effectively? Signs of an ineffective market may include low loss ratios (claims costs as a percentage of premiums paid), high commissions (rewarding the distributor excessively), high proportion of claims not allowed (turned down or declined) and even the distribution of claims amounts - how many are of vast or even life changing proportions.
In exploring this, the concept of ‘maintenance’ insurance – insurance with a stable frequency and low volatility of claim amount - vs a ‘catastrophe’ insurance – insurance having a very low and unpredictable frequency coupled to potentially vast payouts - is relevant. Also, the personal, contrasted with the business or commercial, dimension, not expecting an individual personal consumer to have the same degree of insight and judgement as a professional business buyer.
Much more can be said, but I hope this has stimulated thinking and raised questions. I’m sure there are still plenty of mis-selling and poor value cases yet to be explored!