The Imperfect World of Insurance

In a perfect world, there would be perfect markets, including a perfect insurance market. A perfect market means that every market participant is able to transact their business exactly perfectly. All participants have perfect information, which allows them to buy or sell at precisely the optimal price. The value of the product is perfectly matched to the expectation of the purchaser. The supply of products matches exactly the demand of the market.

You get the point. This kind of market only exists in the minds of academic economists, who spend their days thinking grand thoughts about what the world could be if only it were perfect. Since we live in the real world, where perfect markets are only a figment of smart imaginations, we have to deal with the markets that exist.

In our imperfect insurance market, we must deal with the market the way that it is.

Insurance companies aren’t interested in writing insurance for all available customers. Not all potential insurance customers are interested in the insurance they need. Also, some insurance customers aren’t interested in providing perfect information regarding the exposures for which they want to buy insurance. Add to that the fact that risk exposures are continually evolving in ways that are both predictable and unpredictable and that insurance companies don’t want to write every possible coverage. You find that a perfect insurance market is impossible to create.

Two tangible results of this imperfection are the existence of insurance regulation and the existence of market fragmentation. Insurance regulation is beyond the scope of where we want to go today. Our focus is on this idea of market segmentation. What I mean by market segmentation is the truth that not every insurance consumer can buy insurance from those companies you normally think about. The name-your-price tool doesn’t work for everyone.

The Admitted Market and What It’s Good At

You may already be familiar with this, but the admitted market includes the insurance companies that submitted their plans, financials, rules, rates and forms to the state department of insurance. The state then graced them with a certificate of authority to transact insurance business within the state. They were admitted to the market.

As a rule, the admitted market is very good at writing insurance policies that fit easily into certain boxes, which they will usually refer to as classes of business. Some companies really like to write homeowners’ insurance. Others really like to write personal auto. Some companies that write commercial business like to write BOPs (business owner policies), some write commercial package policies, and others just like to write certain lines of business.

The admitted market is best for exposures and coverages where there is plenty of historical data available. The more information a company can gather, the more they will like writing the business. There are over 200 years’ worth of data about buildings that catch fire. This is an example of what the admitted market does well.

The admitted market is a reactive market. It does not anticipate what the next insurance need is. It also doesn’t really take well to emerging risks. This goes back to the need for data and how it can be applied. Without proper data, an admitted company won’t be able to calculate proper rating factors or anticipate the most appropriate base rates for their filings. Without proper rating justification, the insurance department may reject the filing, which means that the company won’t be able to write the business well. Also, without proper exposure information, the company will have trouble creating coverage forms, including the best coverage and appropriate exclusions.

The Residual Market and What It’s Good At

There are certain risks that fall outside the appetite of the admitted market. We’re not dealing with unusual risks and exposures. We’re dealing with risks and exposures that are too risky for the admitted market for some reason. These are the risks that the residual market is designed to deal with. The residual market is where you see terms such as joint underwriting association, assigned risk, or wind pool.

The residual market is designed to pick up the insurance policies of those insureds who should seek coverage in the standard market but for some reason, they are not eligible for coverage in the standard market. It’s the market of last resort (or at least it should be, Florida).

Think about personal auto, homeowners or dwelling fire type policies. These are the homes that the big companies won’t write because of some issue. They have existing unrepaired damage. They have had a series of losses that makes actuaries sick. The insured has had several claims at different properties. The location is too close to the ocean. The insured has had six moving violations, two multi-vehicle accidents, and a mysterious rollover collision.

These tend to be risks that underwriters look at and give a hard “no” to. No negotiation. No haggling over price. There is no rate high enough to write the policy. That’s why the residual market exists and why there needs to be a robust residual market.

Residual markets need to provide bare-minimum coverages at a price that makes people wince in pain. They can’t just set the price so high that people choose not to maintain coverage, though. (There’s a big enough uninsured driver problem out there.) But the price needs to reflect the risk and so does the coverage.

The purpose of the residual market is to help the insured to clear up their loss history, make the investment in the property, or whatever else is necessary to allow them back in the standard market. I also support automatic thresholds where the residual market attempts to place risks back in the standard market annually, or at some consistent interval. That keeps the residual market small, as it should be, and the standard market healthy.

The E&S Market and What It’s Good At

That leaves us with one more market to look at. This is the most responsive of the insurance markets — the excess and surplus market. This isn’t the market of last resort, it’s the market where risk takers and risk profiters meet up to make new things happen.

Consider the emerging risks we’ve seen in the last few decades, such as cannabis businesses and cyber insurance. For the most part, the standard market doesn’t want to touch risks like these because there is too much unknown for them. That’s not judgment. It’s just a fact. The insurance companies that work in the standard market are established and they like the routine of their markets. They don’t want surprises.

The E&S market thrives on surprises. That might be an overstatement, but they have always been available to write risks that are too far outside the proverbial box for most companies.

Consider again why people buy insurance. We buy insurance either to pay for losses that we cannot afford to pay for ourselves or to protect assets in the event of a loss. The E&S market exists to help meet that goal when the loss relates to something that’s not exactly “normal.” Consider the soccer player who wants insurance to cover the financial impact of serious injury to his legs. Also, the actress who needs insurance to cover the financial implications if something happens to her trademark smile. Or the business who needs insurance to cover damages that may occur if something happens to the founder and face of the company.

That doesn’t mean that the E&S market can’t write more normal exposures. They come alongside other companies and write DIC policies to cover the exposures that standard market insurers won’t touch for certain properties. They write physical damage coverage for exotic, expensive and custom autos. They write condos on the beach because no one else will.

The fact that there are insureds that admitted companies don’t want makes the existence of both the residual market and the E&S market not only viable, but necessary.

Some call the residual market a problem because it’s often run (at least partially) by a state (or the federal government, which should always stay out of insurance). Some think that the E&S market is unstable and unreliable. I would ask how often an E&S carrier pulls out of a state, becomes insolvent, or stops operating. My guess is that it is less frequent than the insolvency rate in Florida among property insurers.