Life is full of examples of human behaviour that point to the need for collective action to counteract the destructive self-interested actions of the individual. JM Keynes pointed out that while the man who feared being made redundant and saved more of his income was acting rationally, if everyone did this, the recession would be longer and deeper than was necessary – hence Keynesian economics.
Even in financial services, we can find self-interested actions worsening the collective outcome. How paradoxical that life assurance, one of the ultimate expressions of the benefits of sharing risk, is one such case.
To illustrate this, I ask you to join me in a thought experiment. It starts in 1960, when a set of 10,000 people aged 30 buy 25-year term assurance policies. They each fill in a four-page application form and over 90 per cent are accepted at normal rates. Over the following 25 years, a few of them die – fewer than the life assurance companies anticipated, enabling them to show a greater profit than they expected.
Fast-forward to 2011, when another set of 10,000 people aged 30 buy 25-year term assurance policies. They each fill in a 20-page application form and only 40 per cent of them are accepted at normal rates, the rest pay higher premiums depending on their size, gender and personal and family medical history.
Over the next 25 years, the pool accepted at normal rates will deliver a fairly predictable outcome – fewer of them will probably die than the insurance companies currently expect. But the various pools underwritten at different rates will show much more variable outcomes. Because the pools are smaller, a few more or less deaths than expected within the next 25 years will tilt the outcome towards losses for the insurers in some cases and super profits in others.
As for the costs, the expected mortality of the entire group of 10,000 in 2011 will, as it was in 1960, be paid for by the whole group of 10,000. But who is paying for the costs of the 20-page application forms, the complicated underwriting, the multiple applications, the medical reports and the advisers’ time? Strip out the effects of mortality and technology on reducing premiums, and what we see is that between 1960 and 2011 the life assurance industry has loaded a pile of extra costs on to its customers.
Of course, some individuals are winners and some are losers from what has happened. But that does not mean it is right to describe today’s process as fairer than what happened in 1960. On the contrary, for society as a whole, the outcome is worse. Collectively, we pay more for the same cover (excluding mortality gains) – and a lot of previously insurable people now cannot get cover at all.
The industry has made something simple into something unnecessarily complex, because it was in the interests of companies to create ever more marginal distinctions in their underwriting process in their attempts to offer lower premiums to one group or another. It is a race to the bottom and if it continues, we can expect the proportion of people underwritten at normal rates to be 10 per cent in 2030. That daft projection shows the folly of the whole process because it implies the elimination of risk-sharing.
And how do we escape from this not at all merry-go-round? You tell me.
Chris Gilchrist is director of Churchill Investments and editor of The IRS Report