As a student in my third year studying both Actuarial Studies and Economics, I’ve pondered many times whether there is a feasible link between the two degrees. To ease my anxiety about potentially wasting my university years doing things that are completely uncorrelated, I decided to take a deep dive into the recent history of Australia’s private insurance industry.
In a bittersweet surprise, I did learn that maybe my naive decision to study both insurance and economics in unison with one another (along with maybe about 5 other people) held some merit to it. However, the story of Australia’s private insurance sector serves as a cautionary tale, with all the ups and downs you’d expect from any Shakespearean classic (if you know, you know).
Let’s start our story with an overview between the general synergy of insurance and economics.
An Overview
Although studies are still quite young compared to other disciplines, the role of insurance cannot be understated in modern economies. Life insurance provides economic protection against an unforeseen death; health insurance covers the egregious fees of medical assistance; and bank deposits in Authorised Deposit-Taking Institutions (ADIs) are guaranteed by our federal government. Despite stagnant revenue growth in the past couple of years, direct premiums still increased by 1.6% to 18.5 billion dollars in 2018, serving as a reminder of how big the industry actually is.
In fact, it follows that insurance maintains the basic economic principles that many commodities (such as Labour) are predicated by. Yes, that means we also have a Supply and Demand curve for insurance
Figure 1. Source: The Actuarial Profession
The supply for insurance is based upon how insurers price their products. With prices (measured in the form of insurance premiums paid by agents) too low, insurance companies will not maintain the equivalence principle. Specifically, this is the notion that the expected value of the risk they are undertaking must always equal the amount they are getting back in premiums. In layman’s terms, insurers won’t supply any products if the amount they get paid is less than the amount they would pay out in the case of a claim being made by an agent. Although there are more complex and accurate ways to ensure that insurers don’t underpay their risk (such as the Variation Principle), the equivalence principle is often used as the general rule of thumb.
The underlying factor behind these mechanisms is the concept of risk. Unfortunately, risk remains an extraordinary expense which can never be fully eliminated, hence explaining why we will always have demand for insurance. We can’t get rid of it, but the whole point of insurance is to at least mitigate it at a specified premium.
Here is where we start to diverge from classical economic theory. Normally, the cost to produce a commodity stays constant in a perfectly competitive market. However, in insurance theory, the cost of providing insurance is directly dependent on the identity of the purchaser themselves. To illustrate this point, let’s have a look at life insurance premium prices.
As can be seen in Figure 2, the premiums agents pay are extremely variable. In the best case, a non-smoking woman in her 20s will only pay $33 a month for life insurance. In the worst case, a smoking male in his late 50s who will be forced to be 18 times that! Going back to the equivalence principle, this extraordinary discrepancy in premium pricing is due to the fact that the male carries a lot more RISK. In this context, he is at greater risk of dying (due to the fact that he’s older, male and a smoker) and hence the insurer will more likely pay out a claim, leading them to charge more money.
Figure 2. Source: Canstar
Now, it must be stated that simply splitting the population by gender and whether they smoke or not is incredibly surface level. Realistically, the underwriting process takes into account a multitude of factors including job occupancy, location and history of family illness. However, just like many economic markets before it, the issue of asymmetric information pervades this process. Going back to Figure 2, what is feasibly stopping an agent lying about how much they smoke to cut their premiums in half? Although economic signalling (such as getting a doctor to test a patient for symptoms of smoking) may ease the issue, doing this for each insured individual will prove costly over time. Asymmetric information tends to snowball over time, leading to what is known as a ‘Death Spiral’.
The Death Spiral
Death Spiral. It seems a bit hyperbolic doesn’t it? After all, the term is used in the context of insurance. What could be so terrible about these that it coined the name of a ‘90s horror flick?
Symptomatic of adverse information, a death spiral occurs when premiums rise due to an event in the economy, leading lower risk agents to exit the policy as they would be paying more than their risk entails. If an extremely young person has such little risk of dying, what incentivises them to purchase an inflated life insurance product?
With the low-risk agents now out of the picture, the high-risk agents face even higher premiums as they bear the brunt of this mass exodus. Eventually, it will get to a point where not even the high-risk agents can justify paying such high prices, consequently wiping out the entirety of the initial cohort in a market crash.
Figure 3. Death Spirals Explained
Believe it or not, this mechanism isn’t a stranger to broader economic theory. Let’s cast our minds back to Mr Watergate himself, Richard Nixon, and his presidential term. In the 1970s, Unionisation had started to take effect, with unions pushing for higher wages. However, corporations had strict profit margins to maintain and hence translated these increasing expenses by charging even higher prices for their products. And you guessed it! Unions responded by demanding even higher wages! This led to what was known as the Wage-Price spiral, which behaves very similarly to the death spiral we have come to know and love (albeit in a much different context).
Getting back on topic, the notion of death spirals become extremely relevant when discovering that Australia’s private health insurance sector was in one late 2019. The exodus of low-risk agents from policy was so severe that George Savvides (who ran Medibank for 14 years) likened it to “a climate change event in the health system”. The issue is especially exacerbated in the context of health insurance, as low-risk agents are normally younger people who face anaemic wage growth and can’t afford higher premiums. As seen in Figure 4, this has been effectively quantified by a downward trend in the percentage of population with private hospital insurance since 2014. In fact, a ball park figure of people leaving is at approximately 875,000 people!
Figure 4. Source: Australian Prudential Regulation Authority (APRA)
However, for all the doom and gloom that came with Coronavirus, it actually afforded a lifeline for a sector that is facing impending collapse. This was due to the fact that all elective surgery was paused during the pandemic. Elective surgery remains one of the greatest expenses for insurers, hence meaning that they were able to cut costs without any reductions in their premiums. Although temporary, Macquarie estimates that even if claims fell by 20%, this windfall of cash would still provide a net profit of $1.18b.
Despite all this, it is effectively the equivalent of putting a band-aid on a gun shot wound. Instead, health ministers need to find more effective and sustainable ways to keep costs down and incentivising younger people to stay with their policies. Health Minister Greg Hunt has already made steps in the right direction, by offering discounts to members below the age of 25.
Let’s see if they can save this sinking ship.
References:
https://www.econlib.org/library/Enc/Insurance.html
https://www.cato.org/publications/commentary/remembering-nixons-wage-price-controls
https://indaily.com.au/opinion/2020/02/19/no-pull-up-from-private-health-death-spiral/
https://home.kpmg/au/en/home/insights/2019/11/life-insurance-insights.html
https://www.canstar.com.au/life-insurance/cost-of-life-insurance/