Demotech Commentary on Covid-19

“The towels were so thick there I could hardly close my suitcase.” Attributed to Yogi Berra, this quote illustrates how it is often acceptable practice to treat another’s asset as if it was your own. ‘Theft or embezzlement’ occurs when your liquid assets are seized without your permission or knowledge. Concurrently, robbing Peter to pay Paul is a colloquialism associated with the counterproductive practice of moving money around when it is convenient for the borrower to do so.  

In the grip of multiple and diverse COVID-19 updates each day, it is all but forgotten that the health insurance sector recently stepped up to waive deductibles and copayments related to coronavirus testing and protocols. 

Was this generous cost transfer the edge of a slippery slope? Have we desensitized ownership and responsibility to the point where it is deemed justifiable to ask the insurance industry for a contribution that is appreciably more than its fair share?  

A few of the calls to action directed at the insurance industry are “paying losses that are not specifically excluded.” In the U.S. House, legislation entitled the Pandemic Risk Insurance Act was drafted, and litigation has begun to “clarify” the perils covered by business interruption insurance.  

In response to these attempts to shift the burden onto the insurance sector, on March 26, 2020, the National Association of Insurance Commissioners (NAIC) issued a statement that noted, “we would caution against and oppose proposals that would require insurers to retroactively pay unfunded COVID-19 business interruption claims that insurance policies do not currently cover. Business interruption policies were generally not designed or priced to provide coverage against communicable diseases, such as COVID-19, and therefore include exclusions for that risk.”

During disasters, whether catastrophes — such as flood, earthquake, tornado or hurricane — or economic crises, each component of the insurance industry — property, casualty, life, health and title is often asked to do more than its fair share. More often than not, the appeal is not based upon contractual liability, but is because “we can afford it.” I have some thoughts on this. 

To quote Pogo, the cartoon creation of Walt Kelly, “We have met the enemy and he is us.” Although generally accepted accounting principles (GAAP) are utilized by publicly traded companies throughout the business world, statutory insurance accounting principles (SAP), focused on protecting policyholders and claimants, are specific to the insurance industry.  

You have heard that GAAP is based upon the assumption that the company is a going concern. Under GAAP, the assumption is that the company will continue to be in business beyond the accounting date associated with the financial statement. In this situation, in the income statement the matching of revenues and expenses is a critical consideration. An expense appears when the company receives the revenue associated with the sale. In some situations, expenses may be reported in the future if the sale will take place in the future.  

In the balance sheet, intangible assets such as goodwill or the value of intellectual property such as patents, etc., or other assets with limited liquidity and a unique value are carried with a value.

In contrast, SAP is based upon the assumption that the insurer may cease doing business as of the accounting date of the financial statement. In this situation, the critical question is not the matching of revenues and expenses, but rather the protection of insureds and claimants in the event that the insurer ceases operations as of the accounting date.  

Some examples of the disparate treatment of certain assets will clarify the impact of GAAP versus SAP on the balance sheets of the entities subject to them. GAAP permits a company’s assets to be increased by goodwill and other intangibles. SAP precludes such practice. In fact, SAP precludes assigning a value to furniture, fixtures and the other tangible items needed to work in an office. You buy them, you expense them. No depreciation is permitted.  

To protect policyholders and claimants, high quality, liquid assets are mainstays of an investment philosophy that is shaped by statutory restrictions on investments. Swinging for the fences, such as purchasing penny stocks or investing in exotic businesses, is frowned upon.

 GAAP permits matching revenues and expenses. SAP established a formula for earning annual premium on a monthly basis while establishing a liability for unearned revenues, while also requiring the immediate deduction of all expenses associated with the sale of the policy. On each policy, SAP requires partial revenue recognition with full expense recognition. This is consistent with the assumption that every day may be the last day.  

The result of these and a variety of other treatments associated with the disparate assumptions underlying each set of principles means that when the economy is great, under SAP, insurers look great, and, under GAAP, other companies look great. And when the economy is in decline, under SAP, insurers look great while, under GAAP, other businesses look not so great. Industry balance sheets are built with the protection of policyholders and claimants in mind.  

Recall Aesop’s fable of the ant and the grasshopper. Insurance companies are the ants, consistently working. We cannot jump like grasshoppers; but they will never outwork us ants. Also, recollect the fable of the tortoise and the hare. Insurance companies are the tortoise, consistently moving forward. The consistency and integrity of insurance industry balance sheets and operational integrity sets us apart from most of the companies in the same economy. It is SAP and the singular focus on protecting policyholders and claimants that has created balance sheets that withstand The Great Recession and 2020 B.C., ‘Beyond COVID.’

Consider the following financial excerpts of each major insurance industry segment: property and casualty, life, health, and title. As for the data, the data source of the P&C, life, and health data is The National Association of Insurance Commissioners, Kansas City, MO, by permission. Information was derived from an S&P Global product. The NAIC and S&P Global do not endorse any analysis or conclusion based upon the information presented. The title insurance data was compiled by Demotech from individual title underwriter financial statements forwarded to us. 

These excerpts were based upon SAP. The orange bar of each graph represents the reported total liabilities of the industry segment. The blue bar represents the reported cash and liquid assets of the industry segment. The gray bar represents the net worth of the industry segment, its surplus as regards policyholders. This is the segment’s total admitted assets less total liabilities.  

Surplus is a safety margin to protect against the underestimation of total liabilities.

The P&C industry has an impressive margin of safety, as its cash and invested assets exceed its total liabilities PLUS it has an impressive net worth to further protect consumers.

In the U.S. House, legislation entitled the Pandemic Risk Insurance Act was drafted, and litigation has begun to “clarify” the perils covered by business interruption insurance. The life insurance industry, heavily dependent on interest rates for investment income to fund future liabilities, presents an excellent position. The life insurance industry’s positive cash flow, not depicted here, facilitates the payment of future claims.

The health insurance industry also has an impressive margin of safety, as its cash and invested assets approximate its total liabilities and it reports an impressive net worth as a further safety margin. 

The title insurance industry has an impressive margin of safety, with cash and invested assets exceeding total liabilities by a wide margin AND an impressive net worth to protect consumers.

While there is no doubt that the financial stability of the insurance industry is impressive, keep in mind that it has accomplished this by meeting the needs of each and every policyholder day in and day out. Furthermore, its current financial stability can be adversely impacted by establishing current or future claim procedures, practices or protocols that are markedly different than the procedures, practices or protocols underlying their coverage documents and pricing assumptions.

A critical rationale behind SAP is the carrier’s responsibility to honor or defend a policyholder’s meritorious claim(s). To accomplish this objective, the NAIC and the departments of insurance go above and beyond what other industries do. They augment an insurer’s commitment to consumers with guaranty funds. Guaranty funds exist to pay the outstanding claims of insurers declared insolvent. Ironically, the competitors of the fallen pick up the tab of the guaranty funds.  

Conservative investment portfolios and liquidation accounting principles aside, the point implicit in the NAIC’s statement is critical to the continued future success of the insurance industry. The insurance industry can continue to look great and honor their commitments to policyholders and claimants if, and only if, their future experience is consistent with past experience. Revisions to policy provisions or coverage after the fact creates a financial stress that even SAP has not anticipated, nor should it have.  

If you go out to dinner with Jeff Bezos, you should expect to split the check. Just because he has more money than you do does not mean that he should pay for dinner.  

This article first appeared in the Spring 2020 issue of The Demotech Difference, a publication of Demotech, Inc., www.demotech.com. To obtain your own copy contact [email protected].