The role of government in supplementing the private insurance industry and the industry’s response to terrorism were recurrent themes at the seventh annual conference of Wharton’s Financial Institutions Center and the Brookings Institution held earlier this month in Washington, D.C.


The conference, entitled “Public Policy Issues Confronting the Insurance Industry,” included papers on such topics as mergers and acquisitions in the European insurance industry, insurers’ response to the Sept. 11 2001 terrorist attacks, and legislators’ responses to 9/11, Medicare prescription drug benefits and medical malpractice insurance.


According to Richard J. Herring, co-director of the Wharton Financial Institutions Center, Brookings will publish final versions of the papers presented at the conference in a volume late this summer.


Harvard University’s David M. Cutler and Richard Zeckhauser kicked off the conference Jan. 8 with a paper on what they called the increasing divergence between insurance theory and practice.


The authors say insurance is often purchased when theory would suggest it should not be, such as life insurance for the elderly and expensive extended warranties on relatively low-cost consumer electronics. At the same time, many significant risks that should be insured, such as terrorism, are not.


The authors also cited mismatches between parties who should bear risk and those who actually do. “Governments insure risks that the private sector might better bear, and financial markets, with their vast resources and wide participation, are not the risk bearer for many large private risks,” although they should be.


As an example of the disconnect between insurance theory and public policy, Cutler and Zeckhauser cite Congress’ approval of President Bush’s addition of prescription drug benefits under Medicare. Medicare will pay 25% of drug costs (above a $250 deductible) up to $2,250 in total spending. Additional expenses are not covered unless total spending exceeds $5,100, after which the government pays 95% of additional costs with no cap.


“The cost sharing in the new legislation is, by economic considerations, somewhat bizarre,” they write. “From a risk-spreading perspective, a far more valuable insurance policy would have individuals cover more of the up-front costs, and leave the government to take more of the back-end liability.” The authors attribute this anomaly to politics: Policy makers glean more political benefits by spreading coverage to a broader segment of the electorate.


Prescription drug benefits, they note, are extremely sensitive to adverse selection: Only those with high drug needs are likely to buy coverage. That prevents effective risk sharing, making the cost of coverage unaffordable. “The classic economic solution to adverse selection – single payer health insurance – was explicitly rejected as being too regulatory a solution,” the authors write.


Insuring against Large Losses

in a paper on insuring against terrorism, Kent Smetters, Wharton professor of insurance and risk management, was also critical of Congress’ efforts. Smetters said the Terrorism Risk Insurance Act (TRIA) of 2002 was the extension of a 50-year trend in which the public has accepted a larger role for the government in insuring natural catastrophic losses.


The law requires insurance companies to provide coverage for “certified” foreign acts of terrorism in property and casualty lines under the same conditions as the underlying policy. In return, the federal government agreed to indemnify 90% of an insurer’s losses above a retention level equal to 7% of direct earned premiums in 2002, rising to 15% of the direct earned premiums in 2005.


Smetters argues that the law was prompted by an inaccurate perception that private insurers could not respond to events such as 9/11. “Mostly unfettered insurance and capital markets are capable of insuring large terrorism losses, even losses 10 times larger than the $40 billion loss that occurred on September 11, 2001,” Smetters says. “A $400 billion loss in capital markets is common. U.S. capital markets alone routinely gain or lose $100 billion on a daily basis, and often several trillion dollars on a monthly basis.”


Insurers appear to have a hard time providing insurance against large losses, Smetters argues, only because government tax, accounting, and regulatory policies have made it costly for insurers to hold surplus capital and have hindered the implementation of instruments that could securitize the underlying risks.


“Modifying these fiscal policies would have likely been much more efficient than the approach taken in TRIA, which has created several potential problems: Crowding out the development of private insurance; excess demand for subsidized insurance by diversified shareholders; ex-ante and ex-post moral hazard, and, unfunded liabilities on future generations,” Smetters says.


Neil A. Doherty and Alexander Muermann, both Wharton professors of insurance and risk management, also looked at terrorism in a paper suggesting that insurers agreed to cover “non-verifiable” losses – losses not explicitly covered by their policies – on 9/11 in part because of the role of insurance brokers.

While many policies covered or did not exclude coverage of terrorism losses, the authors note, most policies excluded acts of war. Although the attacks were described by President Bush as an act of war, leading insurers announced that they would not fight the claims on such grounds.

Why? Since the brokerage market is highly concentrated, the authors say, news of an insurer’s refusal to negotiate payments on a “non-verifiable” loss would spread quickly through the industry, jeopardizing the company’s reputation and its ability to attract new business through those brokers. Similarly, policyholders unwilling to negotiate on such claims may find it difficult to get coverage in the future.

Medical Malpractice: Issues of Insolvency

While the speakers were critical of government’s efforts on terrorism and prescription coverage, Wharton health care systems professor Patricia M. Danzon and Wharton doctoral candidates Andrew J. Epstein and Scott Johnson said the government doesn’t always ignore economics.


In a paper on the crisis in medical malpractice insurance, the authors cite a recent General Accounting Office report concluding that states that have enacted caps on awards for non-economic damages have had significantly lower rates of malpractice premium increases than those without caps. From 1999 to 2000, for example, general surgeons’ medical malpractice premiums increased 75% in Dade County, Florida, but only 2% in Minnesota for a similar level of coverage.


“Although this evidence suggests that non-economic damages caps have reduced premium growth, such conclusions remain tentative because this analysis was based on only one year of premium increases and does not control for other factors,” the authors caution.


In a separate paper, Danzon, Epstein, Johnson and University of South Carolina Professor Scott E. Harrington examine the role of “aberrant pricing” in the severity of swings between “hard” insurance markets, when coverage is expensive and difficult to obtain, and “soft” markets, when coverage is plentiful and prices may become unrealistically low.

Danzon said the evidence on malpractice insurance supports the belief that insurers who undercharge, due to inexperience or excessive risk taking, contribute to “excessive” competition during soft markets. That results in excessive price increases and insurer exits during the “hard” market that follows. Danzon cautioned that her team’s conclusions were tentative and should be tested with more recent data.


“If these tentative conclusions are correct … appropriate policy response would have to weigh the competitive benefits of easy entry and exit against the costs,” Danzon’s team concluded.


Jay Fishman, a 1974 Wharton graduate and chairman and chief executive officer of The St. Paul Companies, Inc., disagreed with caps on “pain and suffering” awards in the keynote speech to the Wharton-Brookings conference. St. Paul, which will become the second largest U.S. commercial insurer pending its merger with Travelers, quit the malpractice business in December 2001, citing millions in losses.


Fishman said St. Paul left the business after concluding it would need to raise rates 30% annually for three years to reach break-even. Such premium increases would have only accelerated the “death spiral” of adverse-selection for that coverage, he said. “It was an environment in which the insurance mechanism had truly broken down. It really became an issue of solvency for our company.”


But Fishman said damage caps are not the solution. Rather, he said, the increasing pace of innovative and experimental treatments necessitates a better definition of “malpractice.” Doctors should not be liable, he said, if cutting-edge treatments don’t meet the client’s expectations. “Procedures of this complexity don’t always work out.”


Insurance Industry M&As

In a paper entitled “Consolidation in the European Insurance Industry: Do Mergers and Acquisitions Create Value for Shareholders?”, David Cummins, professor of insurance and risk management at Wharton, and Mary A. Weiss, professor of risk management and insurance at Temple University, look at the deregulation of the insurance industry in Europe during the 1990s as part of the European Union’s attempt to create a single market for financial services.


Insurance industry “deregulation led to an unprecedented wave of mergers and acquisitions,” they note. “From 1990-2002 there were 2,595 M&As involving European insurers, of which 1,669 resulted in a change in control. Transactions occurred both cross-border (across national boundaries) and within-border as well as cross-industry (e.g. involving insurers and banks) and within-industry.”


The paper’s goal was to determine “whether M&As in the European insurance market create value for shareholders by studying the stock price impact of M&A transactions on target and acquiring firms.”

Cummins and Weiss conclude that “European M&As created small negative cumulative average abnormal returns (CAARs) for acquirers (generally less than 1%) on average … Targets, however, realized substantial positive CAARs in the range of 12% to 15%.” The paper also breaks down the transactions into cross-border and domestic (within-country) categories.