Page 111 - DMGT512_FINANCIAL_INSTITUTIONS_AND_SERVICES

Financial Institutions and Services

Notes It should be clear that these bills are aimed at making the insurance sector private dominated,
self-regulated and "competitive". Is there a case for such a transition? There is much evidence on
the adverse consequences of such competition and the beneficial effects of government
intervention in the insurance sector. The insurance industry delivers "products" that are promises
to pay, in the form of contracts, which help lessen the incidence of uncertainty in various
spheres. The insured pays to fully or partially insulate herself from risks such as an accident, fire,
theft or sickness or provide for dependents in case of death. In theory, to enter such a contract,
the insured needs information regarding the operations of the insurer to whom she pays in
advance large sums in the form of premia, in lieu of a promise that the latter would meet in full
or part the costs of some future event, the occurrence of which is uncertain. These funds are
deployed by the insurer in investments being undertaken by agents about whose competence
and reliability the policy holder makes a judgment based on the information she has. The
viability of those projects and the returns yielded from them determine the ability of the insurer
to meet the relevant promise. To the extent that the different kinds of information required are
imperfectly available, the whole business is characterised by a high degree of risk.
This makes excessive competition in insurance a problem. In an effort to drum up more business
and earn higher profits, insurance companies could underprice their insurance contracts, be
cavalier with regard to the information they seek about policy holders, and be adventurous
when investing their funds by deploying them in high-risk, but high-return ventures. Not
surprisingly, countries where competition is rife in the insurance industry, such as the US, have
been characterised by a large number of failures. As far back as 1990, a Subcommittee of the US
House of Representatives noted in a report on insurance company insolvencies revealingly
titled "Failed Promises", that a spate of failures, including those of some leading companies, was
accompanied by evidence of "rapid expansion, overreliance on managing general agents,
extensive and complex reinsurance arrangements, excessive underpricing, reserve problems,
false reports, reckless management, gross incompetence, fraudulent activity, greed and self-
dealing." The committee argued that "the driving force (of such 'deplorable' management
practices) was quick profits in the short run, with no apparent concern for the long-term well-
being of the company, its policyholders, its employees, its reinsurers, or the public." The case for
stringent regulation of the industry was obvious and forcefully made.
Things have not changed much since, as the failure and $150 billion bail-out of global insurance
major American International Group (AIG) in September made clear. AIG was the world's
biggest insurer when assessed in terms of market capitalisation. It failed because of huge marked-
to-market losses in its financial products division, which wrote insurance on fixed-income
securities held by banks. But these were not straightforward insurance deals based on due
diligence that offered protection against potential losses. It was a form of investment in search
of high returns, which allowed banks to circumvent regulation and accumulate risky assets. As
the Financial Times (September 17, 2008) noted, "banks that entered credit default swaps with
AIGFP could assure auditors and regulators that the risk of the underlying asset going bad was
protected, and with a triple A rated counterparty." That is, AIG used policy-holder money and
debt to invest like an investment bank through its financial products division. When a lot of its
assets turned worthless AIG could not be let go, because that would have systemic implications.
The alternative was nationalization.
It is in this background that we need to address the question of the "efficiency" of competition
from private entrants. To start with, against the promised private gains in terms of the efficiency
of service providers, we need to compare the potential private loss in the form of increased risk
and the social loss in the form of the inability of the state as a representative of social interest to
direct investments by the insurance industry. Further, if insolvencies become the order of the
day, there could be private losses as well as social losses because the state is forced to emerge as
the "insurer of last resort". The losses may far exceed the gains, implying that the industry
should be restructured with the purpose of realising in full the advantages of public ownership.

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