Risk considerations for innovative products: A case study of the long-term care insurance industry
This report explores key risks and considerations for product innovation using the long-term care insurance industry as a case study.
In 1755, after hearing of the devastation wrought by the Lisbon earthquake and the resulting tsunami, Jean Jacques Rousseau asked, "Is this the price mankind must pay for civilization?" Two hundred fifty years later, following last year's unprecedented natural destruction, that price is at an all-time high. With Katrina, the Indian Ocean tsunami, and the Pakistan earthquake fresh in the collective memory, it may seem we’ve seen the worst-case scenario. But catastrophe models suggest the possibility of further calamities: a caldera explosion in the American Midwest, a landslide-generated tsunami on the American West Coast, super cyclones in Tokyo, a rising of world oceans and a flooding of our largest cities—not to mention the ever-present spectre of terrorism. Even if we can’t predict the next big event, history tells us the next catastrophe is only a matter of time.
What is not yet clear is who will pay the bill for this ever-rising price of civilization—beyond those unfortunate enough to have lost life or property as a result of a catastrophe. Some may believe it is the responsibility of insurers to foot the bill, and insurers certainly have a role to play. But there are sound practical and actuarial reasons why governments worldwide should take on a larger portion of the financial burden. The advantage of private insurance is lost in the face of extreme events; it should not be counted upon without an increased government role, lest we break the system. Can and should public policy develop an effective response to future catastrophic events? Have we now come to the stage where potential losses have become so large that insurance can no longer be relied upon?
Man is increasingly raising cities near oceans, where they are subject to windstorm exposure, on earthquake faults, and close to volcanoes1. Building in such vulnerable locations may be viewed as poor risk management. According to the Red Cross: "These challenges emerge in the face of societal trends that are converging to increase the likelihood, magnitude, and diversity of disasters. Growing population, migration of population to coasts and to cities, increased economic and technological interdependence, and increased environmental degradation are just a few of the interacting factors that underlie the mounting threat of disasters2."
Catastrophes: A breed apart from other insurable events
To assess how dangerous an insurance risk is, it is often convenient to apply the Pareto parameter. This rule—commonly known as the 80/20 rule—states that 20% of the claims in a particular portfolio are responsible for more than 80% of the total portfolio claim amount. With the Pareto parameter as a baseline, we can assess a portfolio’s vulnerability. If a single event can spell financial ruin, there may be a problem.
Hurricane data in the Caribbean indicates that insurers can make profit for a number of years, and then find themselves hit by a "one-in-1,000-year" hurricane, which swallows up 95% of the sum insured in one go. For example, when Hugo hit the U.S. Virgin Islands, the total cost of the loss for residential property insurers was equal to 1,000 years' worth of premiums.
The regulators of the insurance industry generally target a one-in-100-year to one-in-200-year insolvency level. They do not cater to the one-in-1,000-year event. Typical solvency levels for major developed insurance markets that cover catastrophes are on the order of three to six times the cost of a once-in-a-century event. However, Katrina-type losses are not one-in-100-year events. Recent history indicates that they are more like one-in-five-year events, which means every five years the insurance industry can expect a $50 billion loss [the last two being Sept. 11, 2001 (9/11)3 and Katrina4].
Given their frequency, catastrophes could potentially cripple any and all insurers that provide coverage; the amount of global insurance capital is limited and potentially threatened by a single mega-event. It seems that the public is fooling itself if it believes insurers can pay these types of losses. Three losses totaling in excess of $100 billion would suffice to overwhelm the system. One minute of ground movement could destroy 40 years of business.
Outlining the worst-case scenario
The many nightmare scenarios include:
SUPER CYCLONE A cyclone with sustained wind speeds in excess of 240 kilometers (150 miles) an hour smashing into a metropolis like Manhattan or Tokyo could generate claims approaching the total funds available from many insurers and their reinsurers.
METEORITE A meteorite is a meteor that hits the earth. Large ones are rare events; however, recent discoveries suggest that they are not as infrequent as once thought. The expected (mean) annualized rate of death is higher than what resulted from the 9/11 terrorist attacks; although large meteorites are rare, their destructive potential is enormous.
CALDERA EXPLOSION Yellowstone is one example of a caldera. Worldwide, caldera explosions occur approximately once every 60,000 years. The last one occurred 70,000 years ago. Based on the genetic information available, that explosion dramatically reduced mankind’s population5.
TSUNAMI The most destructive tsunamis occur from landslides, not earthquakes. They produce waves in excess of 100 meters (compared with the 10-meter waves of the recent Indian Ocean event). Speculation holds that at some time in the future a substantial part of the Cumbre Vieja volcano on La Palma, in the Canary Islands, will fall into the Atlantic, generating waves that will be more than 50 meters high by the time they hit Florida nine hours later.
These theoretical losses are unrealistic measures of insurers, but it is realistic to consider a repeat of storms, which in today’s values exceed $80 billion. Other possibilities include an earthquake in Los Angeles, followed by a related fire, or a mega-quake off the coast of Seattle, which would be accompanied by massive landslides.
Furthermore, a series of interrelated events could lead to substantial losses. For example, high-level winds often force cyclones along similar paths (e.g., Hurricanes Charley, Ivan, Francis, and Jeanne pummeled Florida in 2004; the windstorms that Lloyd’s has categorized as 90A, 90B, and 90D swept through London in 1990). There have been combinations of windstorms and earthquakes, such as when Hugo hit Puerto Rico6. And there is always the increasing threat of terrorist attacks, which often occur as multiple events.
Given these possibilities, insurance companies have a limited number of options: 1) they can withdraw from the market; 2) they can write policies with exclusions, deductibles, and limits that reflect such major losses; 3) they can apply a (substantial) extra premium for purchasing additional cover; and 4) they can seek protection from government through a guarantee pool that will cover such losses.
These options are not mutually exclusive; in fact, a pairing of several approaches is not unusual. Insurance companies sometimes seek protection by applying one of their premiums to a guarantee pool. Looking forward to the rebuilding of New Orleans, we can expect that certain parts of the city will be viewed as uninsurable for floods, with some risks placed in a government-sponsored pool.
The role of government
Many policies do not exclude certain events. For example, how many policies exclude a meteorite hit? How many excluded terrorism before 9/11? What if the tsunami is a consequence of a landslide and not an earthquake? Terrorism has been an extra cover in the UK for a number of years following explosions in London, but this was only made possible with the establishment of a government-backed reinsurance company, Pool Re.
In many countries, questions like these have led to systems where extreme events are paid for not by the insurance industry but by government. The U.S. government has a complex system for dealing with natural disasters through a partnership with state and local governments, nongovernmental organizations, and the private sector. The major government schemes in the U.S. include:
EARTHQUAKE INSURANCE IN CALIFORNIA The state government requires private companies doing business in California to offer quake insurance and to contribute to the funding of the California Earthquake Authority, which underwrites these policies.
HOMEOWNERS' INSURANCE IN FLORIDA The government of Florida has required private companies to continue writing homeowners’ policies in the state and to participate in various residual market mechanisms as a way of making hurricane coverage available.
FLOOD INSURANCE The federal government offers flood insurance through the National Flood Insurance Program. Property owners with existing structures inside the floodplain are charged "non-actuarial" rates, which create an implicit subsidy.
CROP INSURANCE The federal government offers farmers subsidized crop insurance, which can be triggered by natural disasters such as flooding.
DIRECT AID Emergency aid from government agencies and government employees often arrives at the time of the disaster and immediately following it.
Other mechanisms include federal funding to repair state and local government facilities, loans and grants from the Small Business Administration, grants to individuals from FEMA, and occasional assistance to flooded-out farmers, whether or not they purchased crop insurance.
The U.S. is not the only government to provide catastrophe schemes. Via Consorcio, established in Spain in 1954, provides cover from earthquakes, volcanic eruptions, atypical windstorms (those that exceed a certain threshold), atypical floods, meteorite strikes, terrorism, rebellions, sedition, riots, civil commotion, and actions of Security Forces in peacetime. France now provides a National Fund for Agricultural Disasters. And as already noted, the UK insures against terrorism via Pool Re, established after the St. Mary Axe bomb. Initially Pool Re was voluntary, and the premium was thought by many to be too high (the UK government wanted a commercial venture and saw itself as a lender of last resort). However, when the Bishopsgate bomb went off, there was a sudden rush for cover as insurers realized that their data was insufficient and their risk was further afield than they had thought. Indeed, the largest losses appeared to be from a location in Bristol over 100 miles away!
Governments are involved because catastrophe risk, by its nature, is a highly correlated risk, resulting in many people having claims. The pooling of correlated risk increases the variability of risk, which is exactly opposite the fundamental premise of insurance: namely, the law of large numbers. Thus the advantage of private insurance is lost. Techniques have been and are being devised to mitigate correlated risk, but private solutions are generally expensive. Some form of government involvement is needed to keep the cost manageable7.
Balanced against government involvement, there need to be incentives for private firms and people to make proper risk management decisions. One solution is to consider the losses both without and with government involvement. In the first case, risk analysis and insurance decision8 is vital; in the second, there is a reduction in insurance demand and loss mitigation (that is, there is the moral hazard of risk sharing—one of the main reasons governments do not get involved).
Furthermore, governments need to examine their own role in enabling catastrophes. Time and again, government has undercut the goals of risk mitigation by sponsoring development and redevelopment in areas of known risks, including floodplains or brownfield sites9.
Politics overwhelm pragmatism
The potential political payoff from an investment in a national catastrophe risk management program may come too late for most politicians. Catastrophes often have a long return period, and the absence of a major recent event would render such an expensive program highly unpopular. You can imagine the objections: "It will never happen in my lifetime!" That said, when a major event occurs, it is often a trigger to do something (e.g., an Indian Ocean early warning system).
Further fueling objections is the fact that building a national catastrophe risk management program will divert national savings from investments in other, potentially more immediately productive projects. How does a developing country justify a catastrophe fund when people are in need of basic services? If anything, the mere existence of such a fund in a developing country would send the wrong message and undermine foreign aid.
Governments also bury their heads in the proverbial sand because it is politically convenient to do so. Consider:
Governments make the same blunders again and again—and insurance companies are expected to pick up the tab when things go wrong. These blunders are exacerbated by similar behavior among private citizens and entities. How often do we see new development in volatile areas: floodplains, coastal regions, and the like? Saying "I didn’t know it could happen to me" does not absolve the private citizen of the economic cost of settling in a volatile area. That said, sometimes an event surpasses what is imaginable. Many of the people who were affected by the Indian Ocean tsunami lived near the sea because their livelihoods (fishing, tourism, etc.) depended upon it. These people may have expected storms, but certainly not a tsunami.
Knowing the risk does not necessarily increase the likelihood of being prepared. A recent study by the Rand Corporation shows that only half of U.S. homeowners living in flood-prone areas purchase federal flood insurance. Many of them do so only because it is required by law. Of those who are not required by law, only 20% purchase flood insurance. If individuals won’t take measures to protect themselves, what are the chances of them agreeing to participate in a larger federal program10?
Actuarial contributions to public policy
While there are events that are both predictable and understandable, such as floods and hurricane landfalls, there are others that are not so well understood. Epidemics such as AIDS and flu pandemics tend to be predictable, but the mechanics of disease transmission are not well understood. Earthquakes are understood and can be described by power laws, yet they are not predictable.
Then there are extreme events like climate change that are neither understood nor predictable and have implicitly chaotic structures. A recent headline stated, "London could be among the ‘first cities to go’ if global warming causes the planet's ice to melt, the UK government's chief scientific adviser has warned." In addition to London, cities such as New York and Tokyo are also vulnerable. Yet the reaction from government appears to be minimal. Political and social deadlock abound, and until an actual event triggers reactive thinking, we will be no closer to realizing a sustainable risk management system.
Given this deadlock, actuaries have a role to play in helping influence public policy decisions. Actuarial techniques for handling uncertainty—and pricing it—can advance the debate by lending both predictability and understanding. Certainly the help would be welcome. Most science is restricted to the development of predictions and generalizations; an actuary analyzes uncertainty and applies a cost value to these predictions.
We are moving toward a more complex society, with mega-cities, mega-organizations, and mega-risks. The cost of this evolution is mounting: due to increased value at risk; due to the increased frequency of catastrophic events; due to the consolidation of populations; due to larger organizational and financial risks. The only solution in the long run will be a more complex insurance system with a mixture of private and state schemes.
3. While the insured loss of 9-11 was below $50 billion, the remainder of the loss—including removal of debris and many of the individual claims—was picked up by the US government in one of the more effective recent examples of private/public response to a catastrophe.
4. Extreme events are often cyclical or random. The US hurricane cycles were benign until recently. While statistics indicate hurricane cycles to be long, these cycles are also without reliable predictors. Some have credited global warming and generally warmer oceans as a source of increased tropical storms, but it remains difficult to say whether the recent increase in storm activity is due to cyclic events or global warming. Meanwhile, events like earthquakes have proved random in recent history, although there was a surge in earthquake activity in the Mediterranean in the late Bronze Age.
6. When Hugo hit Puerto Rico, there was a simultaneous submarine earthquake in the Puerto Rico trench that was recorded at a number of seismic sites. No one knows the impact of the earthquake since Hugo was devastating enough. The link between these two events—if any—is still unclear.
7. Granted, that involvement may change depending on the type of event at hand. A pandemic like the 1919 Spanish Flu—which can affect anyone, anywhere—is unique from a flood, which is contained to a specific region.
9. A brownfield site is a housing development that has previously been used for industry or has otherwise been polluted. One example is the banks of the River Thames. The opposite is a greenfield site (previously used for agricultural purposes).
David Sanders is a consulting actuary based in Milliman’s London office. He is a Fellow of the Institute of Actuaries, a Member of the American Academy of Actuaries, a Fellow of the Royal Statistical Society, and a Fellow of the Royal Astronomical Society. He has over 30 years experience as a qualified actuary. He has written many papers, including a recent paper on Extreme Events for the Institute of Actuaries. He has been recognized within the profession with an award for outstanding contribution by the Institute of Actuaries (UK).
The price of civilization
In 1755, after hearing of the devastation wrought by the Lisbon earthquake and the resulting tsunami, Jean Jacques Rousseau asked, "Is this the price mankind must pay for civilization?" Two hundred fifty years later, following last year's unprecedented natural destruction,