Insurance Complexities: The Myth of State Farm's Financial Insolvency and Conflicts of Interests.

I occasionally run across “fans” of Nassim Taleb, a philosopher/visionary who is changing the way people view world events. His black swan concept, which is the name sake for his latest book, is understood and often repeated as the totality of his theory when in reality it is just a small part of his body of work. Russell and I share an interest in Taleb’s work, an interest that derives from actually reading his two books rather than simply embracing the pop culture lite version repeated in the popular media. This subject of insurance is akin to understanding Taleb and his theories; one can get a slight flavor for the concepts of subjects like wind claims dumping from the media but the nuance and complexities of the subject escape the vast majority of the popular reporting just as Taleb’s theories are revealed completely only by reading his books. Taleb’s Black Swan is an important concept but his central thesis is far more involved. Taleb’s website, named for his first book gives a better clue the larger theory he espouses.

Such is the case with the recently issued GAO report and the concepts surrounding the inherent conflicts of interest possessed by the Write-Your-Own insurer and the possible impacts of that conflict manifested in concepts like wind claims dumping following a multi peril flood event such as a Hurricane. David Rossmiller penned a particularly insightful piece on the GAO report tackling the conflicts of interest conclusions of the GAO head on.

“One, this "inherent conflict of interest" certainly exists, just as it exists whenever you file a first-party property claim. This is not very startling, because it has been said -- wait while my computer comes up with the final tally -- 3,456 kajillion times before in insurance literature. For many of you the following explanation will be something you know already, but many don't know it, so I am going to set it down in writing here. As you may or may not know, when someone makes a liability claim against you, say you ran into them with your car, your insurer owes you a fiduciary duty, assuming a duty to defend arises out of the allegations and the language of the insurance policy. A fiduciary duty is the highest duty imposed by law, and requires one to treat another's interests like one's own, resolving all conflicts of interest in favor or the insured. These type of liability claims are called third-party claims. In contrast, claims you file with your own insurer for damage to your house or other property are called first-party claims. An adversary relationship is assumed to exist between the insurer and insured from the time the claim is filed, and generally speaking, no fiduciary duty arises on the part of the insurer.”

Mr. Rossmiller gave his readers a great lesson in the law but also his post implied a great lesson in dealing with an insurer. When a consumer files a first party insurance claim and the adjuster is sent, the insurance company knows a great bit of information in advance of the first visit, including a good idea how the insurance company plans on adjusting the claim. The unsuspecting consumer, who was promised good hands treatment by a good neighbor, has no clue their friendly claims adjuster is actually an adversary, a wolf in sheep’s clothing.

As I pointed out in a post on the concepts of economic transparency and insurance in December this condition is known as Information Asymmetry, “A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge.”

There are public policy implications in these conflicts of interests, both those noted by the GAO and those that are an accepted part of insurance law as explained by Mr Rossmiller. These public policy battles are being played out real time in places like Olympia Washington and Washington DC by people, including politicians who have the ability to see past the law to a greater collective good.

Is State Farm Overextended?

I have read remarks like this one several times in the blogosphere and am again reminded of Taleb and his theories:

(My independent insurance agent) “talked me out of using State Farm (who had the lowest quote), because he said that the opinion of a lot of insurance brokers was that State Farm had overextended itself, and might not be able to pay all of their claims in a widespread disaster. He directed me to a company that was about 20 per cent Higher than State Farm.”

The luck involved with that scenario is stunning. Though I don’t think it is possible to buy State Farm insurance from an independent insurance agent lets assume this statement is true. What were the motivations of that independent agent? To maximize their own commission a la commissioned retail stock brokers? Assuming this poster had combination wind-water damage and their WYO insurer paid them under both wind and flood there is also a large element of luck that the damage was distinguishable as appears the case with McIntosh.

As a group we do not recognize the influence of pure chance at work in our daily lives as we are far more suited to pat ourselves on the back and stroke our egos than see true reality. A central part of Taleb’s observations that deal with how we humans make sense of events was best summed up by Taleb himself when he wrote:

“It is high time to recognize that we humans are far better at doing than understanding, and better at tinkering than inventing. But we don't know it. We truly live under the illusion of order believing that planning and forecasting are possible…..

(we) are too bathed in enlightenment-style (notion of) cause-and-effect and cannot accept that skills and payoffs may have nothing to do with one another.”

So while we try to make sense of how State Farm adjusted their multi peril claims here after Katrina in terms of misguided notions like “they had to commit fraud or they would have gone bankrupt”, it would help to arm ourselves with some facts including basic financial facts such as after paying almost $4 billion dollars in claims, State Farm’s Property and Casualty Subsidiary still had over $3.5 billion dollars of “unassigned surplus” while posting over $2 billion dollars of profits in the two years ended December 31, 2006. That’s right, State Farm actually made money despite paying those Katrina related claims.

For those interested in State Farm’s financial condition the last audit of their P&C subsidiary can be found here.

Next up: Differing views on the problems with NFIP and some suggested solutions.

sop

Purchasing Insurance: Market Transparency and Other Important Concepts Part 1

At the Mississippi Insurance Forum we have identified two main problems with Property and Casualty insurance in the aftermath of Hurricane Katrina:

1. Unfair and predatory claims handling as demonstrated by the unrefuted fact patterns in cases like McIntosh v. State Farm where State Farm threatened to fire their own engineers who found wind damage as the primary cause of the loss rather than flooding. State Farm actually ordered additional engineering reports until they received the "answer" they requested in such cases.

2. A lack of transparency in insurance product pricing, especially in the area of reinsurance.

While we will tackle both issues its worth noting the first has already received a fair amount of press attention while the second has not been addressed in detail except at a few web sites like this one. I suspect the reason the economic concept of market transparency has received such little attention is because it is complicated to explain and understand. I endeavor with this entry to start our readership along the path to understanding these important yet basic economic principles.

First we need to start with the decision to purchase a multi-peril homeowner's policy and examine the criteria consumers use when selecting an insurer. Think about it, how did you choose your insurance agent and insurer? Did you let your fingers do the walking or perhaps you received a referral from a friend of the agent? Or maybe we thought the ad we saw during the football game was good and we feel safe knowing the local agent in the spot showed up when the house burned down. Maybe as a first time homebuyer you got a good tip from your mortgage broker on who to use. Another good question is why did you buy the policy? Because it was it required by the bank or mortgage company? What about the policy limits, were they set to only cover paying off the mortgage because it was cheaper than insuring the total value? How many times since you first purchased the policy have you evaluated the risks you are paying to insure?

These are all very important questions. My professional experience preparing post Katrina income tax returns with casualty loss is that most people literally are asleep at the wheel when it comes to assessing the risks that may impact them in the future. In fact I submit it is basic human nature to avoid thinking about such unpleasant possible future events. The end result of burying ones head in the sand is invariably bad for the consumer once disaster strikes.

Post disaster hindsight reveals the complete inadequacy of the original criteria we used to select an insurer. For instance, the fact your local State Farm agent is a good guy (mine is for certain) is meaningless when the "good neighbor" refuses to pay for an insured risk. And all the accumulated advertising we've seen never prepared us for the very real possibility the good neighbor will force many of it's customers to use the court system to collect on the policy as a matter of internal claims handling policy.

Had we used good criteria originally to purchase insurance, we would have considered variables such as recent claims handing histories of these companies in our purchase decision. I've had people I know off the coast tell me they are not worried about State Farm covering windstorm risks because they are "too high to flood". Human nature then takes over for a time, refusing to believe that State Farm refused to cover obvious wind damage in Oklahoma City after an F5 tornado struck there in May 1999 or that a jury there found, "that State Farm "recklessly disregarded" its duty to deal fairly with policyholders, doing so "intentionally and with malice" through the use of biased expert opinions after the 1999 tornado." Perhaps we decide to switch to another insurer such as Allstate only to find out their internal documents describe treating a claimant/customer with "Boxing Gloves" instead of "good hands" and their record in customer treatment in automobile insurance claims appears abysmal. In fact we find out that according to the AM Best, "In the decade after Allstate instituted the McKinsey program in 1995, the amount of money it paid out per premium dollar in car accident cases declined from about 63 cents to 47 cents". Most importantly we find out the lack of good information the consumer has to evaluate insurers is stunning.

Insurers on the other hand know a good bit about their customers. They know your credit score for instance and will rely on a computer model to determine how your claim is handled. In a previous post on this forum I detailed how insurers spend big money on weather modeling to assess the risk they face. In short most consumers use subjective, sometimes emotional criteria to purchase insurance while insurance companies use objective criteria in how they conduct business. The gap in market knowledge between insurers and consumers is referred to in economics as Information Asymmetry, and is defined as "A situation in which one party in a transaction has more or superior information compared to another. This often happens in transactions where the seller knows more than the buyer, although the reverse can happen as well. Potentially, this could be a harmful situation because one party can take advantage of the other party’s lack of knowledge."

In future posts we will further examine the concepts of Asymmetric information and how it translates into premium pricing, especially in reinsurance.

sop