We will not thank marketing departments when markets collapse.

Insurance is a contract of money for money. One task of the insurer is to make suitable provisions to cover risks associated with the contract. Actuaries provide insurers with baseline risk estimations as a basis for business rules to determine customer premiums. An opportunity to fine-tune risk classification occurs at the time of underwriting, when insurers can elicit further customer information. The risk classification at underwriting in an accepted life insurance contract will persist for the duration of the contract. For life insurers, underwriting will occur generally once, unless customers initiate new contractual terms.?

A failure to properly classify customers is tolerated to some extent with the pooling of risk.??Actuarial expectations about the efficiency of pooling are typically adjusted based on factors including the observed performance of the pool.??

Turning our attention to Disability Income Insurance (DII), the product that retail insurers have commercially struggled with for years, being loss-making for every new contract issued, there are likely to be many reasons for the failure, including (but not limited to) product design (a?focus of the actuaries’ institute), operational issues (inefficient and misuse of resources), regulatory pressures and self-imposed industry restrictions (LICOP). One area that I will focus on, is the role of private information that undermines the efficiency of risk classification and claims management.?

There will always be information asymmetries between customers and insurers. While insurers have commercially sensitive business rules that are relied on to classify risk, this would not be considered an information asymmetry. The information asymmetry that has been the subject of my academic enquiry has been that of customers, the focus of a large body of economic academic interest, for which the equivalent of Nobel prizes have been awarded (see Akerlof,?Rothschild & Stiglitz).?

Akerlof in his famous paper on the?Market for Lemons, predicted that private information would influence both purchases and sales to the point that predicted market collapse. Akerlof focussed on one form of information asymmetry, adverse selection. That form of information asymmetry does not require dishonesty and is not addressed below. Limiting our focus to DII in Australia, loss-making products, even after the modification of actuarial assumptions over several years should invite speculation about the potential for market collapse, including factors that are both contributing to, and preventing such a devastating outcome.

Although my next comments are likely to offend some, offence should not preclude an analysis of factors that could be addressed to ensure market sustainability, and therefore the availability of products critical to many Australian customers.

My doctoral research has focussed on the instability of?customer preferences for honesty. We do not like to think of ourselves or our customers as being dishonest, however dishonesty is a universal phenomenon that would not logically exclude customers. The pertinent question is whether we should expect insurance customers to be any more or less honest than other cohorts.

Estimations of fraud in insurance, typically evokes?hyperbolic figures, that may or may not be true. We know though that fraud has a particular legal meaning and requires intent. The?Insurance Contracts Act?explicitly acknowledges remedies for?various levels?of incorrect information provided to insurers by customers. Some of the incorrect information is in the form of innocent redactions through to motivated, false disclosure and penalties vary accordingly. What we don’t know, and something I have attempted to establish by empirical analysis, is the extent of customer dishonesty.

At the time of underwriting, my research has provided strong evidence, with data obtained from insurers in both Oceania and North America, of a large level of customer dishonesty. Risk classification is heavily dependent on customer-disclosure; customer redaction exposes the insurer to serious underestimations of pooled risk. The participating North American insurer estimated that an eradication of the asymmetry that we identified, could maintain profitability while reducing premiums by around 20% (details will follow in a published paper) if we addressed customer dishonesty at the time of underwriting.?

If you are still reading, the point to emphasise is that information asymmetries pose a large and relevant threat to industry sustainability. So far, I have only addressed underwriting.?

Claimants should not be considered to have different levels of dishonesty than any individual with similar incentives and dynamics. Furthermore, the literature shows?large percentages of studied populations are honest, even in the presence of incentives. So please do not allow offence to impair a discussion about customer honesty at the time of claim.

Our obligation to properly assess claims, extends beyond our customers in need, to the entire customer pool. The current industry focus is wrongly on claimants, who are an important subset of our customers, but whose needs and expectations may not reflect the customer base. This approach has been amplified by our over-reliance on marketing, to skew our sense of priorities towards pleasing those who are dissatisfied but not necessarily attending to the needs of the vast majority of customers who have no voice.

Accepting claims without appropriate due diligence, due to constraints that obstruct our ability to obtain the relevant private customer information, merely passes cost to non-claiming customers, many of whom may be priced out of the market, resulting in a potential outcome of only retaining highly-motivated (read: self-perceived high risk or highly risk averse) customers.?

To properly assess claims, private customer information that is pertinent to the insurer must be obtained to decide the validity of a claim. There are relatively few sources of information available to insurers to resolve the asymmetries, including data from the customer directly, treating doctors, independent doctors and observed behaviour (e.g., social media and private investigation).?

In anticipation of regulatory force, the financial services council as sought to make compromises that they believe meets the community expectations of the life insurance industry. The celebratory remarks made by FSC spokespeople about the LICOP 2.0, a document that is the well-intentioned product of hard work, consultation and executive judgement, are unfortunately akin to a turkey celebrating Thanksgiving.

If you’ve made it this far, we have managed to screen out twitter uses and marketing types, the serious comments follow.?

Limiting information scrutiny undermines the insurer’s ability to make proper decisions. Reducing access to medical records, hobbling risk classification to?genetic testing, reducing information by limiting customer interviews, cruelling the value of?independent medical examiners?by limiting them to those whom the customer likes and limiting private investigations, are all instances where we enlarge information asymmetries in a market that is near breaking point.?

Economics principles dictate that those who benefit from information asymmetries are customers whose contracts are more attractive than they should have been, and claimants who claims are paid when they shouldn’t have, on the basis that insurers cannot obtain sufficient, reliable information to make sound decisions. The customers (the majority) who have been honest with us end up subsidising the un-provisioned risk. We have seen premiums steadily climb, and here is where adverse selection becomes problematic. Those who consider themselves a higher risk to claim will be more motivated to persevere with large premiums than those at lower risk, who may drop out. We then find ourselves lurching toward a market of ‘lemons’ and face an uninsurable risk pool.?

The task of the FSC must be to lead the industry away from collapse, not accelerate towards it by ignoring basic principles of insurance and economics. As an industry, it must communicate complicated, critical issues to the stakeholders that matter. It concerns me that firms have been derailed by those driving marketing and brand protection with an emphasis of virtue over substance, to the detriment of the market. No one will thank them when the market collapses.

The FSC needs to be vigilant about core issues, and be driven by sustainability, fearlessly maintaining the integrity of the financial services market and be unafraid to be transparent.??The sky may not fall in today or tomorrow, but winter is coming if we stay on our current path.?