Insurance Company Profitability: The Truth

I saw an item on the news recently regarding medical malpractice rates being approximately 4 times higher than normal, too few doctors as a result, and so on. The story covered the entire litany of bad things that happen when the litigation environment is too favorable for plaintiff attorneys.

The reporter then interviewed a plaintiff attorney who made all the same comments plaintiff attorneys always make. “Insurance companies make billions.” “Consumers will be harmed if caps are instituted” (because they won’t be able to sue for enough money). “Attorneys should not have caps on how much of the settlements they get.”

I’m going to set a few things straight. The following are points that I never hear either side make and there is likely a purposeful reason they won’t make these points.

First, to address the plaintiffs’ bar’s points. Insurance companies do make billions. But they do not make billions based on the premiums they charge consumers. Over the last 20 years, according to A.M. Best, insurance companies have about broken even on their underwriting with an average annual combined ratio of approximately 100%.

If the insurance lobby truly understood the insurance industry, they would point out that those billions of profits are actually subsidizing many states and lines of business. In fact, carriers would make billions more if they simply quit writing business in many states (GA and CO are particularly bad states), certain lines of business, and then specifically the combination of specific lines in specific states, like medical malpractice in NM (where I saw the news story).

A great question to ask is, why do carriers stay in obviously money losing lines/states? One reason may be that people in the C-suite are often paid based on revenues, not profits. The correlation between their pay and revenues is much stronger than the correlation between their pay and profits. Don’t forget this point. It is important.

The trial attorneys always say unlimited awards benefit consumers from the big bad insurance people. Sometimes this is true. But what they don’t say, and this is the critical element, is that all the consumers who do not win the lottery with a huge settlement pay for that settlement. In other words, if ABC insurance company pays out $10 million and they insure 500,000 people/businesses in that line, every other policyholder will pay $20 more next year.

This is important because no one really notices the $20 until one day, someone realizes their premiums have tripled and yet they have never had a claim.

Insurance is a pass-through business. It’s a cost-plus industry, and cost-plus industries are awful for consumers. It does not matter that an insurance company must pay a $10 million claim in this scenario provided the following:

• They don’t have to pay too many $10 million claims

• The state allows for reasonable and timely rate increases

• Their losses otherwise are reasonable

If these three conditions are met, the carrier will increase rates by $10 million and probably a little more to adjust for inflation. The CEO’s pay might increase because the company’s premiums are now higher. This is why neither side wants to tell a reporter, “These large claims work to the benefit of the trial attorneys, certain individuals within the insurance industry, and the insureds receiving the large settlements. We all get to skim off the backs of regular insureds paying $20 more for every claim.”

Typically, what happens is the trial attorneys succeed too much. This causes rates to rise too fast. At that point, insurance companies cannot raise rates fast enough so the environment is no longer habitable. They pull out of the state or line and then you have an economic problem because some portion of the economy stumbles. This is fairly easy to track when the number of doctors falls suddenly or when rate increases greatly exceed GDP growth. This is not rocket-science to figure out, but again, neither side really wants these points out in the open.

If the carriers think they can raise rates fast enough to at least breakeven, a typical result is that consumers will not be able to afford the insurance. We’re already seeing that for homeowners in large portions of the country. I imagine too that if we had good UM data (the NAIC changed the coding on UM data three years ago so we don’t have much to go on), we’d see a commensurate increase in UM claims.

Also, a carrier must increase their surplus materially to increase their rates materially, at least the carriers managed ethically do. Surplus costs a lot of money. It is not free. Surplus is like bank capital. The banks seem to be whining a lot about having to carry extra capital. This is because carrying extra capital is expensive. It’s likely less expensive for insurance companies for a variety of reasons, but it is expensive. If they cannot increase surplus commensurately, then raising rates to regain profitability is impossible.

What happens then is an insurance desert is created. Rates are too high for too many people to afford and yet, rates are not high enough for insurance companies to make money or even breakeven, assuming they can increase their surplus which is not a given. No one wins at this point. But the conversations involve little more than finger pointing and no one, literally no one in my experience, is willing to state the reality.

Insurance companies can fix these situations pretty easily if management possesses a backbone. For casualty with bad litigation environments, pull out of the state/line. Create pain. This is likely the only solution. Always be telling the politicians that all those billions are actually subsidies decreasing the cost of insurance. Do they want that subsidy to go away?

The only people I actually see working toward a quality solution are the agents’ associations. Keep in mind, agents are paid cost plus, too. The higher the rates, the more money they make. So, to argue that rates need to decrease means they are arguing for their own pay to be cut. Politicians should look to advocates like this for guidance.

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