14 Feb 2017 16:17 IST

The money-making insurance industry

It is so powerful because of its ruthless focus on collecting premiums and limiting claims payouts

The insurance sector is a financial powerhouse, no matter which part of the world you go to. This is because the industry sells protection against a future risk event. Put simply, it sells peace of mind.

If the risk event does not occur, the industry simply pockets premium payments en masse, much like a whale feeding on krill. If the risk event does occur, the industry pays claims out, but grudgingly and only after conducting extensive investigations to validate the claims.

Since no one has a crystal ball, even the industry cannot predict with certainty if a future risk event will occur. During the global financial crisis last decade, the mighty AIG underwrote insurance contract after contract, promising investors that credit default swaps will not go bad.

Except that they did. And when they did, AIG did not have sufficient capital reserves to cover the claims for the policies it had sold. This caused a meltdown of the financial industry, not seen since the Great Depression. And it required an injection of cash to the tune of $7 trillion by the US government to restore markets.

It’s because of the government!

Curiously, it is risk-averse governments that have propelled insurance companies to become indispensable institutions in modern society. Governments require consumers to buy insurance to obtain certain privileges — such as driving a car — and this generally makes sense. The rationale is that the innocent need to be protected from general liability when a driver’s error causes harm to a third party.

Similar reasoning is used by banks to force borrowers to buy insurance on a home before an application for a mortgage is approved. Although, in this case, the enforcement is for selfish reasons — the bank wants to assume no risk that a borrower may default and relies on an insurance company to provide that assurance — at the borrower’s cost. Most large banks have tie-ups with insurance companies — or own insurance subsidiaries — so the forced cross-selling is convenient to both organisations’ bottom lines.

Government mandates keep insurance companies humming because there is never a dearth of clients (In contrast, every other business has to fight to acquire and retain customers). But even a steady supply of customers has not stopped the sector from becoming greedy.

Fiction turns real

In extreme cases, as depicted in Hollywood’s masterly adaptation of John Grisham’s legal thriller Rainmaker, some companies train agents to repeatedly deny a claimant’s benefits, no matter how legitimate a claim is, hoping that the claimant will go away, feeling frustrated.

In the US, a highly litigious society, insurance companies thrive by underwriting policies for every conceivable life event. Do you want to conduct a summer camp for high school children in a rented building? There are scores of companies willing to sell you liability coverage so you are protected against an ambitious parent’s lawsuit alleging that his child’s accidental injury during the camp was a result of your recklessness. There are many public buildings which refuse to rent a hall out unless you demonstrate that you carry sufficient liability protection.

Doctor’s offices carry large liability insurance policies because they have to protect themselves in the rare event of a patient lawsuit. Ever wonder why medical care in western nations is so high? One reason is that insurance costs add significantly to the sticker price of providing care.

US: the insurance enabler

By far, the biggest supporter of the insurance industry is the US government. In 2010, President Obama mandated that people should provide proof of health insurance or be subject to a tax penalty. This opened up 20 million new health care customers for the industry, all by fiat.

The Obamacare rule is different from states requiring third-party automobile coverage because the beneficiary in this case is the individual buying the insurance. This mandate was litigated all the way to the Supreme Court under the legal doctrine that no government can force consumers to buy a private commercial product simply because doing so is good for you, anymore than the government can mandate citizens to consume broccoli or join a health club.

The US Supreme Court ruled in a surprise 5-4 decision in favour of Obama, allowing that the government does indeed have a compelling interest in bringing the cost of health insurance down for the larger good. The court agreed with the government’s argument that the only way they can subsidise the care of the unhealthy is to force healthy individuals to buy insurance. This enshrined Obamacare into law.

Restrictive plans

Even in cases where insurance purchases are discretionary, the industry does fabulously well. Take travel medical insurance as an example. When you are travelling abroad on holiday, no one forces you to have medical coverage (Except when you go in tour groups; then you will be forced to buy medical coverage). But millions of people buy this product each year anyway, all for their peace of mind.

But a look under the hood reveals that travel medical insurance plans are so restrictive, it is almost foolish to buy them. No pre-existing medical condition is covered, whether or not you declare the condition at the time of buying the policy.

For instance, if you have a history of hypertension, any illness related to high blood pressure — including heart attacks — is not covered, even in a life-threatening emergency. How heartless (no pun intended) can an industry be to let a customer die rather than help save a life when a visitor is abroad in a strange environment?

Ruthless focus

This is why the insurance sector is so successful and powerful. It is ruthless in its single-minded focus on doing two things well: collecting premiums, and limiting claims payouts. The only creative part of the business is underwriting — the one which prices risk.

But past events — even laboriously maintained actuarial records — on which underwriting models are based on, are often poor indicators of future occurrences. This often results in vastly divergent quotes from company to company to cover the same risk — proof that one company’s model doesn’t agree with another. The rest of the business is largely administrative.

A popular saying, derogatorily attributed to human relationships, seems to apply well to insurance companies — “You can’t live with them; you can’t live without them”. Until the tech industry or an enterprising innovator comes up with a better model to disrupt things (like Amazon did to the old, staid publishing industry), the insurance sector is, unfortunately, here to stay.

Recommended for you