Unintended Consequences

Bureaucratic Interference

In Prepare for the Worst, Plan for the Best: Disaster Preparedness and Recovery for Small Businesses (Wiley, second edition, 2008), I sought to explain the economics of the insurance cycle. Cash flow underwriting was, until recently, one of its defining features. Cash flow underwriting essentially involves pricing risks below the actuarially expected losses with the expectation that gains on the investment portfolio will bring the insurance operation to profitability. In essence, insurance companies collect premiums from underwriting risks and invest those premiums from which to pay claims and expenses. In the first edition of the book, I advanced the controversial argument that insurance premiums rose dramatically following 9/11, in part, because insurance premiums had been too low. High rates of return in the stock and bond market allowed insurance companies to underwrite business below the actual price of risk. The advantage of doing so was to preserve or gain market share in an environment where insurance was viewed as a commodity and providers competed almost exclusively on the basis of price. The downside to this practice of course, is that we have more volatility in the pricing of insurance risks, particularly commercial insurance and we have to think more carefully about the solvency of insurance companies with these pricing for market share strategies. Unlike the discount retail store, which closes a transaction with the sale of the product, the insurance company has to remain in business for years or decades to come to pay future claims.

Now with the federal government bailout of AIG, we have an interesting situation in respect of the cash flow underwriting dilemma. According to the Wall Street Journal, at a recent meeting with Federal Reserve Chairman Ben Bernanke, insurance executives complained that AIG was using its federal government money to cut prices and buy market share, thereby harming competitors and destabilizing the industry. Of course, as small business owners, we all want low prices, but we also want financially solvent insurance carriers. The federal government bail out of AIG introduced an element of moral hazard that our policymakers failed to anticipate. Of course, AIG may be responding to market pressure to retain business in the face of uncertainty about its future. But should their insurance premiums be inadequate to cover their insured risks, the stage is set for yet another bailout and a very vicious circle for taxpayers and policyholders alike. It is an insightful article and I commend the Wall Street Journal for its reporting.