Insurance – Its Impact and Regulation

The below are edited remarks from a speech delivered by Richard C. Hsia at Duke Law on November 29th, 2018.

I want you to know what I think about Insurance, and I want to know what you think about Insurance.  Most people do not think about Insurance and, if possible, would never think about Insurance.

Many people do not want to think about Insurance, because it involves thinking about adversity.  About bad things happening in law and in life.  About illness, death, destruction and loss.

There’s a lot to think about because the breadth of insurance is expansive, covering all aspects of life and death, spanning cradle to grave and, as the blasphemous might even say, ranging from erection to resurrection.  Insurance is impactful.

My purpose is to make you think about Insurance, and to think differently about Insurance – the penetrating power and exciting beauty of Insurance.

What is the Nature of Insurance?

Fundamentally, Insurance is all about Risk:

• Risk Identification
• Risk Assessment
• Risk Analysis
• Risk Aversion
• Risk Financing
• Risk Management.
• How to select Risk;
• How to transfer Risk;
• How to pool Risk; and
• How to allocate Risk.

The essence of Insurance is Risk.

So, Insurance is about understanding risk.

What are the Key Insurance Principles and Who are the Key Players?

What is the risk that God exists?  Born in 1623, Blaise Pascal was a French mathematician, scientist, inventor, writer, philosopher and theologian – truly a man for all seasons.

According to Pascal’s Wager, humans bet with their lives that God exists – or does not exist. We weigh the gain against the loss in wagering whether or not God exists. What are the consequences in terms of benefits and detriments?  What is the frequency?  What is the severity?

Even if probabilities are low, Pascal posited that it is rational to believe that God exists.  Because by betting on God’s existence, you gain all; but if you lose, you lose nothing.

As a father of probability theory, Pascal, in addition to all his other hats, probably would have made a pretty good insurance underwriter.

Different disciplines are vital to a viable, living insurance process: underwriters, claims people, actuarial scientists, computer experts, financial analysts, reinsurers, all kinds of producers and intermediaries, including insurance agents (who represent the insurer) and insurance brokers (who represent the consumer) and, of course, lawyers.

While not inconceivable, it is unlikely that these critical disciplines will be supplanted any time soon, if ever, by artificial intelligence or robots.  Insurance is not robotic.  Insurance is humanistic.

Insurance is all about riskiness.  Reflecting risk and bearing risk.  More than that, sharing risk; spreading, not concentrating, risk. Insurance involves rationally evaluating probabilities against improbabilities; and weighing their potential consequences – without emotions, but considering the drama, financial and otherwise, that impels insurance.

Insurance involves distributing and spreading risk, taking advantage of the law of large numbers, recognizing that bad occurrences usually don’t happen all at once in kindred groups, while avoiding, if at all possible, adverse selection and moral hazard.

Insurers strive to underwrite better or good risks, reflecting riskiness in rating and pricing, always abhorring uncertainty, while being averse to, and trying to avoid taking on, bad risks, where that makes sense.

You can see these principles in operation, in different ways, across the wide spectrum of insurance – whether in life insurance, health insurance, home insurance, or automobile insurance, as examples we will touch upon.

Insurance is Interactive

Insurance involves human activities, impacts the real world, and is interwoven throughout society, helping to hold the economy together.  Insurance is proactive and protective.

Insurance represents a confluence respecting all aspects of the law and legal practice: contract law, tort law, common law, as well as statutory and regulatory law at the state, federal and international levels.

What judges say, what legislatures do, and what regulators allow, all matter a great deal in Insurance.

A command of language, as well as a command of numbers, are crucial to Insurance.  Insurance relies upon statistics and mathematics, is driven by science and technology, and is heavily dependent upon data.  Big data.  Oceans of data.

Sometimes pertinent data does not yet exist.  So, an insurer can proceed by analogy, by judgment, by evaluating need, and by risk appetite, and may decide to take on the risk and develop new market opportunities.  Given its fairly recent emergence and its myriad forms, cyber liability is a contemporary example where data does not yet exist in volume.

History as well as Time dimensions are critical, because Insurance uses the past to predict (and, at times, prevent) the future.

In sharing and spreading risk, Insurance is based upon the concept of community.  Although classifications matter, Insurance provides unifying, rather than divisive, forces in our society.

Impact of Technology on Insurance

The realm of Insurance turns on technology in many ways.  Technology, for example, is about to turn the world of car insurance on its head, with mind-blowing, system-shattering revolutionary changes and consequences.

Historically, auto insurers look to insure good drivers, encourage good driving, and closely examine driving records.  Insurance makes the world a better, safer place for all of us to live.

What will autonomous driving and self-driving, driverless cars, bring?  I wonder how many of you will trust and ride in cars that purportedly drive themselves?  Even though I’m continually amazed by technology, I‘m not sure that my faith in technology goes that far yet.

Can technology deal with the differences between day and night, changing weather conditions, meandering pedestrians, and overcome all the variables, variations and surfaces encountered on our roads and highways?

Can technology make cars think?  Driverless cars may become perceptive, but can cars be made thoughtful and can they be designed with a conscience?  While human beings, of course, are far from perfect, can computers supplant human error and achieve perfection or alleviate congestion on the road?

With autonomous driving, auto insurance will still exist.  But auto insurance will be transformed from peoples’ liability into products liability and cyber liability, and into predicting and protecting how sensors and computers, rather than human beings, behave and respond.

Of course, whether computers in cars always work perfectly represents another opportunity for cyber crime and cyber liability, which are growing exposures in our modern economy.

All kinds of enterprises must give serious thought to carrying cyber policies, which are beginning to proliferate throughout an insurance industry that realizes we are all under technological assault.

As delineated in the regulation promulgated by the New York State Department of Financial Services, insurers and other financial institutions must institute a regimen of cyber safeguards to secure data and protect sensitive consumer and financial information against cyber breaches.

There is substantial expense in doing so, but the cost of failure due to cyber intrusion and malware can prove far more formidable.

Why Are We Witnessing So Many Catastrophes & Conflagrations?

As our world turns, we find we must confront cataclysms: bigger and more furious hurricanes; and more and more widespread, raging wildfires.

Both frequency and severity of these calamities are increasing, maybe for the reasons set forth in the latest Climate Change report, just released on Black Friday, buried amid shopping hecticity.  It’s a 1600-page report that’s worth reading, although you might freak out when you read it.  It’s pretty scary.

Hurricanes Florence and Michael this year followed Hurricanes Harvey, Irma and Maria last year – each wreaking many billions of dollars in insured damages to homeowners and businesses, yet with multiples more billions of dollars in uninsured damages.

We should quickly note that, while homeowners insurance covers wind damage, it typically excludes flood damage, with the stalling rains from Harvey and Florence inundating large parts of Texas and the Carolinas, causing epic floods.

Unfortunately, too few had the foresight to carry coverage from the National Flood Insurance Program (NFIP), which was first authorized in 1968 and which, ironically, will lapse tomorrow (November 30^th), unless Congress has the foresight to extend NFIP, itself underwater by billions of dollars.  For political reasons, there are likely to be at least short-term extensions.

Flooding events hit everybody all at once, with that simultaneity making private insurers unable to take advantage of the law of large numbers and spread and diffuse risks.  That’s why NFIP is so important.  Because of the scope of flooding, the NFIP is now securing reinsurance from private insurers to help spread risk.

When losses are catastrophic, the insurance industry helps their policyholders recover from devastation.  Without insurance, recovery would be much harder, and so much slower and more agonizing.  In addition to recovery, insurers contribute to resilience, loss mitigation and smarter construction.  To the extent feasible, insurers must strive to master disaster.

But we need to ask: should rebuilding in risk-prone areas continue to be encouraged or even tolerated by the insurance industry, by the flood program or, indeed, by the public-at-large?

What happens when Paradise is lost?  Where losses are widespread and unpredictable, as with the out-of-control Camp Fire and Woolsey Fire that raged in California, how will the insurance industry respond?  By refusing – if they could – to issue or renew homeowner policies in high-risk prone areas, or by markedly raising their rates to reflect higher risks and elevated costs.

California has had respond to these natural impulses by enacting legislation that imposes a two-year moratorium on non-renewals by insurers, and by requiring that insurers recoup their losses over a 20-year period, instead of all at once.

Reinsurance is another leavening factor, as primary insurers lay off layers of loss or percentages of risk on other insurers that specialize in insuring insurers, further spreading the risk.

What is the Proper Role & Responsibility of Regulation?

Much about Insurance is counter-intuitive. Insurance is surely interstate and, indeed, international in nature and scope.  Interstate commerce is definitely involved in Insurance.

Yet Insurance in our nation is primarily regulated by the states –not by the federal government.  Historically, states established regulatory systems for Insurance since the mid-1800s.

Enacted by Congress in 1945, the McCarran-Ferguson Act (15 U.S.C. 1011-1015) recognizes the states as primary regulator for the “business of insurance” –  although, if it deals specifically with the “business of insurance”, federal law is not preempted.

McCarran-Ferguson also exempts insurance (except for group boycott and coercion) from the federal antitrust laws.

Through statistical agents such as the Insurance Services Office (ISO), data and methods are shared among insurers, to promote uniformity and consistency, reflecting the sharing of information that is crucial to insurance and the essence of insurance.

What are the objectives of state insurance regulation?

Accountability is vital, through regulatory standards and the licensing of insurers as well as producers.

Solvency is paramount, through risk-based capital standards, reserving requirements, matching assets and liabilities, investment standards, statutory reporting, and financial examination.  Integrity is the objective.

Rates and policy forms receive close attention, through competitive file and use systems, prior approval systems, or flex-rating systems.

The level and intensity of scrutiny depends upon line of insurance, the degree of competition, and whether personal or commercial lines are involved.

In general, rating standards involve whether the rates are excessive, inadequate or unfairly discriminatory.  Some may suggest this is akin to a public utility rating model, and thus somehow inappropriate.

Yet I prefer to think of this balanced approach for insurance rate review as more an application of Goldilocks and the Three Bears: not too hot, not too cold; not too hard, not too soft; but just right, where typically a great deal of data is involved, together with underwriting judgment, actuarial analysis, and other socio-economic factors.

Apart from the question of charging too much or too little, recognize that Insurance by nature must be discriminating.  Yet, however discriminating, Insurance cannot be permitted to be discriminatory.  This challenging distinction between discriminating and discriminatory must always be kept in mind.  When, for example, are factors such as creditworthiness or education levels unfair?

Respecting policy form regulation, the key goals are promoting comparability and ensuring meaningful coverage, in an arena where comprehension is difficult, yet critical.

Ironically, in an effort to be as clear as possible, insurance policies tend to be virtually incomprehensible, dense, and replete with numerous conditions, definitions and exclusions.

Policyholders typically never read their insurance policies, because they are extremely difficult to read, much less to understand.  Trying to parse insurance policies is a sure way to provide sleep insurance.  Insurance policies are certainly not, and unfortunately can never be, poetry in motion.

Insurance reveals the severe limitations and deficiencies of language, despite plain English requirements, making insurance policy form review and approval by insurance regulatory experts imperative.

Market conduct of insurers is also vital to ensure adherence to fair claims-handling and compliance with governing standards.  Throughout, consumer protection is critical.

Balance, stability and longevity are the overall goals of state insurance regulation, which at the same time seeks to achieve accessibility – availability and affordability – of critical coverages.

Insurance addresses human vulnerabilities.  Insurance regulation is designed to make insurance invulnerable.

Coordination among the states is achieved through participation in the National Association of Insurance Commissioners (NAIC), through its development of model laws and rules and through its accreditation standards.

The International Association of Insurance Supervisors (IAIS) develops solvency standards on a non-binding, global basis.

While the insurance industry is primarily regulated by the states, in contrast, the banking industry is essentially regulated by the federal government.  Some may think that insurance, given its importance, should likewise be regulated by the federal government.

In my view, the federal government has enough to do in regulating banks and needs to do better at regulating banks.

The financial meltdown revealed the deficiencies of many banking institutions.  In contrast, insurers generally proved able to withstand the financial hurricanes of the economic downturn.

Some think what happened to AIG shows the failure of state insurance regulation and proves the need for federal insurance regulation.  AIG almost drowned in a sea of credit default swaps (CDS) that were deemed (and are still deemed) not to be insurance (even though the word “insurance” is almost always used to describe credit default swaps).

Credit default swaps got out of control operating out of AIG’s Financial Products unit that, supposedly, was regulated by the Office of Thrift Supervision, a federal banking regulator.

AIG received a federal bail-out of $85 Billion, not so much to save AIG, but mainly to enable AIG to pay out 100 cents on the dollar to CDS counter-parties, which were banks and investment banks in over their heads that otherwise would have failed.

Meanwhile, due to state insurance regulation, AIG’s insurance operations were secure and remain secure, and AIG was ultimately able to repay the bail-out monies it received with interest, by selling insurance subsidiaries.

When many banks were on the verge of collapse during the financial meltdown, Congress responded by enacting the Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 U.S.C. 1376-2223, in 2010.

Dodd-Frank created the concept of Systemically Important Financial Institutions (SIFIs), putting SIFIs under the jurisdiction of the Federal Reserve.  None of the insurers originally designated as SIFIs retain this label; meaning they are now free from Federal Reserve oversight.

This is not because insurers are systematically unimportant, however.  Indeed, the insurance industry as a whole is crucial to maintaining the stability of the entire financial system.

In contrast to vital liquidity supplied by banking, insurance provides crucial long-term stability to our economy. Banks and insurance are counter-cyclical and should not be regulated as if banking and insurance are the same. Furthermore, the states, in regulating insurance, tend to inform and reinforce each other, while still reflecting and respecting local conditions and needs.

What about the Health of Health Insurance?

Health insurance is vital to humanity.  Without health insurance, it is hard to stay healthy.   Without health insurance, it is virtually impossible for unhealthy people to regain their health or retain their dignity.  Health insurance dictates whether and what kind of health care is delivered – how much and how well.

Health insurance is primarily regulated by the states, and with the advent in 2010 of the Patient Protection & Affordable Care Act (“ACA” or “Obamacare”), which specifically deals with the “business of insurance”, is also regulated by the federal government.

The ACA has transformed the health insurance landscape for everyone, especially for small groups and individuals.  The ACA creates exchange mechanisms and subsidies to increase accessibility; institutes essential health benefits; abolishes annual and lifetime caps; requires health insurers to cover those with pre-existing conditions; and, if states agree, expands Medicaid.

As a result, millions more people enjoy meaningful health coverage, and no longer need to defer health care or resort to expensive emergency room treatment.

Health insurance requires the broadest spread of risk in order to achieve accessibility – availability as well as affordability – so that people can receive healthcare when they need it.

That is why truncated enrollment periods and enrollment assistance, withholding designated funding, selling plans across state borders, and short-term skinny or emaciated plans undermine stability, heighten uncertainty, and result in adverse selection. People are seemingly tempted to purchase lower cost plans with decidedly less coverage, creating coverage gaps.  These efforts compel vigilance by state insurance regulators.

Health insurance is changing rapidly.  Hospitals and health care professionals continue to consolidate.  Meanwhile, multi-billion-dollar mergers are poised to take place, as CVS acquires Aetna, a $70 Billion deal that just closed, while Cigna seeks to acquire Express Scripts (ESI).

CVS/Caremark and ESI are major pharmacy benefit managers that negotiate complex deals on behalf of health plans with pharmaceutical drug manufacturers.  Drugs might work miracles, but they devour billions of health insurance dollars, and over-prescription of pain meds has contributed to the opioid epidemic in America.

Pending vertical mergers between major health insurers and major pharmacy benefit managers have been receiving regulatory approvals.  In contrast, regulators rejected proposed horizontal mergers between major insurers (Anthem & Cigna as well as Aetna & Humana).

Conclusion

In conclusion, I wish you health.

Who knows what the future of health insurance, and of insurance generally, may hold. There will always be a future for insurance, and you can play a part in whatever develops.

Thanks so much for listening.