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Archive for the ‘insurance’ Category

Riskiness

A few weeks ago, the Penguin family had a very enjoyable time at Rocket Car Day, in inner-city Sydney. Our car, the Silver Surfer, won its heat, and was a respectable third place in its repechage final (also in the SMH here). The day was very enjoyable. It was entirely frequented by inner-west geeks (or those who were inner-west geeks at heart, like us). Each new rocket car that was unveiled was admired by the spectators, particularly those (like the R2D2 car) which had clearly had some decorative effort put in, or some careful design effort.

The organisers had put on a barbecue, in best Australian tradition, and the lightheartedness of the event was summed up by the visual joke of the trigger mechanism

Acme Rocket Car launcher

Also at the event, all of us, wearing sandals, were about two metres away from the person who had a one centimetre diameter hole burnt in her foot by one of the more streamlined entries. She was wearing an enclosed shoe.

The organiser was quoted in the SMH:

‘Last year we drew some blood, there’s a variety of things that go wrong.”

But despite the dangers of stray projectiles, tempered by the rule ”too light, won’t race”, lots of children are apparently part of the elated crowd.

”I’ve always tried to keep the spirit of it very community-based … and very relaxed,” Mook said.

I imagine that this event will be quite different in a few years time. Despite the very strong disclaimers at the beginning (you are watching at your own risk, please stay out of the path of the cars), someone is bound to sue for injuries after a while. And then there will be fences, an entry fee, compulsory enclosed shoes, and the wonderful community spirit will be diminished.

Here in Australia, we have a mixture of ways of compensating for accidents that cause injury. They start from the legal view that if the accident was someone’s fault other than your own, you should be compensated by the person at fault. But they’ve changed a lot over the years, as that view became too expensive, in some cases.

If there is clearly no-one at fault but yourself – bad luck – no compensation. But that group of injuries is getting smaller and smaller. At rocket car day, I imagine the woman with the hole burnt in her foot would have a reasonable case against the person who made the rocket car that hit her, or against the organisers, despite the disclaimers.

And then there are a variety of possible organisations or persons who could be at fault:

  • your employer – in which case there are very defined limits as to how much you get per injury
  • the person driving the car that hits you – again very defined limits per injury
  • someone who can be sued for negligence (for example a council), which relies on the courts deciding how much you get per injury)
  • the doctor who caused your injury (which also relies on the courts)
  • Nobody (which is what the organisers were hoping in this case)

And, of course, if your injury comes from illness, then there is no-one to sue.

But in New Zealand, they have an Accident Compensation Commission, which gives you the same amount per permanent injury regardless of who was at fault (even no-one, or yourself). The key to this, is that nobody can be sued for causing personal injury. The laws in New Zealand have been changed to stop that.

This approach does seem to genuinely lead to a different attitude to risk. The ACC is funded through employment, car insurance, and general taxation. Which means that community organisations, councils and other people organising events do not have any financial consequences in the event of an accident.

Here in Australia, some laws (notably workers compensation and motor accident laws) have been changed (in different ways in different states), to take away that right to sue. But not for all injuries.The Productivity Commission has recently set up an inquiry into a national disability care and support scheme. This is looking at, among other things, whether there should be a social insurance scheme for all disabilities. On the face of it, that seems like a great idea – the long term disabled in this country mostly get a raw deal, but a very variable one, depending on whether there is anyone to sue. But substantial legal reform would be needed to make that work – providing the funding to make disability compensation a more level playing field by type of injury.

We do get a benefit we get in this country from the risk avoidance that comes from people being scared of being sued. But we also get a cost in that many moderately risky activities just don’t happen. That rocket car day was probably very close to that boundary, and may not stay on the do-able side for long. I’d rather not lose it. But that is much easier to say if you’ve never suffered one of those catastrophic, possibly preventable injuries that our legal system tries to stop.

I hope the productivity commission comes up with something more like NZ. But I doubt if it will happen. It seems too old-fashioned some how.

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Nearly there, Dad

My dad, who isn’t competitive at all, asked me recently how old he would have to be before he had outlived 50% of his contemporaries. He suspects he may have passed that age sometime in the past few years. So I’ve been exploring the ABS mortality statistics.

If you look at the most recently produced life table, the answer is that a man must make it about four months past his 82nd birthday (The life expectancy at birth on current rates is 79.2 years – the difference is the difference between a mean and a median).

But that doesn’t tell the whole story. The most recently produced life table uses mortality rates from 2006-2008. So it overstates the chances of living that long, for my dad’s contemporaries, who have lived through a time where mortality rates were worse than they are now. So I had to go and see what I could reconstruct about mortality rates, to reflect the actual experience of my dad’s contemporaries. I’ve cheated, and used Australian statistics for the whole period (my dad didn’t move to Australia until his late 30s, but he lived in New Zealand and the US, mostly, until then).

The difference is actually less than I thought it would be. He has to live to almost exactly 78 years old to outlast half his contemporaries. But his life expectancy at birth (based on the actual experience to now) was only 70 years.

One of the striking improvements in mortality was at birth. 4.5% of babies born back in the 30s didn’t make it to their first birthday (including my dad’s older sister). In 2006-2008 table, 0.5% of babies didn’t make it. Another measure of general improvement is that back when Dad was born, his life expectancy based on mortality rates for the population then was only 63 years. Improvements in medicine, nutrition, and public health have added 7 years to the lifespans of babies born back then.

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The insurance cycle is something that is well known to general insurers (property and casualty, if you are in the US). For many classes of business, the price of insurance fluctuates much more than the underlying cost. The general consensus is that it is about availability of capital. If the insurance market as a whole has suffered substantial losses recently (think 2005 and the nightmare Hurricane year in the US) then all the capital that is generally available for insurance companies will have been used up paying claims. So companies will have to pay much more for capital, reinsurers will charge higher premiums, and the market as a whole will charge much higher premiums for the next few years. This is, of course, completely contrary to the Efficient Market Hypothesis that would suggest that the premium should reflect the best forward looking view of the risk, but it is a well known phenomenom.

But in my view, there is a different (closely related) reason. Insurance cycles generally happen in “long tail” business – that is business where the claims are paid a long time after the premium is received. Think workers compensation insurance, or (for an extreme) asbestos insurance. And this means that the company is deciding on the premium rate to charge a long time before they know what the ultimate claims will be. Of course, they will get it wrong (that is the only certain thing about insurance). If the insurance companies charge too high a premium for that year’s risk, capital will come flooding into the market because there are superprofits to be made.  And the price will come down substantially.  And if they charge a premium that is too low, the opposite occurs. The problem with this approach is that it is happening a long time later. So inevitably there is an overcorrection – hey presto – an insurance cycle where insurance companies make super profits some of the time, and diabolical losses (if they are still in the market) the rest of the time.

If you know what you are doing, the way to make good profits on this kind of business this is to hold your nerve on price. You need to charge the higher prices that the market generally is charging just after a disastrous year, but when the prices start going too low, you need to be able to hold your nerve and refuse to participate. That takes a long term, patient, shareholder, and a company where the pricing power is nowhere near the marketing team (which will have sales targets they are expected to meet). Of course, you won’t know whether you were right until many years later.

A colleague of mine recently described the group life insurance market as a commoditised business – low margin high volume. It would be, if the ultimate cost of the product was known up front. But the insurance cycle (group life claims, particularly for  disability are paid up to 10-15 years after the premium) changes this dynamic. Instead, I think it is a business where the way to make money is through disciplined and very superior pricing. Which is not very common in any financial services business, and may be the reason not much money has been made in this business historically.

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This is the season for industry events, so I’m musing on what I’ve seen on this blog. It feels quite strange to be doing professional blogging here, but that’s why I originally started this blog after all!

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