Author: Jay Jiyuan

The best way to know is to read my thoughts on the blog site: Ideabins.blog. I have been a managerial consultant for 10 years and then college teaching for 12 years. Entrepreneur in heart, interested in financial leteracy

Did You Know?

What Makes Insurance Business Model Unique?

Post author By Jay Jiyuan
Post date June 13, 2023

The Takeaways:

Insurance is a future oriented business: Insurers (insureds) charge (pay) premiums to prepare for risk and uncertainties in the future, not in the past.
The business model of the insurance industry that everyone has been talking about is to make money from collecting and investing premiums. But we should add in risk sharing, which leverages the uneven and asymmetrical chances of filing claims by different policyholders to protect underwriting profit.
Risk sharing differs from risk pooling. The former adds an additional step of selecting for good risk to the latter.
Risk sharing has two forms: people sharing and money sharing. Cost sharing, a term familiar to most in the health insurance market that takes the forms of deductibles, co-payment and coinsurance, is a part of money sharing, together with others like different premium, lapsed policies and universal premium rate changes in a state.
Risk sharing works for both predictable and unpredictable risks. In health insurance the law prohibits discrimination against preexisting medical conditions, both in enrollment and in premium charged. While this makes risk prediction irrelevant, risk sharing still works through enrolling as many people as possible when they are entitled to and eligible for Medicare.
Risk sharing may have a reputation of being unfair to different policyholders, but that’s wrong because life is fair in terms of all humans facing the same future related uncertainty and risk. While those with insurance claims are being financially rewarded by insurers, those without filing insurance claims are gaining peace of mind. Nobody’s premium is wasted.

Surprisingly, as far as I know nobody has talked comprehensively about how insurance companies (or “insurers” for short) make money as a whole. In my view, if you don’t know the business model of an industry or a profession, you don’t know the industry at all no matter how long you have been doing it.

Unfortunately most businesspeople focus on how to make money for themselves, not the fundamental business model. As a result, this topic has been rarely touched upon even at the most basic conceptual level. We end up seeing “trees” but not “forest” even though no tree exists alone and the ecology of forest shapes each and every tree.

A quick sidenote: A business model is just a strategic plan of how a company, a business entity, or in our case, the entire industry, will make money. Here making money means earning a profit by receiving more money than spending it.

Insurance Is a Future Oriented Business

But don’t take the topic for granted or presume it’s meaningful. Instead, it’s always healthy to ask why we should be bothered with a question or a topic. Compare insurance with other businesses helps.

Consider retail businesses (e.g., supermarkets, department stores, or online retail distributors like Amazon), which make money by selling goods or services to customers. Insurers receive money from policyholders’ premium rather than from, and insurers pay money through fulfilling insurance claims (to designated beneficiaries, policyholders, healthcare service providers, the courts, employees, third-party claimants, to name just a few).

There, we see that insurance is a future oriented business, meaning insurers receive and spend money for events in the future, while retailers do business by selling previously made goods and/or existing services. They typically won’t collect consumers’ money ahead of time without offering goods or services in exchange.

The Challenge of Charging a Price for the Future

Insurance is not the only future oriented business, many other (e.g., renewable energy, space technologies and even healthcare, in which a crucial part is to develop new drugs and new treatment regimens) do that.

Going deeper, almost all businesses have to deal with elements of the future. It’s not that some businesses are exclusively working for the past while others exclusively for the future. Therefore, I won’t say insurance is unique because it focuses on the future.

Of course, a future focus does have its ramifications, chiefly among them is future related uncertainties or risks. For example, it is relatively simple for retailers to decide how much to charge customers: They can always use the production cost, plus transportation or distribution cost to get started. The nice part is that both production and distribution costs are known before sales, retailers only need to add the desired profit margin to set the final price.

Insurance has a different story. We must determine the price (i.e., premium) of our product (i.e., insurance policy) ahead of time or before an accident or an undesirable event happens to policyholders. We don’t have the luxury of seeing the event first, and then figure out the cost and consequences to decide how much the premium should be.

Insurers Have a Unique Business Model

Determining the right premium is a risky and uncertain business. If we charge too much, we lose business to the competitors; if we charge too little, we fail to cover the bottom lines to grow.

But risk is everywhere, they just come in different shapes and forms. Just like all businesses have to deal with the future, they also face risk and uncertainties. Retailers take the risk of buying the wrong amount of goods from wholesalers, for example. If they buy too much, more than consumers would buy, they suffer a loss by having to cut down sales price; if they buy too little, consumers will move to competitors with more stable supply.

Maintaining “just right” inventories is just one example. More risk arises from predicting consumers’ future taste and preferences. We have seen stories where retailers missed the trend of demand and drove themselves out of business altogether.

Risk Sharing Makes Insurance Unique

Once again, my point is that the uniqueness of insurance is not in dealing with risk, even with future oriented risk, but in its unique business model. This is where the idea of “risk sharing” comes into play.

There have been posts, articles and websites on how insurers make money. A good example is the article by Policygenius.com published April 2023. It summarizes four ways life insurance companies make money: charging premiums, investing premiums, cash value investments, and lapsed policies.

I won’t get into details but will point out that the above four ways really apply to all insurers, not just life insurers. All insurers share the same business model that has been functioning for centuries.

The problem is that the presentations so far have all overlooked one fundamental part of risk sharing.

That’s right, risk sharing plays a fundamental role in all lines of insurance, be it personal or commercial, life or health, properties or liabilities. It does not negate or eliminate the role played by premium investment, but does cut down its relative importance.

Simply put, before collecting and investing premiums, the two ways discussed by pretty much everyone, we need something else in place, something that has unfortunately been severely underappreciated.

The “Law of Large Number” Differs from Risk Sharing

Before defining what risk sharing is, let’s find out what it is not. We do hear the “law of large numbers” that has been taught as one of the fundamental axioms for insurance business. It states that the larger the number of exposure units independently exposed to loss, the greater the accuracy of the prediction of loss.

As a statistical axiom, this law is applicable everywhere, not just insurance. In population surveys or polling, one can be easily convinced that the result from a sample of 1,000 is more reliable than that from a sample of 100 people, for example.

But the law of large numbers is not the same as risk sharing, even though both are relevant and related to each other. The former helps insurance companies estimate the possibility of making insurance claims to be paid by insurer. Once the risk of claim is estimated right, insurers then charge the corresponding premium to cover the estimated claim losses, which is the key step in insurance underwriting.

Risk Pooling vs Risk Sharing

The law of large numbers is sometimes interpreted as “pooling of risks,” which is inaccurate. In its original and official sense, the law simply tells us that the bigger the sample size, the more accurate the sample estimates will be — other things equal, no more and no less.

If the law really means pooling risks, it must gather diverse risks of different types and shapes, as gathering similar risks makes little difference. To use an extreme example, talking to 1,000 people of identical age, gender and/or health record is the same as talking to one person. Pooling risk only makes sense when it works with risk diversity.

But here is what “risk pooling” differs from “risk sharing:” While the former works with diverse risks, risk sharing favored by insurers works with selected risks. Whenever possible, insurers always seek policyholders who possess low or “good risk,” which ultimately comes down to a low probability of making a huge insurance claim in the future.

Insurance firms do not hide their preference. When one applies for an insurance policy, insurers will typically ask questions regarding one’s claim history. A history of frequent claims, especially those involving a large amount of money, will make one’s application more likely to be rejected, or being charged a higher premium.

Predictable vs Unpredictable Risks

Selecting good risk matters because it is the main way for insurers to boost underwriting profit or reduce underwriting loss (i.e., the net profit or loss an insurer makes from issuing insurance policies without counting in investment gains).

Let me use a hypothetical example to illustrate underwriting profit or loss: Say an insurer has 1,000 policyholders, and collects $1 million premium each month but on average pays out $1.5 million on claims. The insurer will have a net underwriting loss of $0.5 million, even though it has an average gain of $50,000 each month from investing the premium in financial markets.

But no matter how carefully insurers select for good risk, bad risk will enter the population of policyholders, especially with simplified underwriting that skips medical exam and collects less information from applicants but relies on third-party sources to gather information about the applicant, such as their prescription drug history and driving record.

Bad risk or the number of claims also rise dramatically during natural disasters (for property insurance like hurricanes in Florida) and pandemics (for health insurance like Covid-19).

But “good” and “bad” risks are all relative and can be turned into each other. This is because insurance handles more or less unpredictable events. An auto insurance policy covers only injury and damage from a traffic accident but not intentional damages, wars and losses from regular wear and tear, all because these losses are highly predictable, unlike an accident.

Similarly, a homeowner policy protects your home from rare or accidental perils like fires, hail, theft, windstorm, smoke, lightning, explosion, riot or civil commotion, tree falling and volcanic eruption — but not from wars, earthquakes, landslides, floods, or even a large scale power failures, which all share the feature of incurring more predictable and heavy losses.

But here is the thing: A rare and accidental event can turn a “good” risk into “bad” and does the opposite for an originally “bad” one. Consider a hypothetical example: An auto policyholder who has never even had a single traffic ticket for 30 years is certainly considered a “good risk” in the eyes of insurer. However, this poor guy has recently lost his wife of 25 years and decided to drink a little. The next thing we know is that he hit five cars in a row and incurred injuries and damages at more than $1 million.

My point is that insurers can only do so much in selecting good risk, and no matter how hard they try, they will have to deal with some bad risks in the real world — the question is how. It’s never enough for insurers to predict risk — they must share it among policyholders.

Defining Risk Sharing

A formal definition of risk sharing is the constantly functioning mechanism that allows insurers to leverage the uneven and asymmetrical chances of filing insurance claims by different policyholders to protect underwriting profit and/or reduce underwriting loss.

The reason risk sharing works all the time is due to the silent fact that some policyholders will contribute premium without making any claim, or making fewer and smaller claims, while others may file large and /or frequent claims. People in the former group effectively pay premiums that end up covering claims by policyholders in the latter group.

It is risk sharing that makes the insurance business model unique, more so than the other two parts of collecting and investing premiums.

Two Forms of Risk Sharing

Risk sharing has two forms: people sharing and money sharing. Cost sharing, a term familiar to most in the health insurance market that takes the forms of deductibles, co-payment and coinsurance, is a part of money sharing.

Money sharing takes other forms, such as charging different premiums for different policyholders with different risk profiles. Universal money sharing is also possible in a state where rate increase applies for all existing and future policyholders, like we see in Florida, California and other states recently.

Finally, money sharing also comes when some policyholders had trouble making premium payments, and their lapsed policies will leave money to the insurer, indirectly funding insurance claims.

People sharing is the least known, but works quietly and forms the foundation for money sharing. Without people staying, either among policyholders with the same insurer or among policyholders in the same state, money sharing is very difficult or even impossible. After all, it can only happen among the people in the same state or with the same insurer.

It is not much different from a bank having a diverse clientele base like Bank of America or JP Morgan Chase versus a bank of highly homogenous clientele like Silicon Valley Bank. In the former different clients involuntarily assist each other due to different needs and preferences, making the bank financially more stable, while in the latter the missing diversity makes the bank financially more vulnerable.

Another simpler analogue is a housing co-op, where residents share a meal plan with all residents paying the same or similar amount of money, but those eating less will quietly help those eating more every meal without making it a big deal.

Risk Sharing with Predictable Risk

Risk sharing works not only for unpredictable risk (e.g., in an auto policy) but predictable ones (e.g., in health insurance, where insurers have no choice but to enroll everyone eligible, even knowing the extra cost associated with people of preexisting medical conditions.

Yes, in health insurance the risk is somewhat predictable — to the extent that people with preexisting medical conditions tend to have higher chances of making medical claims while enrolled in Medicare, Medicare Advantage, Original Medicare (Parts A & B) and Medicare Part D.

It is the laws and regulations that make risk prediction largely irrelevant. Since 2014 the Affordable Care Act (aka Obamacare) has changed the previously more or less accepted practice of discrimination against pre-existing medical conditions. Now no eligible enrollees can be denied enrollment nor be charged higher premiums. This means insurers won’t spend time figuring out who is more likely to file a claim.

The good news is that even when risk prediction becomes irrelevant, risk sharing still works for programs like Medicare. Here is how.

While the law prohibits discrimination against preexisting medical conditions, it also places penalties to enroll a sufficiently large number of people when they first become entitled to Medicare Part A (in patient services) and eligible to enroll in Part B (out of patient services). It’s a number’s game and with all enrollees on board, there will be enrollees who may never need intensive healthcare or will need it much later in life, by the time they would have paid enough premium to cover themselves and perhaps even provide surplus money for others.

Risk Sharing Is Still Win-Win

Why is risk sharing not openly discussed? Fairness and justice is perhaps a key concern. If some policyholders are essentially “money doners” while other recipients, it does not sound fair. On the country, the law of large numbers sounds “scientific” and entirely fair and safe to talk about.

But the seemingly strong argument against risk sharing has a problem: It ignores the fact that future insurance risk can never be completely and accurately predicted. Consider health insurance: Yes, people with preexisting medical conditions are risky in the future, but so are people with a very clean medical record. We have all heard stories of sudden death of presumably very healthy individuals. The truth is no one can guarantee you a “claimless” life. A fancier way to say this is that your probability of getting sick is never 0 nor 1. It falls somewhere in between. Life is fair at least in this fact involving probabilities.

Some policyholders or enrollees will be rewarded financially through claims, while others gain peace of mind without claim. We can even make a point on the “fairness” ground: Having insurance coverage for everyone provides a fair and safe environment for everyone in society. Consider the FDIC insurance for banks, when all depositors are protected, everyone gains directly or indirectly from a sound banking system, even though most banks may never need the FDIC protection. It seems fair to say that nobody’s premium will be wasted, with or without making a claim.

Tags Business model, Cost sharing, Future oriented, Insurance industry, People sharing and money sharing, Predictable vs unpredictable risks, Risk pooling, Risk selection, Risk sharing, Win-win

Financial talks at dinner table Life insurance

A Family Conversation on Life Insurance

Post author By Jay Jiyuan
Post date May 19, 2023

The Takeaways:

Only half (50%) of the US population owned life insurance policies in 2022, down from 63% in 2011.
The good news is that the “ownership gap” (between people who believe they should have a policy and people who actually own one, sometimes known as “Need-to-Have” gap) for life insurance is smaller (at 18%) than property insurance (up to 54%). The bad news is the gap has been increasing recently.
There are two fundamental types of life insurance: Permanent vs Term. A term life policy is for temporary coverage over a predetermined length of time, typically no more than 30 years, while a permanent policy covers policyholder’s entire lifetime ending in death.
All term life policies only cover death benefit with zero cash value regardless of the length of term, while all permanent life policies accumulate cash value to be used for policyholders before death. Term life policies are much cheaper to begin with, but they all have a specific “expiration date,” after which your premium payment is completely gone if you are still alive. Permanent life policies do not expire and the money you saved will be there — for you or your loved ones.
For policyholders, the most important “must know” concepts are living- versus death-benefits. The former is designed for policyholders’ own welfare before death, while the latter for the named beneficiaries.
For a long time in the past, life insurance has been largely driven by “altruistic” death benefit in the sense that only proven (or presumed) death of the policyholder triggers benefit distribution. However, annuities for guaranteed post-retirement income, critical care insurance for acute illnesses and long term care for chronic illnesses, these have changed the game profoundly.

Last time the Kingstons talked about inflation and central banks in relation to decentralized finance or DeFi. Today they decided to talk about something more practical and mundane: Life insurance.

Lily: Yesterday we talked about inflation and local reservoirs for holding the flood of money directly from central banks. Kim mentioned household savings as the terminal end of reservoirs, and I talked about life insurance policies as an alternative to household savings. Can we talk more about life insurance today? Part of my job involves marketing life insurance.

Kimberley: That sounds interesting, unless Mom and Dad had something else in mind.

Joy: Insurance is fine with me, especially life insurance, as many people bought auto insurance because the law says they must, but I assume life insurance is not as popular as auto insurance.

Lily: I’m glad you mentioned that. My company invited a knowledgeable speaker from a top life insurance company to educate us last week, and everyone feels they are gaining a lot. The speaker made frequent referral to this website called bestliferates.org during his presentation. Check that site out if you are interested. The only thing is that it covers data up until 2020, not the latest. Anyway, in 2020, only about 54% Americans had life insurance.

Kimberly: So barely over half the people are covered by life insurance in this country.

Lily: Yeah. That 54% is called the rate of “market penetration” for life insurance. Here is the bad news: Over the past decade the penetration rate has been moving downward, meaning fewer and fewer Americans have life insurance coverage today than before. In 2011, for example, 63% Americans had life insurance, but only 54% did in 2020, almost a 10% decrease.

Jason: I wish we knew more recent figures, like from last year.

Lily: We do, actually. This website called Statistica.com tells us that in 2022, based on the LIMRA, which stands for Life Insurance Marketing and Research Association, and Life Happens’ 2022 Insurance Barometer study, the penetration rate was 50%, 4% lower than 2020.

Joy: Hmm. Did the speaker explain why the penetration rate is down?

Lily: He did — at least partially. He talked about insurance “ownership gap” or “need gap,” which is the difference between how many people believe they need life insurance and those who actually own one. Sometimes it’s called the “Need-to-Have” gap. So if 50 out of 100 people believe they need life insurance but only 30 of the 50 actually own a life policy, that gap is 50% – 30% = 20%, meaning life insurance companies have a big job to do to get that 20% to buy life policies.

Jason: Wait, what is a “life policy?” Isn’t a “policy” a rule or regulation like “No gun in school” policy or no racial discrimination policy?

Lily: I don’t know why an insurance contract is called “policy” or “plan.” If I must guess, it may have something to do with the “contract of adhesion,” meaning in an insurance contract only one party, usually the “insurer” or insurance company, fixes the terms of the contract and the other party, usually the “insured” or policyholder, must accept or reject it. So this is like government or authorities make policy and citizens must obey it.

Kimberly: Back to the ownership gap, I just want to make sure I get it. You said if 50 out of 100 people wanted life insurance but only 30 had it, the ownership gap is 20%. Now, let’s say 45, not 30, of the 50 people had a life policy, the ownership gap would be only 5%, right?

Lily: Right. The good news is that compared with property insurance, life insurance has a smaller ownership gap, meaning more people who want a life policy will get one. I remember reading somewhere that says the ownership gap was huge in properties insurance when we look at property losses from natural disasters. We are talking about trillions of dollars there.

Greg: You are right. The most reliable source for that is reinsurance companies, you know, those provide insurance for insurers, or “insurer of the insurers.” I read …

Jason: So why do we need reinsurance companies if we already have insurance firms?

Greg: Well, it’s a way to control or rather to transfer risk for each insurance company. Think of why we buy insurance. We buy a policy because in case something happens to our home, our auto, our health, our income, or our capability to live a normal life, what can we do about it?

Jason: Not much. We just hope bad things don’t happen to us.

Greg: This is a common mindset but seriously, there are several common strategies in handling risks. One is avoiding, meaning if driving is risky of traffic accident, we don’t driving at all. Another is risk retention, meaning we simply accept the risk and swallow the consequences.

Jason: These are not insurance, right?

Greg: No, of course not. If everybody is avoiding and accepting risks, there is no business doing insurance. The idea behind insurance is transferring risk, not avoiding, not accepting. Insurance is basically a deal or a contract between insured and insurer, the insured won’t take the risk by themselves because it’s too much for them to take. So they pay the premium money to an insurer and ask them to take the risk for them, in the sense that insurer will pay money to the insured to cover their losses when bad things do happen.

Kimberly: So in that case, insurers need reinsurance just like we ordinary people need insurer?

Greg: Exactly. That’s why reinsurance is called “insurance for insurance companies,” or a contract between a reinsurer and an insurer. Just like we pay premiums to insurers, an insurer also pay premiums to the reinsurer. Anyway, back to the ownership gap in the property insurance world as I was saying, there is a study by Swiss Re, one of the largest reinsurance firms, that says only 45% of global economic losses from natural disaster were covered by insurance in 2022. That means 55% were not insured, which is a shockingly large number.

Kimberly: 55% is for the world, perhaps the US is lower?

Lily: Not necessarily. I remember reading an interesting article on AP news that says our country is Earth’s “punching bag” for nasty weather because of the unique geography. We are hit “by stronger, costlier, more varied and frequent extreme weather than anywhere on the planet.” We also have the two oceans of Atlantic and Pacific, plus “the Gulf of Mexico, the Rocky Mountains, jutting peninsulas like Florida, clashing storm fronts and the jet stream combine to naturally brew the nastiest of weather.”

Kimberly: Interesting! Now, if we take 55% as the ownership gap for property insurance, what is the ownership gap for life insurance?

Lily: Much better actually. The highest life insurance ownership gap came in 2020 at 16% if I remember it correctly. Jason, could you go to the website “bestliferates.org” please? I want to cite numbers there.

Jason: I just found it. Which numbers are you looking for?

Lily: Search for the words “ownership gap” please.

Jason: Sure. It says in 2011 the ownership gap was 7%. The lowest gap was only 3% in 2013, while the highest, like you said, came in 2020 at 16%. But wait, here is another website called Moneygeek.com that has newer figures. In 2022, 50% of Americans had life insurance like you mentioned earlier, but 68% believed they needed life insurance coverage, so the ownership gap is 18%, 2% higher than in 2020.

Joy: Hmm, I was gonna say that the pandemic finally woke people up for life insurance, but I guess that hasn’t been translated into real ownership figure. Instead of reducing the ownership gap, it increases it.

Lily: That seems to be the case. Life insurers really need to do a better job for reducing that ownership gap to a single digit.

Jason: The same website, I mean “Moneygeek.com,” also tells us that of the 50% owning a life policy, 59% bought on their own, while 23% received a policy from employers. The remaining 18% had life coverage from both sources.

Kimberly: Maybe it makes sense to add that 59% and 18% together: These are the people who actively bought life policies on their own, which is 77% or nearly 80%. The other 23% perhaps don’t count as much because they were given a policy by employers or someone else. After they retire or leave the job, they may or may not have life insurance.

Lily: You are right. Employer provided life policies are a part of employment benefit and are almost always group life policies. Many group life policies automatically terminate once the employee leaves the job. Some companies may offer “portable” policies that continue to cover you after retirement but that’s rare and there is no guarantee. Therefore, if a life policy was given by the employer, the person may not continue after retirement.

Jason: Wait, what is group life insurance?

Joy: It’s a type of insurance offered by employers or organizations to employees or members. There is a single “master” contract between the employer and the insurer, but covers everyone or at least full time members for the employer. Each employee or member receives a certificate of coverage. Because of its coverage to many people, its price is usually lower. This is just like buying stuff from Costco, when many shoppers buy in bulk from the same place the price goes down.

Greg: I wonder whether we should completely ignore group life policyholders. The way I understand it, employer-sponsored group life insurance comes in two types: Basic and Supplemental. Basic group life insurance is a policy offered as an employee’s benefit, typically free or highly affordable. In addition, they are often guaranteed issues, meaning you will qualify regardless of your age or medical history.

Kimberly: That makes sense: If someone is still working, they can’t be too old nor too sick. But why would anyone buy supplemental policy if they have the basic policy?

Joy: Because a basic life policy is what its name says: Basic, in the sense that it only provide basic or barebone coverage. I remember reading an article on Forbes Advisor that says the basic policy typically pays the amount that’s equal to one year’s salary, or a lump sum that is, depending on the employers, typically only around $25,000 according to a survey of compensation. That’s not enough for many if not most people.

Kimberly: So people buy additional supplemental policy to get more coverage for themselves or for someone else?

Joy: Both. They can choose to add additional coverage for themselves, or they can buy additional coverage for spouses and children. It is also called voluntary life insurance and typically bought from the workplace. You obviously need to have basic insurance before you buy supplemental. According to the article by nerdwallet.com, “Maximums typically hover around $500,000 but can reach into the millions of dollars. In some cases, managers or high-level executives have access to higher amounts than rank-and-file employees.”

Kimberly: Basic policies are guaranteed issue, how about the supplemental policy?

Joy: Generally no. At the minimum, health questions or even a life insurance medical exam may be needed. Employees usually will have to buy it with their own money, although for spouse or child the prices are generally cheap.

Kimberly: You talked about having a master contract for the entire group of employees. How does the employer sponsored group life insurance work?

Lily: Most group life are term life policies, sometimes you need to renew it every year, called Yearly Renewable Term or YRT. Other times term life policies last longer, ranging from 5 to 30 years. The most popular term is 20 years, followed by 10 year and then 30 years, according to an insurance survey report. Regardless of the length of the term, it’s still term, meaning there is an “expiration” day when the term is over. In general, all term life policies are cheaper than permanent life, meaning you pay lower premium. A group term life policy covers many people, so it’s even cheaper than individual life policy.

Jason: Other than being cheaper, is there any other difference between term- and permanent-life insurance?

Lily: The most obvious difference is that term life provides temporary or limited time protection while permanent life is “permanent,” meaning the coverage is there for the entire life of the policyholder.

Kimberly: Do they really mean that? What if someone lives to the age of 100? Will her permanent life insurance policy still cover her?

Joy: I’m glad you asked. I was reading this article of Forbes Advisor. It says, “many forms of permanent life insurance issued prior to 2004 have maturing dates of 100,” meaning even a permanent life insurance will expire before death. What is bad is that “the policyholder (and their heirs) get nothing, despite decades of paying into the policy.”

Kimberly: That IS terrible. Are they still doing that?

Joy: Not according to the Forbes article, which tells us that in 2018, there were 94,000 “Centenarians” according to the Census Bureau, meaning people who lives past 100. I won’t be surprised if we now have 100,000 centenarians in this country.

Jason: So how do they fix the expiration problem?

Joy: Interestingly they did it in a scientifical way in 2004 using the so called “mortality table.” If you don’t know, mortality table, which is also called life table or actuarial table, is a statistical table that lists the rate of deaths by ages, or more accurately the probability of death over ages. This table is used not just by insurance but also governmental agencies like the Social Security Admin. For example, when you are before your first birthday in the US, your death probability is 0.005837. But when you are 119 year old, you have a death probability of 0.972793, which is close to certainty. Previously the maximum was 100, but after 2004 it is 121 year old.

Kimberly: The new mortality table would offer extended coverage but what about those who bought the policy much early, before 2004?

Joy: Good question. The answer is provided in the same Forbes article: “Many insurers, in addition to updating their mortality tables beyond age 100, have added a Maturity Extension Rider (MER) to existing policies issued long ago to extend their coverage.” In other words, even though the old mortality table did not have anything above 100, the old policyholders will still be covered by a rider or extension.

Lily: We’ve been talking about permanent life policies and now I want to go back to comparing term and permanent policies. The difference is not absolute because once the term expires when the policyholder is still alive, she can (1) renew or extend it for another term; (2) convert to a permanent policy, or (3) stop the contract altogether. In that case the person loses life insurance, which is not recommended.

Joy: The key difference I believe is that a term life policy gives no value to a policyholder, because it is all about death benefits, meaning the insurance firms pay the beneficiaries money when the policyholder is dead before the term is over. That death benefit is guaranteed. Let’s say you bought a 20-year term life policy and 20 years later if you are still alive, you get nothing back from the policy — unless you switch to a permanent life policy or extend it to another 10 years.

Greg: This is why they say term life is a “using it or losing it” policy. The insurance company that sells 30 year term policy is betting that you won’t die within 30 years, so they get to keep your premium money without paying you anything. This is also why they charge so low a premium, especially for young people, who are unlikely to die in 30 years.

Jason: Sounds like insurance company has good deal: It can collect premium from term life policyholder but not paying death benefit to anyone — unless the policyholder died before the term is over. They should go around finding more people who they believe will still be alive after 30 years and then sell term policy to those people, right?

Greg: It’s tricky to say that insurance companies make money by term life premium. It’s true that term life premium becomes a source of income for an insurer, and if a term life policy paid no death benefit, the insurer would make money from the premiums paid by the policyholder. The same goes to some insurance policies that go unclaimed. Any expired term life policies or unclaimed policies are good news for insurance firms because it means they have collected decades of premiums without paying out any claims.

Joy: I have a feeling that you have more to say on how insurance firms make money. It’s getting late and let’s stop here as we’ve had a long meal today.

Tags Altruistic life policy, death benefit vs living benefit, group life policy, ownership gap, Penetration rate, property insurance, Reinsurance, Term life vs permanent life policies

Cryptocurrencies & NFTs

Intrinsic Value of DeFi & Inflation

Post author By Jay Jiyuan
Post date April 9, 2023

The Takeaways:

The intrinsic value of cryptocurrency comes from being a part of decentralized finance ecosystem, where we divert the power of central authorities of the Fed and the FDIC and to distribute it among more agencies and entities.
Decentralization does not mean getting rid of central authorities, now and in the future sometimes only central authorities possess the power to make a drastic difference.
Decentralization does mean strengthening rules and regulations that are to be applied to all players and closing legal and financial loopholes as early as possible.
Quantitative Easing monetary policy can work magic but can also induce inflation. The key is to turn the extra QE money into productive or non-productive uses. The former works to create new assets/wealth while the latter merely changes the ownership of existing assets and pushes the price up along the way.
Transforming QE money into productive uses is easier said than done as creating new assets requires time and selective fund allocation to the best players while QE money can be created almost overnight.
The reason central banks should work through local commercial banks is to turn the latter into local reservoirs that can release the QE flood of money slowly and selectively to the best value adding players, instead of overflowing to the entire economy indiscriminately overnight, which will push up overall price level.
During the Covid, the Fed established multiple programs of “going direct” or sending money directly to firms and consumers on the ground, failing to take advantage of local money reservoirs, or overflowing them.
The fiscal stimulus of directly distributing cash to households also exacerbate the inflationary risk, although out of necessity due to Covid.
Institutional decentralization (through local banks) is one way to build fund reservoirs, the other is household savings (and /or purchasing life insurance policies) to avoid too much money hitting the market at the same time. Firms and entities can inject cash into R&D projects, buying CDs and investing in money market funds.

It has been a long pause since the Kingstons last gathered together at the dinner table to talk about financial issues that interest them. Greg (the father) has been traveling out of the country for a multinational research project, while Joy (the mother) has been promoted to be the managing director of her consulting firm. Lily (the first daughter) is about to graduate from college but already started working full time for a financial service company, while Kimberly (the second daughter) just started her freshmen year in a local college. The Kingstons have finally found a day to all sit down at the dinner table to chat.

Kimberly: Gosh it feels like years since the last time we all had dinner together!

Lily, Jason & Cleo: I know!

Joy: So should we vote for the biggest event or largest change we’ve seen since we last met?

Greg: It has to be the collapse of the Silicon Valley Bank in my view.

Jason: I think it’s ChatGPT and artificial intelligence chatbot.

Cleo: What about Russia’s invasion of Ukraine?

Kimberly: I’ll vote for Donald Trump’s indictment.

Lily: Dad, you mentioned the Silicon Valley bank, what about the Signature Bank, the one that had a heavy hand in cryptocurrency?

Jason: Yeah, speaking of crypto, it seems that we’ve wasted all our time talking about it before.

Joy: Why did you say that?

Jason: Well, just look at the news. It seems every day someone from the crypto world is getting arrested or suited. We had no idea there were so many bad guys out there.

Kimberly: But should we separate the idea of cryptocurrency from its promoters?

Greg: That’s exactly what I was gonna say. Crypto as a new idea still has its value even though we have seen enough of the bad players.

Lily: So what is the value of crypto anyway in your view?

Greg: Nobody can deny the value of decentralized finance. That is ultimately where the intrinsic value of cryptocurrencies and blockchain is. In other words, the most fundamental value of cryptocurrencies is not directly measurable in money. Instead, it is measured by the value added from decentralized finance and decentralized professional services.

Joy: I agree. To be sure, it is still possible even today for any single cryptocurrency to fail or to crash just like Terra’s UST did, and the crypto prices will go up and down, sometimes significantly. Theoretically speaking — even though unlikely in reality — Bitcoin itself could die one day, making many Bitcoin haters or scoffers happy, allowing them to claim, “I told you so!”

Greg: If you think of it, the intrinsic value of blockchain and crypto is just like ChatGPT or large language models: They empower individuals and entities to reduce their reliance on third party entity whenever possible and whenever necessary. This is a part of the bigger trend, anything working toward that should be embraced.

Lily: But we can also learn a regulatory lesson from Silicon Valley Bank and the crypto world: Encouraging and embracing changes but working diligently on the rules and regulations to close the potential legal and financial loopholes as early as possible.

Greg: Excellent point there. Decentralized finance is not unregulated finance. It actually calls for more and tighter rules and regulations to provide guidance and guardrails, so everyone follows the same path. What I am saying is that the concept of decentralized finance needs to be clarified: It doesn’t mean to delete central authorities but rather to diversify and to spread the power to more parties and entities.

Jason: Excuse me, I know we talked about it before but what is decentralized finance?

Joy: Instead of asking us, why don’t you ask ChatGPT?

Jason: Actually I’ve been using Perplexity.AI lately. It allows current website search with no time delay. Okay, here it comes: “Decentralized finance (DeFi) is … a financial ecosystem based on blockchain technology that offers services such as lending, borrowing, and trading without intermediaries. DeFi operates on decentralized platforms using smart contracts, which are self-executing contracts with the terms of the agreement between buyer and seller being directly written into lines of code.”

Lily: Sounds like getting rid of the central authorities and middlemen.

Greg: I probably won’t get rid of central authorities and all middlemen altogether. Sometimes a central authority can do magic with unmatching power from decentralized agents. Decentralization simply means adding more active agents to the system without completely destroying central agents. It’s about dividing the power of authority among more people to allow more to use financial services anywhere, anytime.

Kimberly: The idea sounds good, but I can’t stop thinking that in reality, all we’ve seen is the power of central authorities like the Fed and FDIC as this time for the Silicon Valley Bank.

Lily: I agree. Sometimes only government intervention can get the job done. Look at the First Republic Bank: After the nation’s top 11 banks pledged $30 billion to its deposit, the bank’s share was still down by 33%.

Greg: Like I just said, centralized and decentralized players each have strengths and weaknesses and it’s best to integrate the two. But the other thing we should not forget is that currently we only have a centralized system. So of course we can only see the Fed & FDIC acting to make magic differences.

Joy: I agree. The current system works because everything moves around central authorities like planets moving around the sun. People have little idea how decentralized systems work so they always turn to central authorities for solutions.

Lily: Are you saying in the future the decentralized system will become mature and people won’t panic and only ask the Fed or FDIC for solutions?

Greg: That’s the hope, and we have reasons to expect a brighter, decentralized future. For one thing, I’ve seen commentators pointing to the Fed as the source — not the solution — of the Silicon Valley Bank crisis this time.

Joy: I’ve noticed that, too. There is one article by the pioneer of Quantitative Easing, Richard Werner, who basically says the central banks created the inflation crisis.

Greg: Are you talking about that article on Conversation.com, I believe it’s called “Why central banks are too powerful and have created our inflation crisis”?

Joy: That’s right. I still remember what he said about how central banks managed to get more powers with less oversight, despite repeated policy failures.

Lily: So this guy, Werner, created the idea of quantitative easing?

Kimberly: Wait, what’s quantitative easing?

Joy: Werner did come up with the QE idea when he worked in Japan, which later became a widely used monetary policy after financial crisis of 2007-2008. To answer your question, Kimberly, QE is a monetary policy used by central banks to stimulate the economy. Central banks can increase money supply in two ways: buying short term treasuries or buying long term, riskier assets like treasuries and mortgage backed securities, even stocks. QE mostly does the latter.

Greg: Historically the Fed has been controlling money supply by adjusting the federal funds rate, or the (very short) rates that banks charge each other for overnight loans. The problem there is that sometimes we are out of luck — when the fed funds rate was already cut to zero or near zero and the economy still needs an extra push. QE is then used as another tool to reduce interest rates and encourage lending.

Lily: Can we use Federal funds rate and QE together at the same time?

Greg: Yes. The two work differently in two ways. First of all, the federal funds rate works on short term interest, while QE on longer term interest. Secondly, reducing the federal funds rate does not increase money supply directly, only indirectly through reducing the cost of borrowing money. QE on the other hand increases money supply directly.

Jason: What does it mean to increase money supply? You mean the government printing more money and adding it to the market circulation?

Lily: Printing money is an old way of increasing money supply. Although it is still used today, it is not the most efficient and most used way because in the modern economy, physical money is only a small portion of total money. The Fed today has better ways of doing it mostly through electronics.

Joy: Yeah, remember a central bank is still a bank, so it does what banks do the best: working with other banks, except a central bank works only directly with large national banks, not smaller ones at street corners. These banks largely make up the money supply system, energizing the economy like the blood vessel does to a human body.

Lily: That’s right. The details can vary but basically increasing money supply means a central bank gives more money to commercial banks, which then lend the money to businesses and consumers. When more money becomes available, the price of money goes down just like anything else.

Kimberly: But what’s the price of money? I know money is used to measure the price of everything, but I never knew money has a price itself. Isn’t a dollar always a dollar regardless of how much money is out there in the market?

Lily: You are talking about nominal value of money, which always stays the same: $1 is always $1 like you said. But “price of money” is different, and it can mean two things. One is the nominal interest rate, or the price of borrowing money. If I lend you $1,000 at 5% interest today, it means one year later you’ll have to pay me back $1,050. The extra $50 is the price you pay to be able to borrow $1,000. This is what we mean by “price of money.”

Kimberly: I see. What’s the other meaning of “price of money?”

Lily: It can also mean purchasing power of money, meaning the amount of goods or services each unit of money can buy. Purchasing power has more to do with inflation. By definition inflation always means lower purchasing power of money, meaning the same amount of money buys fewer goods and services.

Greg: Here is a good example. I visited Venezuela a couple of years ago and I can tell you how crazy inflation was in that country. In 2018, the hyperinflation rate was 1,000,000%, meaning the prices of goods and services have been up by 10,000 times.

Joy: Anyway, going back to Werner’s article that says central banks are the source of the problem. His arguments are interesting by separating two kinds of QEs, “productive” versus “unproductive.” The first one spends the extra QE money on real economy, while the second spends on buying and selling existing financial assets like bonds, stock shares and futures. Those transactions only change the ownership of assets from one agent to another, pushing up asset prices without adding real value to national income. Werner believes this is where QE can go wrong and leads to inflation.

Lily: Let me make sure I understand it. So Werner says “good” and “bad” QE totally depend on how the QE money is used. Using it wisely, we can stimulate the economy and avoid recession; using it unwisely, we will run into inflation.

Kimberly: But how to use the money wisely? Is the key on investing the QE money for tomorrow, not spending it today?

Joy: Not exactly. Bear in mind not all investments are equal, and the key is to create new assets or add new value to the economy. When people are competing for the ownership of existing assets, they are still investing for the future, not exactly spending for today. What Werner is saying is that we really need to invest money to create new assets, not redistributing the existing ones.

Lily: If value added is the key, does it mean to invest to revitalize the manufacturing sector for the US, like the US government is currently trying to do?

Joy: Interesting questions! I believe it takes years or even decades to bring all manufacturing jobs back to the country, even if we assume that’s a smart thing to do. At the end of the day, economic principles still rule the game: Production flows to where the cost and risk are low, even after we take national security risk into account, even after we take governmental subsidies into account.

Greg: Yeah. This is not a financial matter, but have you noticed that Washington is quietly copying the moves of Beijing? China boasts its strength in manufacturing, so the Biden administration is trying to bring manufactures back to this country.

Joy: Speaking of that, sometimes this country moves not by long term strategic thinking but by reacting to its enemies in the short term. When Putin expected the US will stop supporting Ukraine after a while, Biden claims we will support Kyiv for as long as it takes. When Beijing wants to retake Taiwan, Biden then says we’ll send US military to defend Taiwan.

Greg: Let’s go back to financial matters. To answer your question earlier, Lily: No, creating new assets does not necessarily mean investing in manufacturing, although that would help. The good news is that this country is still the best in the world when it comes to innovations. All we need is a little financial push to make it better. A perfect example for creating new wealth is ChatGPT or AI Chatbots. Look at how much time we are saving each time we are search for answers to the questions we have in mind.

Jason: That’s true. Now that we have ChatGPT or Perplexity.AI, we are not going back to Google search, which was such a waste of time. Every time you ask a question, Google gave you millions of websites but just not the straight answer you need the most. It’s really a lose-lose game: You lose your precious time, and Google loses in giving you too much information that you never really needed.

Joy: Another good example of new asset is the mRNA based Covid vaccine. We were able to create a brand new drug in such a short period of time that beats China’s vaccine hands down in efficacy.

Greg: But here is a problem: Financial resources and innovation do not always go hand in hand. There will be mismatches. For one thing, it takes much longer to achieve innovations and breakthroughs, while financial resources can flow in and out of the economy at a much faster pace. We need to think about how to best spend the QE money, which can come quickly, almost too quickly to allow the economy to be absorbed and turned into value added assets.

Lily: Yeah, I see your point. Perhaps it’s easier said than done to follow Werner’s advice. It’s almost impossible to let the flood of QE money flow into new assets quickly, but it’s easy to use the money on consumption for today, not worrying too much about tomorrow.

Kimberly: Yeah, people were not allowed to work during the pandemic lockdown, but still needed money to buy groceries if nothing else. We can’t tell them to stop normal spending. So here is a problem: as workers we were not creating new wealth, but as consumers we were giving money for spending. This is a problem created by nature though, beyond human control.

Greg: Werner believes there is another problem with central banks that has direct bearing in inflation. He devotes an entire section to the cause of the current inflation and says the Fed was following the proposal of a private entity to go direct, meaning to get central bank money directly to the hands of businesses and consumers. Going direct means bypassing retail banks, who are in the best position to create credit by making loans to those most capable of creating wealth.

Joy: So we had two direct channels of money flowing: from central banks to businesses — bypassing commercial banks — and from federal and state governments to consumers in those stimulus checks to households.

Lily: Is it true that the Fed really went direct like Werner claimed?

Greg: Some evidence says yes. There is an article by the Brookings Institute that did a good job summarizing all the monetary programs by the Fed during the pandemic. Turned out that the liquidity was added to corporation (through the Primary Market Corporate Credit Facility , Commercial Paper Funding Facility , Secondary Market Corporate Credit Facility, supporting loans to small- and mid-sized businesses, Supporting loans to non-profit institutions), households and consumers (through Term Asset-Backed Securities Loan Facility or TALF) and state and municipal borrowing (through Direct lending to state and municipal governments, Supporting municipal bond liquidity).

Kimberly: Guess what I was thinking? If QE money flows too fast, especially without going through local banks, there is a simple way to avoid or reduce the bad consequence: Having businesses and households save the money and then slowly release it for the best time to use it.

Lily: I don’t see your point. Could you explain it?

Kimberly: Think of the QE money like a huge reservoir. When we open the dam money flows out too fast and too much at a time. Werner suggests that we use local banks to distribute the money more efficiently for creating new value. In a way the local commercial banks are like smaller reservoirs all over the country. When money flows from the big reservoir to many smaller ones, it protects the economy from being flooded by too much money, right?

Lily: Yeah, it makes sense. So instead of relying on local commercial banks, we can achieve the same result by asking households to save the money they receive from governments, not spending it right away.

Kimberly: Yeah, we essentially turn households into tiny reservoirs. That way, even though the Fed may have gone direct, bypassing local banks, households are still protected from the instant flood of money by saving it for the future.

Lily: We can also ask business firms to do the same. They can deposit money in the money market, in CDs and more importantly, inject it to R&D projects.

Joy: These are all good points. We may not be able to achieve those as most Americans don’t have a strong taste for savings.

Lily: We could suggest people invest in future oriented purposes like buying life insurance policies.

Greg: Speaking of the future, with today’s technologies we must rely on local banks to find the best value adding players but who knows, maybe in the future we can rely on ChatGPT to get the job done without so many local bank branches.

Everyone: That’s true!

Tags Decentralized finance, Fed & FDIC, Household savings, Inflation, Intrinsic value of crypto, Kingstons, Quantitative Easing, R&D project

Life insurance

Why Everyone Needs a Life Insurance Policy

Post author By Jay Jiyuan
Post date March 26, 2023

The Takeaways

Life Insurance is better called “death insurance” for most cases because it covers the death of a policyholder and pay the coverage to the beneficiaries.
Life insurance is the most altruistic insurance of all — to the extent that insurers will pay the beneficiaries rather than policyholders.
Not everyone is altruistic, which is why not everyone will buy life insurance, especially if they do not a close family relationships.
The need for long term cares changes everything. Unlike other needs for life insurance, buying long term care insurance is entirely for the policyholders themselves. Given the prevalence of health care needs at senior ages, nobody is safe without the coverage. Another even bigger driver is the cost of long term cares.
You can buy a standalone long term care insurance or add a long term care rider to a life insurance policy. For most people, the latter is a better choice because a standalone policy is “use it or lose it” without accumulated cash value, while a life policy with a LTC rider allows death benefits to beneficiaries even if it turns out that you have no need for long term care.

Why Do We Want to Buy Life Insurance?

Why would anyone buy a life insurance policy? This is the question I have asked myself lately.

Do not take the question for granted, nor think it’s a no-brainer. After all, life insurance is not what the name may sound like: to insure one’s life. Life is full of risks and nobody can guarantee your life for even a short period of time like one year, let alone your whole life.

This is why many celebrities insure their body parts like voice, legs, hands, or feet? Even for those parts insurers will not guarantee the integrity and functioning of the parts, only compensate their losses.

Sometimes I tell myself that “life insurance” is a misnomer, and for the majority of life insurance policies, a more accurate name should be “death insurance,” because they cover your death event more than anything else, and the main beneficiaries are not you but your loved ones. In that sense, life insurance is the most altruistic or benevolent policy of all types. You really need to have a big heart to buy it.

Life Insurance for Final Expenses

I used to be with a life insurance marketing company that sells nothing but final expenses, meaning the only reason someone buying the policy and pay premium for it is that at the end of their lives their “final expenses” in life, such as the funeral, the cemetery site, and the cost related to cremation, will all be taken care of by the insurance company.

The fact that a firm is selling nothing else but final expenses shows a solid market demand for this type of policy. Apparently for some people, that’s the only reason for them to buy life insurance.

But there are several things to be noticed on final expenses. First of all, strictly speaking, final expense is not exactly nor entirely altruistic because the policyholders are mainly concerned about their dead bodies more than others.

Secondly, not everyone is willing to pay money today for something remotely in the future. For one thing, this is not one of the “hard needs” or “must haves” to consider, unlike foods, water and air. For high net worth individuals, final expenses are too small a portion of the money they leave behind, and are automatically included in their estate. But for those “have nots” it is too little for the beneficiaries. For example, would anyone buy a final expense policy when they still have mortgage outstanding?

Finally, we often hear stories that parents or grandparents decided to leave properties to the youth but then quietly used some of the money that is supposed to be passed down in its entirety to next generation. The truth is that gifts and inheritances are promises but as humans we may or may not be good at keeping the promises.

How Long Term Care Changes Everything

Buying life insurance to cover the need for long term cares makes perfect sense for two reasons: the need for cares and the cost of cares.

Let’s look at the need first. According to the Centers for Disease Control and Prevention (CDC), 70% of people who turn 65 years old will need some form of long-term care services and supports in their remaining years. That is almost 3 out of every 4 seniors, although the length and level of long-term care vary from person to person and often change over time. For example, women tend to need care longer than men, with women staying in long-term care facilities for an average of 3.7 years and men for 2.2 years.

CDC also gives the following percentages for people aged 65 or above:

Percent of adult day services center participants: 63.3% in 2020.
Percent of hospice patients: 94.8% in 2017.
Percent of nursing home residents: 83.1% in 2018.
Percent of inpatient rehabilitation facility patients: 87.9% in 2017.
Percent of long-term care hospital patients: 74.3% in 2017.
Percent of residential care community residents: 94.2% in 2020.

Now consider the cost of long term cares. According to the Administration for Community Living, the average cost for long-term care in a nursing home is $225 a day, which amounts to $6,824 per month for a semi-private room and $7,698 per month for a private room.

Guess what, for an average American, she or he will spend more money during their final stage of lives than they made. According to the Bureau of Labor Statistics, the average salary across the entire country in the first quarter of 2020 was $49,764 per year, which breaks down to $957 per week and $191.4 per working day.

Savings and Retirement Money May Not Cut It

Relying on your savings and retirement money is not a smart idea because it may not cut it for long term care costs. Notice Medicaid, a government program for low income individuals and families, requires meeting a low income threshold. Another government program, Medicare that covers people who are 65 or older, as well as some people under 65 with certain disabilities or conditions, only cover short term, not long term care needs.

This leaves two viable options for most if not all Americans: Buying long term care related insurance and buying life insurance with a long term care (LTC) rider.

Standalone LTC Insurance

When we talk about long term care insurance, this is what they have in mind: A special type of insurance policy that is designed specifically for LTC.

Long-term care insurance is an optional (unlike auto) insurance product that reimburses the policy owner for costs associated with long-term care. It is purchased before it is needed, with the knowledge that many older adults eventually need long-term care. Long-term care is expensive and isn’t covered by traditional health insurance or Medicare.

Long-term care insurance typically has an elimination period lasting 30 to 90 days at the beginning of the care period. This means if you buy a policy today, you will have to wait for at least 30 days, maybe even 90 days, before the insurance begins to cover your need of LTC. The covered person pays for the care during this period, and the insurance company evaluates medical records to determine if the person qualifies for reimbursement for long-term care. If the person qualifies, they can file a claim with the insurance company.

There are two types of long-term care insurance policies: traditional long-term care insurance and hybrid long-term care insurance. Traditional long-term care insurance is becoming less common due to high costs. Hybrid long-term care insurance combines long-term care insurance with life insurance or an annuity. Hybrid policies are more expensive than traditional policies but offer more flexibility.

Long-term care insurance is not cheap, and not everyone can buy a policy. Long-term care insurance companies won’t sell coverage to people already in long-term care or having trouble with activities of daily living. Private savings, Medicaid, annuities, and other insurance can also help pay for long-term care.

One of the most important features of standalone LTC policy is that it accumulate no cash value, so you must use it or lose it.

Life Insurance with LTC Rider

This is the option I would personally recommend. A long-term care rider is just a normal life insurance policy. You will receive death benefit when you die, but before that, you can receive a portion of the death benefit while you’re still alive, if the policyholder is unable to perform at least two of the six Activities of Daily Living (ADLs), they can access the long-term care benefit via the LTC rider. The monthly allowed amounts vary but could range from 1% to 4% of the policy’s death benefit.

The LTC life insurance rider allows you to combine your life insurance benefit and long-term care needs.

It is important to note the followings. First of all, while standalone long-term care insurance policies were more prevalent in the market, they’re now rare and can be expensive. More people opt for the rider option.

Secondly, you want to buy a permanent life insurance, not term life policy. The latter does not have cash value accumulated over time, it works exactly like standalone LTC insurance in the sense that if you don’t use it, you lose it. For example, if you buy a 15 year term life at the age of 30, and by the end of the 15 years when you are 45, you are still healthy and alive, you get nothing back from the policy.

On the other hand, if you buy a permanent or whole life, you pay premium over time and the money will be divided into death benefit and cash value. A permanent life policy will not be “using it or losing it” because the death benefit and cash value are stored like in a bank’s checking /savings account. They stay under your name — unless you prematurely used them up.

Finally, when you buy a permanent life insurance policy with a long-term care rider. You pay a bit extra above and beyond the life insurance premium. Long-term care riders pay either by reimbursement or cash indemnity.

A reimbursement policy means you collect the receipts from everything you’ve spent on long-term care, home health aides, occupational therapists, nursing homes, etc. You submit them to the insurance company, and you get reimbursed.

A cash indemnity policy means you get a set amount of money each month, regardless of how much you spend on long-term care. Some insurers are better than others. For example, Equitable life insurance, which has a partnership with Farmers, allows the insured to hire anyone you like to take care of you, whether your family members, your neighbors, friends or colleagues.

Tags Life insurance, Long term care, Rider

Did You Know?

What We Really Learned from Silicon Valley Bank

Post author By Jay Jiyuan
Post date March 24, 2023

The Takeaways:

Decentralized finance (DeFi) with smart self-regulations through technologies like blockchains, smart contracts & generative pre-trained transformer GPT inside each financial institute represents the future of efficient risk management.
We can establish interest rates markets to allow different parties with different financial profiles and different needs to trade to their desires rates based on their needs, risk levels, time lengths, credit ratings, insurability, and expected returns from fund investment.
FDIC should raise its coverage cap above $250,000 — partly paid by depositors with an excess amount — because uninsured deposits proved riskier this time than we assumed due to the self-fulfilling prophecy.

Not All Lessons Were Born Equal from SVB

Learning the right lesson is the key for the better future. There are so many potential lessons out there and everyone can and will have a different opinion on what to learn and how to prevent future crisis of financial institutions like banks.

Part of reason is that the case itself is very complicated, making it possible to have many things to say. If someone fell down from his bike, there is one or at most two lessons to learn: Either the road is too slippery or the rider was not focused. But when a bank with billions of dollars of asset fell, having only one or two lessons sounds like a failure in learning. It has to be more involved in it.

Not all lessons were born equal. For one thing, we must focus on risk management more than rescue scheme. The best that a rescue scheme can do is to arrive at a “no-loss + loss” result, while the best of risk management is to achieve a “win + win” for all parties.

Another relevant point is mindset more than demographics. For example, a lesson that I have heard many talking about is to attract a diverse pool of clients and avoiding over-exposure to any single sector, single industry or single type of clients. This is always true and always makes sense. However, I do believe we can do things without for an ideal client base. After all, having a special type of clients is not always a bad thing. For one thing, they allow us to develop the best resources for serving a unique group of people, rather than serving everybody. Imagine such a boring landscape picture, in which all banks have the same customers. I would rather see a more diversified picture in which banks are proud of their unique clients.

It’s an open secret that regional banks always face a bigger challenge in attracting diversified clients than national banks. The way the former compete with the latter is not in size and types of clients but in doing one or two things better than the latter.

Ultimately, the key is not about client type but always about risk management. A good risk management strategy starts with, and grow on, the existing clients, not betting on changing them.

With SVB clients, we can learn to (1) know the existing clients well, especially their demand liquidity; (2) do periodical stress tests and (3) possessing bond funds and/or bond ETF. All these can be done without waiting for a safer diverse client base to come by.

A Deeper & Bigger Lesson

If there is one forward looking lesson out of all lessons, if we must say something fundamentally important, it is this: Stop trusting central human regulators and switch tech enabled decentralized smart regulations, where the word “tech” refers not only to FinTech but all the new technologies in and out of financial world.

We can start from the recent report on Fed’s San Francisco branch that missed the red flag of SVB. More generally, the time of central bank intervention determines everything. Regulators need to allow a time cushion following a quick turn of monetary policy. For example, banks with maturity mismatch should have access to funds to keep liquidity and to avoid “fire sale” of their portfolio with huge losses.

But it is always easier said than done with the current system. We have witnessed the modern bank run this time but there is no guarantee that it will not happen again. Humans are not always smart learners and we do have a tendency of repeating the same mistakes over time. In my last post, I highlighted two lessons from SVB: interest risk and liquidity risk. We have been talking about them since day one in financial world, and yet we are still struggling with them decades later.

How do we truly make progress in financial risk management from now on for the future?

The first thing I want to say is this: Although one of the direct casualties this time was the Signature Bank with strong crypto link, the message that carried by the dead messenger is more relevant than ever: The future lies in decentralized and proactive “smart regulations” that assist each bank, including those led by “zombie leaders” like in the case of SVB whose only strength is to guard self-interest but little else (尸位素餐), to constantly monitor current and future risks.

“Smart” More Than “Decentralized” Regulations

The name “decentralized” may sound exclusive rather than inclusive. In my mind “smart regulations” will reserve a big seat for central banks instead of eliminating them. The SVB case tells us that sometimes only words and resources possessed by central authorities would work, and does so dramatically.

Here is another example from the insurance industry. According to this commentary of AM Best, the largest credit rating agency in the world for the insurance industry, that had the U.S. government not stepped in to make all depositors whole, underwriters of directors and officers insurance for startups and venture capitalists, as well as the financial institution insureds supporting such entities, could have faced financial distress given that they are operating on very thin capital.

This is because “’startups are by nature much more agile and less risk-averse than other companies, their directors and officers often make decisions quickly,’ said David Blades, associate director, industry research and analytics, AM Best. ‘Therefore, the potential for D&O claims for startups would have been high in the case government had decided not to help the depositors.’”

There will be lawsuits for sure no matter what. According to this report of AP, “A class action lawsuit is being filed against the parent company of Silicon Valley Bank, its CEO and its chief financial officer, saying that company didn’t disclose the risks that future interest rate increases would have on its business.”

“It is looking for unspecified damages to be awarded to those who invested in SVB between June 16, 2021 and March 10, 2023.

“In particular, the lawsuit said that annual reports for 2020 through 2022, “understated the risks posed to the company by not disclosing that likely interest rate hikes, as outlined by the Fed, had the potential to cause irrevocable damage to the company,” the lawsuit stated.”

“It also claims that the company “failed to disclose that, if its investments were negatively affected by rising interest rates, it was particularly susceptible to a bank run.”

With the above being said, let’s go back to remedies and we can do two big things toward smart regulation.

Decentralized, Flexible FDIC Caps

We have already seen solutions include raising FDIC insurance coverage cap above the current $250,000 line. Lawmakers all seem to be open on this idea, with the focus on how much the new cap should be.

This is a good idea because we have learned this time that non-FDIC insured deposits can post a big risk. It directly triggered the bank run of SVB, and explains why the share price for the First Republic Bank has been down by 70%. Uninsured deposits prove riskier this time than we assumed due to the self-fulfilling prophecy.

However, unlike the old cap of $250k, this time we probably do not want to have a fixed, nationwide new cap of FDIC coverage. Instead, we want FDIC’s new coverage cap determined through a negotiation process by individuals, and to be paid partly by depositors with an excess amount, sort of like copayments in the healthcare business. This way, depositors will share the responsibility and will be given personalized choices in determining how much risk they want to take.

The range of caps can go from 100% to 0% theoretically, and it’s up to the depositors to decide. Those who choose 0% extra coverage can always take advantage of the existing cap of $250k by having multiple accounts across financial institutions for excessive amount of money, not leaving all eggs in a single basket.

Depositors can either spread fund across banks or using Certificate of Deposit Account Registry Service CDARS, opening a cash management account, relying on MaxSafe by Wintrust or finally using Depositors Insurance Fund (DIF).

Either way, each depositor will sign a legally binding contract with FDIC and the bank where they deposit their money, stating that they fully understand the risk and in case of bankruptcy, only the amount they have purchased will be covered by the program.

Establishing National and Regional Interest Rates Markets

This is a bigger deal and of course will be subject to discussions and debates. But the basic idea is simple and interest rate swaps already exist and are an important component of the fixed-income market according to a Smartasset.com article. We just need to expand it to make market interest rate floating rather than fixed and to allow variation

The first thing about interest rate swap is that they are financial derivatives traded over the counter, where investors will typically exchange a fixed-interest payment for a floating-rate interest payment, which is known as vanilla swaps. Investors use these contracts to hedge or to manage their risk exposure.

But we do more than vanilla swaps, including allowing parties with different needs and profiles to trade directly among themselves.

The basic driver of an interest rate market or markets is different needs and different financial profiles of different parties. On the profile side, entities with low credit rating are willing to offer higher interest rates to attract buyers of their products, while the opposite holds true for the high credit rating entities.

The other profiling factor is time of economy. During a booming economy, parties don’t mind paying a higher interest rate because their returns from the fund are expected to be higher. On the other hand, when a future project does not have big expected return the owner of the project is only willing to pay lower rated fund. To the extent that a region is growing fast, many investment projects can expect high return, which push up a higher interest rate in that region.

At the end, we just need to calculate the average bidding interest rate in a region to come up with a region specific & time specific interest rate as the “going rate” for all.

On the need side, some entities are willing to pay a higher interest rate when getting funds quickly matters more than higher interest rates. Other entities do not have any urgent need for fund and will only pay low rated funds. The average of the ongoing highest price a fund buyer (the bid price) is willing to pay will be the “going bidding rate” of interest. The average of the ongoing lowest price fund sellers (the ask price) are willing to accept will be the “going asking rate” of interest. The average of the going bidding interest and going asking interest will be the market going interest rate.

The idea is to replace the single nationwide interest rate set by central banks to a diversified and decentralized, market determined interest rates, in which central banks can still set basic rates but anything beyond is subject to market forces.

Tags Decentralized finance, FDIC cap, Fed, Interest rate, Interest rate swaps, Interest rates markets, Negotiation, Risk management, Silicon Valley Bank, Smart regulation

Did You Know?

Court Rulings Make a Big Difference in Insurance Claims

Post author By Jay Jiyuan
Post date March 21, 2023

The Takeaways:

Small difference in case circumstances and insurance documents sometimes can make or break the entire case in insurance claim.
In a case involving homeowner insurance policy in Massachusetts, the lower court initially ruled in favor of the insurer, quoting the policy clause that excludes any abuse and molestation. The state Supreme Court later reversed the ruling, claiming that the abuse and molestation clause only applies when there is an imbalance of power between parties involved.
In a case involving business interruption insurance in Louisiana, the state’s Supreme Court overruled an Appeals court decision on Covid-19 related business interruption insurance coverage, with the majority opinion insists on the requirement of direct physical loss and damage to trigger the coverage.
The lesson here is to read the insurance policies very carefully to detect — and then to close —any legal loopholes in the contract as early as possible. We can expect AI GPT model to help us both draft better contracts and explain them for people without legal training at all.

It is no secret that insurance business has a close tie with the legal business as oftentimes we must settle insurance claims through court. What is less well known is that sometimes a little teeny tiny difference in the case scenario or documents can make or break the case.

Once in awhile you hear stories involving insurance companies and insurance contracts (i.e., policies) that open your eyes on how seemingly trivial difference can make a big legal and coverage difference.

This report by Insurance Journal on March 17 told us an interesting story involving homeowners policy: “Leonard Miville, a 61-year old man, who was visiting his girlfriend, was seriously injured by a 30-year old man, William Brengle, who was living next door with his parents. Brengle initiated an unprovoked attack on Miville, punching him in the head and repeatedly kicking him after he had fallen. Miville sued the Brengles.”

Initially a lower court granted a judgment in favor of the insurer, which in this case is the Dorchester Mutual Insurance Co. The lower court essentially says the insurer should not cover the attack because the homeowner policy contains a specific “abuse and molestation” clause to make any case involving abuse and molestation excluded from coverage.

“The Dorchester policy contained multiple exclusions from personal liability coverage, including the abuse and molestation exclusion, which excluded coverage for ‘bodily injury . . . arising out of sexual molestation, corporal punishment or physical or mental abuse,’” the report tells us.

The Massachusetts Supreme Judicial Court has now ruled otherwise, saying that the “act of physical abuse is not excluded by an abuse and molestation exclusion in a homeowners insurance policy unless the act involves ‘an imbalance or misuse of power in addition to being physically harmful.’”

In everyday language: Although the homeowner policy says abuse and molestation are excluded from insurance coverage, meaning insurer won’t pay for the injuries and damage caused by abuse and molestation, the high court disagrees. Instead, it believes that the attack by Brengle to Miville should not be excluded because the only time the abuse and molestation clause can apply is when there is an imbalance or misuse of power.

The way I look at it, the abuse and molestation clause seems to be designed for scenarios like when an underaged girl was abused and molested by her next door neighbor adult — or any adult she met online from a remote place — as that clearly involves imbalance and misuse of power of one party over another. Between a 61-year-old and a 30-year-old adults however, the imbalance of power is not obvious in the eyes of the high court, so should not be excluded. “The court found the age difference between the attacker and victim unavailing.”

Insurer of course sees the case differently. They argue that the age difference between Miville and Brengle demonstrated a physical power imbalance between the two. Additionally, the insurer argued that the incident was both violent and unprovoked, and thus Brengle’s disposition to inflict pain and suffering could be inferred from his conduct.

Interestingly, instead of inferring from the attacking incidence or circumstance, the high court chooses to infer from the insurance policy — a legally binding contract — in which “(i)mmediately preceding the term ‘physical abuse’ in the abuse and molestation exclusion are the terms ‘sexual molestation’ and ‘corporal punishment.’ Both ‘sexual molestation’ and ‘corporal punishment’ generally involve an imbalance or exploitation of power between the perpetrator and the victim, the court noted.”

In other words, although “physical abuse” in the contract does not have an explicit definition that demands power imbalance between the parties, the court tracks its chain of thoughts down to the neighboring terms to figure out what the contract intended to say.

“’Words are, at least in part, defined by the company they keep,’ the court commented.”

Another place the high court uses to help clarify the original policy ambiguity is to go back to the history of the abuse and molestation exclusion. The exclusion started in the early 1980s, when there was a surge of sexual abuse claims arose against clergy members within the Roman Catholic Church.

It said its interpretation of physical abuse requiring a power element is supported by the context in which the exclusion originated. In the early 1980s, A majority of states, including Massachusetts, determined that sexual abuse claims brought against an accused abuser were not covered by the terms of an accused’s liability policy that excluded coverage for expected or intended bodily injury. It was against this backdrop that insurance companies began including abuse and molestation exclusions in their policies.

Another Court Case Concerning Commercial Insurance

Here is another case in which Louisiana’s Supreme Court overruled an Appeals court decision on Covid-19 related business interruption insurance coverage.

In case you are unfamiliar with it, business interruption insurance is a type of insurance coverage that replaces business income lost in the event of a disaster or covered peril, such as a fire or natural disaster. Typically it is not sold as a separate or standalone policy but is either added to a property/casualty policy or most typically included in a businessowners policy (BOP), which is a bundled policy involving several coverages.

Note business interruption coverage typically requires a direct physical loss or damage to a property caused by a covered peril, such as fire or water damage, in order for the coverage to apply. In other words, there are numerous, even unlimited, ways a business can be disrupted, but only those caused by physical loss or damage will be counted by this coverage.

This requirement has been upheld by courts consistently. Specifically, a slowdown of income will have little chance to be counted toward business interruption by the court.

The upside of this rule is to make cases easier to judge, while the downside is that sometimes it is too narrow. Of course, business owners can always buy additional coverages for losses from flooding, earthquakes, and mudslides.

What make this Louisiana story interesting is that there is a split of opinions in the Louisiana Supreme Court ruling, 5-2. The case itself is rather simple: If an insured bought business interruption insurance before Covid, they would like the insurer to cover their business income losses due to Covid. On the other hand, insurers argue that the Covid does not exactly cause any direct physical damage or losses, so that it should not be covered.

This is not the first time the same case is brought to the attention of the court. In fact there were 10 other similar cases in other states’ supreme courts, all ruled in favor of the insurers. The only exception was in the state of Vermont, where its high court favored policyholders.

Another reason Louisiana differs from other states is that the same case has undergone three turns. The first trial in February 2021, a Louisiana state judge ruled in favor of the insurer, meaning Covid-19 did not qualify for direct and physical loss or damage to property. In June 2022, the first ruling was reversed by the Louisiana appeals court, which held that the restaurant was entitled to business interruption coverage because of ambiguous policy language.

In its ruling, the Louisiana appeals court says, “the phrase ‘direct physical loss of or damage to’ was ambiguous and should thus be construed against the drafter and in favor of coverage.”

This report of BusinessInsurance.com tells more details in the Louisiana Appeal court ruling. The court “said the policy ‘covers the loss of business income due to necessary ‘suspension’ of operations caused by ‘direct physical loss or damage to the property.’” “‘Suspension’ is defined in the policy as the ‘slowdown or cessation of your business activities.’ Therefore, under the terms of the contract, the complete cessation of operations and uninhabitable property are not prerequisites to payment for business losses suffered due to the suspension of operations caused by ‘direct physical loss or damage to the property.’”

I would personally support the above ruling and ask the insurer to take at least partial responsibility of covering the restaurant by a vague terminology in the contract that is open to different interpretations.

From the beginning of the story we already know the final turn of the case from the Louisiana Supreme Court: It reversed the ruling by the Appeals Court. The reasoning of the majority opinion of the high court focused on the requirement of “direct loss or damage” to property, and said, “‘COVID-19 did not cause damage or loss that was physical in nature.’ It ‘never repaired, rebuilt or replaced any property that was allegedly lost or damaged.’”

The dissenting opinion is also interesting. It states that “while the restaurant did not suffer any physical damage, “it did suffer physical loss of its property due to the physical contamination of the property by the COVID virus, a physical thing.”

It even used an analogy of smoke and business interruption. “Like smoke for a fire next door that did no physical damage to other premises, but caused the business to be closed until the odor could be removed and the business cleaned, a physical loss occurred.”

This opinion has been viewed positively by the attorney for policyholders. “If a business has to close because of smoke, even if it did not have the fire, it is ‘absolutely physical damage.’”

The Lessons

All parties, both insured and insurer, should draft and read the insurance contract or policy carefully to detect and then to close any loopholes in the documents. This used to be easier said than done but today the story is different, because we have the AI powered GPT (generative pretrained transformer) to help us. It is safe to expect future insurance contracts to contain fewer legal loopholes than before.

Based on the Massachusetts case involving homeowner liability coverage, legal loopholes can arise not only from particular terms that stand alone by themselves (e.g., the word “suspension” of business due to Covid in Louisiana) but also the contextual circumstances (i.e., the words before and after, like we see in the Massachusetts case on “abuse and molestation” clause).

AI GPT can also help everyone, including people with no legal training at all, understand legal contracts better, by entering documents into a GPT model and then ask for quick explanations in laymen’s terms. With the AI assistance we can expect fewer lawsuits in the future.

Tags AI GPT, Business Interruption Insurance, Clause of abuse and molestation, Direct physical loss and damage, Homeowner policy, Insurance claim, Liability insurance

Did You Know?

Silicon Valley Bank: New Casualty, Old Causes

Post author By Jay Jiyuan
Post date March 20, 2023

The Takeaways:

Bank runs are still possible today because although we have learned to tighten centralized financial regulations, we are still weak in financial risk management that proactively predict risk and take preemptive steps — even for highly predictable and familiar risks.
We have seen textbook examples of (1) how interest risk grows to a bank run through the well-known inverse relationship between bond price and (2) how liquidity risk from duration mismatch exacerbated by dramatic change in interest rate has created enough momentum to kill a solvent bank.

Silicon Valley Bank: The Good Beginning Story

Silicon Valley Bank (SVB, NASDAQ symbol SIVB) is not exactly a household name even in northern California where the bank is located (in Santa Clara County, one of the nine counties in the San Francisco Bay Area.) Frankly, I heard the 6 season comedy TV Series “Silicon Valley” since 2014 but don’t recall the bank’s name on top of my head, even though it is the 16th-largest lender in America, with about $200 billion in assets.

According to this article by Seeking Alpha, “ from 2019 to late 2022, SIVB total deposits more than tripled, growing from $61.7 billion in 2019 to $173 billion as of December 2022.”

A great story, right? Sure it is or was. But then comes the bad one. It all started from what the bank did with the deposited money. Normally this is not a problem, because most of the time most banks will lend the money out to individuals and businesses who can make a better use of the money than the depositors can, and earn a higher interest than they pay to the depositors.

This is what most banks do for living, among other activities.

For example, say SVB received a total deposit of $1 million from a startup firm called NuLife in Santa Clara County. SVB pays NuLife $20,000 (2% of the $1 million) in interest for putting their money in the bank, while keeps the rest of $980,000 in its account. The bank will not let the money sit there collecting dust but will lend it to another business called OldBuz at 5% interest, which is $980,000 x 0.05 = $49,000. In so doing SVB will earn a net amount of $49,000 – $20,000 = $29,000.

Earning a higher interest rate from the loan recipients than the interest rate banks pays to the depositors, this is the basic business model and SVB is not different from others. The only difference is that it did better than many others by attracting more depositors, especially tech startups and venture capital firms.

The Pandemic Shocks & the Changed Course of Government

Then the pandemic changed everything. I agree with this article of Business Insider that the SVB fallout “was a byproduct of the Federal Reserve’s hiking of interest rates by 1,700% in less than a year.”

But to fully understand the impact of the quick change of course by Fed, we must understand how much Fed had done during the pandemic, or how hard the Fed worked to make sure all lenders and borrowers can have easy access to money.

This paper of the Brookings Institute summarized the key changes by the Fed during the pandemic months, which has been credited with staving off an economic crisis and bolstering financial markets at a time when there was a “sharp contraction and deep uncertainty about the course of the virus and economy sparked a “dash for cash” — a desire to hold deposits and only the most liquid assets — that disrupted financial markets and threatened to make a dire situation much worse.”

First of all, the Fed purchased large quantities of government bonds and other securities, famously known as Quantitative Easing or QE, to make it easier for individuals and businesses to access credit, to stabilize financial markets and to support economic activity.

The Full Package of Stimulus from the Pandemic Era

The pandemic stimulus is not a single step but a full package of multiple programs, spanning not just monetary but fiscal steps. Let’s begin with the four (new and renewed) programs to promote financial liquidity for banks:

Money Market Mutual Fund Liquidity Facility (MMLF), a program introduced in March 2020 to provide liquidity to money market mutual funds (MMFs), which are investment in short-term, low-risk securities like commercial paper, certificates of deposit, and Treasury bills. Fed lent money to eligible MMFs at a low interest rate in exchange for collateral in the form of high-quality assets, such as Treasury securities and agency debt.
The Primary Dealer Credit Facility (PDCF), a lending program introduced in March 2020 to provide short-term funding to primary dealers, which are firms that have a trading relationship with the Federal Reserve and participate in the buying and selling of government securities, such as Treasury bonds and bills. These firms, which include SVB since 2015, are considered essential to the functioning of the financial system. Under PDCF, primary dealers can borrow funds from the Fed for a period of up to 90 days, using a variety of eligible collateral such as Treasury securities, agency debt, and mortgage-backed securities. The interest rate charged on these loans is set by the Fed and is typically lower than market rates.
Direct lending to banks with a lowered rate by 2 percentage points (from 2.25% to 0.25%). It’s said that eight big banks agreed to borrow from the discount window in March 2020, just so that other banks won’t feel bad and fear that markets and others will think they are in trouble.
Temporarily relaxing regulatory requirements to encourage banks to use their regulatory capital and liquidity buffers to increase lending during the pandemic.

The above are not the only game in town, as the Fed had other things in mind. Turned out that the liquidity it added to the shocked economy covered corporation (through the Primary Market Corporate Credit Facility or PMCCF, Commercial Paper Funding Facility or CPFF, Supporting loans to small- and mid-sized businesses, Supporting loans to non-profit institutions), households and consumers (through Term Asset-Backed Securities Loan Facility or TALF) and state and municipal borrowing (through Direct lending to state and municipal governments, Supporting municipal bond liquidity).

The following answer from Perplexity.ai, which integrates current web search results into the GPT (Generative Pre-training Transformer) process, tells us more about the fiscal stimulus on top of the monetary policy changes:

“The US government implemented both fiscal and monetary stimulus measures to mitigate the economic impact of the COVID-19 pandemic. Fiscal stimulus measures included direct payments to individuals, paycheck protection, student loan forbearance, eviction and foreclosure moratoriums. The economic impact of the pandemic sent the US economy into a recession in February 2020, with unemployment rates rising as high as 14.7% in April 2020.The direct payments to individuals were referred to as “economic impact payment” checks amounting to up to $1,200 per eligible adult.

“There were three rounds of such checks, including additional payments of up to $600 and $1,400 per person in 2021. The size and scope of these direct checks was a new experiment for the US government.

“The Federal Reserve Bank estimated that US fiscal stimulus during the pandemic contributed to an increase in inflation. However, economists largely agree that the money helped local governments shoulder significant pandemic-related costs and many governments avoided deep budget cuts. Many states have even reported surpluses.”

Here we have it: a teamwork of government branches toward the same goal of avoiding pandemic induced recession.

The Insightful Warning

Installing stimulus is one thing, foreseeing its full consequences is another. It is the latter that is the key for risk management. For that we must thank the former U.S. Treasury Secretary Lawrence H. Summers, who was the first to point out the danger of inflation following fiscal and monetary stimulus during the pandemic. The following answer from Perplexity.ai tells us that “In February 2021, he warned that additional government stimulus efforts to combat a pandemic slowdown raised the risk of inflation. He has since sent several warnings to Washington urging them to tap the brakes on stimulus or risk unleashing a serious burst of inflation.” Not only that, but Summers disagrees with the common belief that inflation is transitional as points out by this article of Barrons.com. “He was right: Consumer prices rose 8.6% year over year in May, the fastest pace in 40 years.”

Coordinated Stimuli Require Coordinated Risk Management

I agree with this article by Business Insider that cites Lundy Wright, partner at Weiss Multi-Strategy Advisers, that “(w)hen you raise interest rates quickly, after 15 years of overstimulating the economy with near-zero rates, to not imagine that there’s not leverage in every pocket of society that will be stressed is a naive imagining.”

Wright used a “double negative” sentence that is not the easiest to understand. His message is simply that we should expect some passengers to fall off of the bus when the driver made a sharp turn without reducing the speed.

Once again, much attention has been given to Fed’s monetary policy but not enough to the fiscal side, at a time when coordinated risk management is called for.

The aforementioned article of Business Insider points out that Fed’s “prolonged period of low interest rates created many financial dislocations that are now flaring up.”

In the SVB case, the “dislocations” came from two familiar places. The first is interest risk showing as the inverse relationship between interest rate and bond prices; the second is liquidity risk as maturity mismatch between long term asset holdings and short term liability demands. The SVB management has done a lousy job in handling both risks. These when combined with the startups’ high liquidity demand, led to the collapse of SVB.

The First Dislocation After QE: Interest Risk

Let’s begin from the inverse relation between interest rate and bond price. I’ll simply call it interest risk because what drives the inverse relation is the changed interest rate.

Long story short: The pandemic QE made it hard for banks to earn high interest income from writing loans to businesses and individuals. This is because when money is everywhere available, charging a high interest for bank loans is a mission impossible, it only drive customers to your competitors.

So here is the problem: SVB was sitting on a big pile of deposited money and must find a place to keep it safely and profitably. SVC chose to park its money in treasury bonds, which is known as “risk free” because they are backed up by federal government tax revenues so there is no need to worry about default, meaning no need to worry about the bond issuers (the Treasury Department) to go bankrupted without paying off their debts to bond buyers or investors.

Of course, hardly anything under the sun is entirely risk free. Although the Treasury Bond (or “T-Bond” as it is often called, or simply “Treasuries”) itself is very safe, it does have a time related problem, where T-Bonds fight with each other to turn it into a risky game.

To illustrate, let’s think of a car dealership selling both used cars and new cars. The Treasury department is a new car dealership and only sells newly issued T-bond to investors. Bond buyers however don’t have to keep their bonds until maturity, just like car buyers don’t have to keep the same cars until they are no longer functioning. Bond buyers can sell their bonds before maturity just like a car buyers can sell his used car before it is dead — in a secondary market.

But here is where a risk free product becomes risky: In the secondary market where bond owners trade among themselves like used car owners do to their second or third hand cars, the price is not guaranteed. Some “used” T-bonds can sell a high price while others low, just like “hot” and not so hot brands of used cars.

One thing different in the used car market is that the price is almost entirely determined by the age of the car. A 1998 Civic will be sold cheaper than a 2011 Civic, other things equal. Another thing that is almost certainty is that nobody will ask a price higher than his original purchasing price — unless the car belongs to some rare classic models.

Unlike used cars, the old T-Bond can be resold in the secondary market either above or below the original purchase price. The age of bond has little impact on the resale price, only the difference between new and old interest rates.

Yes, in the bond game interest is the king, almost nothing else matters as much. Most people expect that the principal will be returned at the end of the maturity date, so This is so because people buy bond for the one reason of receiving interest payments, much like people buy car for driving. Buying bond is lending your cash to the bond issuer, who must pay interest to entice bond buyers.

Imagine someone wants to borrow $1,000 from you. Your first response is “Why would I lend you the money? I don’t even know you.” Well, the shortest — but convincing — answer from the stranger will be “I’ll pay you interest every month before I return your $1,000 in two years.” For most people, that’s a reason good enough.

Back to the old or secondary bond market, the key question buyers ask sellers is not how old the bond is, like in the used car market, but “what interest did you (or do I) get?” The reason is simple, if the seller gets 2% interest, that’s the rate the buyer in the secondary market will get after buying.

Here is the question: If the newly issued bond is paying 3% interest, why would anyone buy the “used bond” that only pays 2%? The only reason for a rational buyer is when the used bond (paying 2% interest) is offered at a lower price than the seller paid before. This is where an inverse relation between current interest rate and bond price comes into play.

This is similar to selling your old, gas inefficient car today at a lower price because buyers have more gas efficient new cars to buy from someone else in the new cars market.

SVB got itself into such a troubled situation as the bond seller: The bank needed to sell bonds for quick cash to pay depositors, but the only way for anyone to buy the bond is when SVB lowers the bond selling price. Every transaction when the bond changed hands means a loss for SVB.

The Second Dislocation After QE: Liquidity Risk

Liquidity risk, in its simplest term, means you are out of cash when you need them the most. It differs from poverty, which means no money anywhere in any form, people facing liquidity problem have money but in the wrong form or wrong places other than cash.

SVB got itself into a liquidity trouble because it invested heavily into mortgage backed securities (or MBS for short), in addition to Treasuries.

For those not familiar with MBS, starting from mortgage loans would help. Strictly speaking, a mortgage is a loan, so you don’t have to say, “mortgage loan,” just “mortgage” is fine. Mortgage is a loan specifically for buying a home or property. Of course, lenders are not charities and then offer mortgage because they will receive interest payment from homebuyers.

When you take out a mortgage, you agree to pay back the money you’ve borrowed (called “principal”), plus interest, over a set period of time like 15-30 years, in addition to taxes and insurance. If the borrower fails to make payments on their mortgage loan, lenders have the legal right to take the home (or commercial property) back and put them in the market for sale through a foreclosure auction.

Generally speaking, mortgages that last anywhere at or above 10 years are long term loans. Most mortgages are therefore long term loans. The other feature is that individual mortgages are not considered securities because they have little risk — lenders can always take back the properties from borrowers, called collateral, for failure to make loan payments. Finally, a mortgage cannot be traded in the market because it is not an investment vehicle but a loan involving two parties: borrower & lender.

The story with MBS is different. First, it is created when banks issue mortgages to homebuyers and then pack or bundle up many mortgages and sell the package to a group of investors. As such, MBS is always an investment product bought and sold through a broker by investors, which include individual investors, corporations, and institutional investors on a secondary market.

MBS is designed to free up the capital of the original mortgage lenders, often banks, credit unions and other financial institutions, so they can lend to more potential homeowners by leveraging investors who want to have a low risk investment at a discounted price.

Secondly, most mortgages in the US are securitized, meaning they exist in the form of MBS that is traded in the markets for profit. Thirdly, most MBSs are issued by government-sponsored enterprises such as Fannie Mae, Freddie Mac, and Ginnie Mae that buy mortgage loans. Fourth, they are considered relatively low-risk investments especially if an MBS is guaranteed by the federal government, investors do not have to absorb the costs of a borrower’s default.

That said, an MBS is only as safe as the mortgages that back it up. During the subprime mortgage meltdown of 2007-2008, many MBSs were vastly overvalued due to non-payments. More generally, interest rate risk always exists with MBSs, as its price can drop when interest rates rise — just like the Treasuries (remember the discussion we had earlier?) In many ways MBSs are like bonds, both are fixed-income securities that pay a set amount of interest over time.

Interest risk explains “reinvestment risk” because when interest rate is low, borrowers want to refinance to take advantage of the lower interest rate. Let me illustrate with a hypothetic example.

Imagine you are currently paying off a fixed-rate mortgage with a 30-year loan term at 6% interest rate. Now, say the current interest rate is only 4%. You decide to refinance, which means to take out a new loan to pay off an existing mortgage.

To make it easier to understand, say you have two investor friends, Fred and Sam. You met Fred first when the prevailing interest rate is 5%. Fred offered you $2,000 at 5% interest a year for two years, you thought you did not have choice, so you agreed. One year later you met Sam when the prevailing interest rate is 3%. After hearing your story with Fred, Sam says he’d be happy to lend you $2,000 for two years at only 3% interest.

Guess what you will do? You will borrow $2,000 from Sam and give it to Fred right away, telling him the deal is over as you find a lower interest to pay — assuming you’ve already paid $100 interest (5% of $2,000) to Fred for the last year. This is refinance and you saved yourself $80 because instead of paying $200 in two years to Fred, you only pay $120 to Sam in two years (3% of $2,000).

Fred now has a “reinvestment” problem because his money (a loan) was prepaid by you so he must find another borrower to lend the money to. Knowing Sam’s is willing to go as low as 3%, Fred will have to go down with the lower interest rate.

In addition to interest risk, credit and default risk is also associated with MBSs. This is straightforward: investors will experience losses if borrowers fail to make their interest and principal payments. Importantly, MBS investors are not the owner of the mortgage, so if a borrower defaults, not only the investor’s income will be interrupted but they do not claim any proceeds from foreclosure sales.

The Macroeconomic Risk of MBS: Negative Convexity

Interest risk, reinvestment risk and credit and default risk are all real but in the case of SVB, the macroeconomic risk associated with MBS is negative convexity.

First of all, convexity means curving outward—like the shape of the outside of a contact lens. The opposite is concavity, which means curving inward—like the shape of the inside of a contact lens. Put differently, a concave shape can be “filled,” while a convex shape creates a dome.

In our context, to understand convexity we need to understand duration first, which measures how sensitive bond price is to changes in interest rates. For example, if a bond duration is 3, it means when interest rate increases by 1%, bond price will decrease by 3%.

There are two contributing factors: time to maturity and coupon rate. The longer time before bond or MBS maturity, the higher the duration. This is easy to understand: If you lent money to someone and the borrower will pay you back tomorrow, you don’t care much about interest rate change because the loan has the “time to maturity” of just one day. Now, if you loan money to someone for 20 years, then interest change matters much more to you because your interest risk is higher over a longer period.

Similarly, the larger the coupon rate, the lower the duration, because a part of money has been paid back through coupons, which is just another name for “annual interest.” In an extreme case, we have bonds that are zero coupon bonds, meaning do not pay any coupon or annual interest at all until it’s maturity date, then duration is equal to time to maturity.

Now, convexity is measuring the rate of duration changes. Turns out duration is an approximation of the change in bond price in response to interest rate changes. For small changes in interest rate, it is accurate but not for larger ones as it always overestimates the price change if interest rates rise a lot, like the situation we are seeing today. Convexity helps correct this overestimation and provide a more accurate estimate of how much a bond’s price will change given a certain change in interest rate (or “yield” as commonly called).

With negative convexity, when the interest rate increases (like we are seeing today), the price of a negatively convex bond will fall by a greater rate. This does not hold for the opposite case when interest rates decrease. In other words, bond or MBS price is more sensitive to a rate increase than a rate decrease. A rate increase (like we see today with inflation) poses a bigger risk on bond price than a rate decrease. This makes negative convexity a bigger issue for SVB this time.

Callable bonds and mortgage-backed securities are examples of negatively convex bonds.

Tags Bank run, Bonds, Duration, Fed, Interest risk, Liquidity risk, Maturity mismatch, Monetary policy, Mortgage backed securities MBS, Negative convexity, Pandemic shocks, Quantitative Easying, Risk management, Silicon Valley Bank, Stimuli, Treasuries

Did You Know?

Ways to Lower Insurance Premium During Inflation

Post author By Jay Jiyuan
Post date March 10, 2023

The Takeaways:

Inflation will always have an impact on insurance cost or premium because the labor and parts cost of repairment and replacement for damaged properties will be higher.
Inflation increases the value of insured assets like homes, cars and personal property. As the value of these assets increases, the cost of insuring them also increases.
Inflation also pushes up medical costs, which in turn increases health insurance as insurers must pay more to cover medical treatments, prescription drugs and other related costs.
Inflation has another type: Social inflation that may directly push up insurance cost due to the legal fees and attorney activities encouraging lawsuits and compensation or indemnification of financial losses, leading to protracted litigation and higher claims costs.
Homeowners and renters should review policies to avoid underinsured during inflation.
Shopping around, bundling policies, increasing deductibles, reviewing your insurance policy periodically and maintaining good credit scores and keeping your mileages low, these can all help decrease insurance costs even during inflation.

Bad News on the Insurance Front

Are you feeling the pinch of rising insurance premiums? You’re not alone. Inflation has a significant impact on the cost of insurance, and unfortunately not everyone is well prepared when it comes to planning or budgeting their policies ahead of the time.

In this blog post, I’ll explore how inflation affects insurance, why it can make your coverage more expensive, and what you can do to mitigate its impact.

Let’s begin from auto insurance. This report tells us that a recent study by Bankrate found annual auto insurance premiums will go up by $101 in California, to an average of $2,291, roughly 2.81 percent of their income. Say an average Californian is making $3,500 a month, then since 2.81% of $3,500 is roughly $98 a month, an average Californian will pay $98 for auto insurance.

Insurance business is regulated by state; thus insurance rate also differs across states. However, we can always compare the spending of auto insurance as percentage of income. In this regard, California is ranked 32^nd in the nation, where the lowest (rank 1^st) is Maine and the highest (rank 50^th) is New York.

Why Insurance Rate Is Higher During Inflation: Demand Side

Knowing insurance cost is higher does not tell us why it is so. The best way to know the reasons, like knowing most everything in the market, is to look at the demand side and the supply side, as together they jointly determine the price of auto insurance.

Normally the demand for auto insurance is measured by how many people will buy auto insurance. However, since auto insurance is required by the law, at least for the liability auto insurance, meaning when you hit someone and it’s your fault, you will have the money to pay for the medical bills for the victim, and money for fixing the car. In that sense, the number of auto insurance buyers stays the same as everyone is supposed to buy it — unless when we look at the number of people buying auto insurance above and beyond the basic liability insurance but also policies with collision and comprehensive coverage. We will talk about that in another time.

There is another way to measure demand for auto insurance: How many people are filling insurance claim. Other things equal, more insurance claims mean more traffic accidents. In case you don’t know, an insurance claim is a formal request from the policyholder (i.e., anyone bought an auto insurance policy) to their insurance company asking for payment after a covered incident.

Turns out that this is a more interesting measure for demand, which varies from time to time rather than being fixed. If more drivers do not follow traffic rules, there will be more accidents, which in turn lead to more claims.

One important factor driving up insurance cost is the riskier driver behaviors after the pandemic. Auto premium rates are affected by frequency and severity of claims. After decades of decline, traffic deaths have increased in the past several years due to riskier driving behaviors — more speeding, driving under the influence, not wearing seat belts, distracted driving — during the pandemic.

It’s like we have waited long enough at home during the lockdown period that when we finally get a chance to hit the road, we all trying to release ourselves by driving faster.

Let’s look at the numbers from the highways: In 2021, U.S. traffic fatalities reached a 16-year high, with nearly 43,000 deaths. In the first quarter of 2022, the National Highway Traffic Safety Administration (NHTSA) estimates, 9,560 people died in motor vehicle crashes, up 7 percent from the same period in 2021, making it the deadliest first quarter since 2002.

It is a safe bet that reckless driving leads to more accidents, followed by more insurance claims, which drive up insurance cost. After all, insurers do not have the magic power to keep the insurance premium the same regardless of how many claims they received. Remember several insurers became insolvent after Hurricane Ian in Florida? The truth is that when many insured file claims at the same time, insurers will have insufficient amount of fund to cover all the claims. They can do two things: raising premium and going to reinsurance for coverage.

Similar considerations come into play for homeowners insurance. Global economic losses from tornadoes, hurricanes, severe storms, wildfires, floods, and other natural disasters reached $270 billion in 2021, according to Swiss Re. Of those losses $111 billion were insured, Swiss Re says.

Much of this loss trend is due to people moving into risk-prone areas. More people, homes, businesses, and infrastructure means more costly damage when extreme events occur. More damage to insured properties means more and larger claims. An Aon analysis of U.S. Census Bureau data shows the number of housing units in the United States has increased most dramatically since 1940 in areas that are most vulnerable to weather and climate-related damage.

Why Insurance Rate Is Higher During Inflation: Supply Side

Now we must consider the supply side factors that also drive up insurance cost: the people and businesses whose jobs are to fix cars involved in accidents, care for drivers injured, and repair and recover properties lost or damaged.

Unless your car is “totaled” or deemed worthless for repairment, insurers will pay for your vehicle to be fixed. From the following Triple-I issue briefing on inflation and higher insurance premium:

As material and labor costs rise, the cost to repair and replace damaged homes and vehicles increases. If the original premium rates are too low to cover these increased costs, insurers would quickly exhaust the funds they set aside for the rainy days to ensure they can keep their promises to pay all claims. If their losses and expenses exceed their revenues by too much for too long, they risk insolvency — unless they have reinsurance or insurance for insurers.

Social Inflation: Definition and Cost

The other side of story is social inflation, which is the amount of insurance claims that above economic inflation. One narrow definition is “legislative and litigation developments which impact insurers’ legal liabilities and claims costs.”

ChatGPT offers a more detailed definition: “Social inflation is a term used to describe a phenomenon where the cost of insurance claims rises due to societal factors such as changing attitudes towards personal responsibility, increasing jury awards, and the growing willingness of juries to award large sums of money to plaintiffs. In other words, social inflation refers to the trend of increasing costs of insurance claims due to broader social, cultural, and economic factors rather than traditional factors such as inflation, interest rates, or market fluctuations. This trend has been observed in a variety of industries, including personal injury, product liability, and medical malpractice claims. Social inflation can have significant impacts on insurance companies and their policyholders, leading to higher premiums and reduced coverage options.”

Two things to be remembered about social inflation. First, it is social rather than economic, which means the cause of it is not economical but social, especially the legal part of society. Two, its impact is not to be underestimated.

In a recent report by Triple-I, it is found that “U.S. commercial auto insurance liability claim payouts increased $30 billion more than would otherwise have been expected between 2012 and 2021 due in part to social inflation.”

Inflation and Underinsured Homeowners

Inflation means lower purchasing power of the same amount of money. For example, $1 before inflation could buy you 4 eggs but only 3 after inflation. But the same logic can apply to buying insurance. The best example is from homeowner insurance. Before inflation your $1,500 premium homeowner policy could be enough to cover the cost needed for repairing a partly damaged house. However, after inflation everything (parts, labor) has a higher price, meaning your insurer will have a hard time to cover the cost of repairing the house to the original state.

According to a report by policygenius.com in 2022, construction costs have risen sharply because of inflation, which means you may not have enough home insurance to rebuild your house after a disaster, which in turn means many homeowners could be left underinsured.

During periods of rapid inflation, the cost to rebuild may suddenly spike to account for higher lumber prices or a shortage of contractors. If homeowners don’t update their policy to reflect these fluctuations, they may not have enough insurance to fully rebuild their home after a disaster.

The price of materials used in home construction has increased 36% since the start of the pandemic. As we settle into what forecasters predict will be another active hurricane and wildfire season, it’s more important than ever for homeowners to review their policy and make sure they have enough coverage should disaster strike.

From a recent survey of insured homeowners by policygenius.com:

More than half of homeowners (56%) did not review their home insurance policy in the last year to see how much coverage they had.
Homeowners who reviewed their policy’s coverage limits in the last year (44%) were more likely than those who didn’t to:
- Increase their home’s coverage limits.
- Take action to lower their insurance premiums.
- Have at least one coverage feature in their policy that accounts for high rebuild costs.
- Be “very sure” their house is fully insured.
Just 9% of homeowners have increased their home’s coverage limit in the last year to account for rising construction costs and inflation.
Only 33% of homeowners are “very sure” their home’s coverage limit is high enough to cover their home’s entire rebuild cost.
83% of homeowners either don’t have or aren’t sure if they have inflation guard coverage, which is a crucial coverage feature that automatically increases your home’s coverage limit each year to keep pace with inflation. Notice this is an endorsement so it will cost you money to keep it. For example, say your home is insured for $100,000 and your inflation guard coverage is set at 8%. Now say you suffer a total loss of your home 90 days into your year-long policy term. Your dwelling coverage limit will be upped to reflect an 8% daily inflation rate, so your coverage limit would now be around $101,973, instead of $100,000.
More than two in three homeowners (68%) may not have guaranteed replacement cost coverage, and 80% of homeowners may be without extended replacement cost coverage — two important coverage add-ons that buffer the impacts of demand surge and higher rebuild costs after a disaster. Note replacement cost is a basic type of insurance policy that pays for the cost of replacing or repairing a damaged property up to its current market value of materials and labor. This type of coverage does not take into account any increase in the cost of materials or labor that may occur in the future. Guaranteed replacement cost provides coverage for the full cost of replacing or repairing a damaged property, regardless of the current market value. This means that even if the cost of materials or labor increases in the future, the insurance company will still pay for the full cost of repairing or replacing the property.

Things to Do for Lowering Insurance Cost During Inflation

There are things you can do to lower or control your cost of insurance even with inflation being high.

The first thing is to shop around for the best value. Note the need to avoid the trap of comparing apples to oranges: You don’t want to just look at the premium and decide on the policy or insurer that offers the lowest premium. You must take the insurance coverage payout into consideration and also ensure that you have the right coverage for you and your family. Many low premium policies come with coverage limits. One easy example is that your house is valued at $1.2 million but the policy only covers $1 million replacement cost. That defeats the purpose of buying insurance in the first place, as you will not have peace of mind when something bad happened to your house.

The second thing is to keep a decent amount of deductible, which is the amount you will have to pay — out of your own pocket — before your insurance coverage kicks in. It is always the case that a higher deductible means lower insurance premium because insurer knows they don’t have to cover all the cost in a claim, you will pay a part of it by yourself. This applies to those with enough savings to pay the deductible. The other reason insurer prefers high deductible is that people willing to pay a higher deductible tend to be more careful in avoiding risks.

The third thing, perhaps the most important and least risky, is to bundle your policies together. See my other post on details.

The fourth thing is to maintain a good credit scores, which insurers use to determine the premium rate.

The fifth thing is to ask for discounts from your insurer. There are numerous discounts, and many insurance agents will actively search for you in order to attract you and to get your business.

Note the flip side of seeking discounts is to avoid “premium boosting” factors. The best example is having a teenager driver on your auto insurance policy. For example, this report by Bankrate tells us that for a married couple the national average premium without a teen driver is $1,898, but after adding a teen driver it jumps to $4,392! The final thing is to always review your insurance policy to ensure that you have enough insurance coverage even during inflation. See above discussion on homeowner insurance for details.

Tags Auto insurance, Bundled policies, deductible, Discount, Homeowner insurance, Inflation, Premium, Social inflation, Supply and demand, Underinsurance

Did You Know?

Why Bundled Insurance Policies Are Good for You

Post author By Jay Jiyuan
Post date March 9, 2023

The Takeaways:

Bundled Insurance policies are often promoted by insurers, but many insurance consumers see them as gimmicks and quickly say “No” to them.
Unlike bundled packages from most car dealers, bundled insurance policies are transparent and should not be seen as gimmicks. They can bring real savings to consumers, in addition to the extra convenience, additional coverage and improved customer service experiences.
There is a solid statistical reason for insurers to offer discounts to bundled policies: The joint probability of two or more independent events is always smaller than that of individual event.
The most common bundles are home and auto policies for homeowners or renters and auto policies for renters.
Many insurance consumers do not know that Business Owners’ Policy or BOP is a bundled policy by itself. Umbrella policies are also bundled policies.

What Are Bundled Insurance Policies?

The best short and concise answer is provided by this article of Forbes: “Bundling insurance is when you buy two or more insurance policies from the same company and get a discount.”

Most insurance consumers (i.e., people like you and me) own multiple insurance policies, such as health insurance, auto insurance, home insurance or life insurance. Given that you are the only owner to them all, are they “bundled policies” around you?

Not really. As long as these policies are written by different insurers, they are not bundled. You may have a life policy from New York Life, an auto policy from Progressive, a home policy from Farmers, and a health policy from Kaiser Permanente. Each insurer cares little or wants nothing to do with another insurer. Why would New York Life care about whether you use Progressive or Allstate or Geico to insure your autos? Either way does not make any difference for their life insurance business.

The only case you have a bundled insurance policy is when you buy at least two policies from the same insurer.

Is Bundled Insurance Good for Insurers Only?

This article from Harvard Business Review offers a seemingly simple and straightforward rule of thumb for bundled pricing or bundled packaging: “Should you prefer to purchase it as a breakdown of the base car plus handpicked options or are you better off buying it as one all-inclusive bundle? There is a simple and pretty consistent rule of thumb on the question. Here it is: Unbundling or a la carte pricing benefits the buyer and packaged or bundled deals give the advantage to the seller.”

The reason according to the article is that if you are the customer, “unbundled pricing creates transparency and allows you to pick exactly the options you want. Most bundles make margin in giving you some of the things you want, but also some of the things that you will rarely use.”

This is true in car shopping but obviously not true for everything. In insurance, for example, auto insurance and home insurance are most likely required by the law or by lenders. When two things are both required, buying them together from the same seller makes sense, because it creates a win-win case for both sellers and buyers.

Why Insurers Want to Offer You Bundled Policies

Insurance companies or insurers all want you to buy bundled policies from them because, as this article points out, “it’s cheaper for them to service one customer who has multiple policies than it is to service multiple customers who each have only one policy. In that case, insurers are not any different from any retailers who always want you to buy more from them, and they will be happy to offer you discounts for doing that.”

There is another realistic advantage that I want to call “consumer stickiness,” which means, as the aforementioned article says, “bundling makes it less likely that you’ll switch to another company, which saves the insurance company both the cost of acquiring a new customer and the risk of losing money if that customer files a claim.”

In other words, bundled customers tend to be loyal customers.

Risk Management Advantage for Bundled Polices

In my view the biggest advantage for insurer is in risk management. Believe it or not, offering both auto and home insurance policies helps reduce insurers’ overall risk exposure, which can result in cost savings for both the insurer and the customer. Here is how it works.

Say you have both auto and home insurance with Farmers, it is less likely for you to file claims for both policies at the same time. This is because the risks that could result in a claim for one policy (such as an accident or theft of a vehicle) are less likely to also impact the other policy (such as damage to a home from a natural disaster).

Simply put, Farmers is betting that the chance for them to pay you on both auto and home damages at the same time is smaller than just paying you on one policy. This is how they save the cost of doing business with you.

The Law of Probabilities Favors Bundled Policies

Is it smart for insurers to bet that way? Yes. The multiplication rule for independent events, one of the basic rules of probability, says that the probability of two or more independent events occurring together is equal to the product of their individual probabilities.

I know the above sounds complicated but let me make it simple. Say you like to drink every Friday afternoon after work and sometimes you drive under influence or DUI. Seeing one ticket from your DMV record, all auto insurers will see you as a bigger than normal risk, and almost nobody wants to write you a policy unless you pay extra dollars for a higher premium.

On the other hand, drinking at home Friday afternoon presents little risk there, and your home insurers are unlikely to raise your premium just because you drink once a week in Friday afternoons.

What I am saying is that the risks from drinking behind wheel and drinking at home are almost independent — in terms of causing accidents or property damages — even though the two events are not entirely independent from each other. For one thing, they involve the same person (you).

Now, as long as two events are independent (for insurance purposes), the chance for them to happen at the same time is equal to the product of their individual probabilities. Since a probability cannot be smaller than 0 and larger than 1, the product of two probabilities is always smaller than the probability of one event.

You are probably confused by now so let’s continue with the Friday drinking example. Say the chance for you to get a DUI ticket is 1/180 days or roughly every six months, while the chance for you to set your house in fire after being drunk is 1/1,095 days or once every three years. The chance for you to get a DUI ticket and to set the house in fire is then 1/180 x 1/1095 = 1/197,100 days or roughly one out of 200,000 days (i.e., roughly 540 years). Apparently the result is much smaller than 1/180 or 1/1095.

This is why insurers are betting it right and they have nothing to hide from you when they say they want to give you a discount if you buy auto and home policies together from them.

Bear in mind however that when there are catastrophic events like hurricanes or earthquakes, the events that both your home and you cars will be damaged are no longer independent. This is why insurers need to buy reinsurance to cover themselves as they often must to make payments to many claims at the same time.

Why Bundled Packages in Car Dealership Are Often Not to Your Advantage

The story is different with a car dealership. You see each year car manufacturers always try to introduce some new features to their cars. It goes without saying that it costs money to introduce new features. Say for the 2024 model year, Toyota wants to introduce a new feature called “Auto on Cartoons” that the backseat screen will automatically detect when a child is seated and starts playing the Cartoon Network programs for them during the entire trip.

Apparently such a feature only makes sense if there will be children around in the house, but not for the “Empty netters” whose children all left out of the household. However, Toyota decides to make this feature available to all cars in the 2024 models in order to quick cover the cost from doing research and development. Meanwhile all Toyota dealers will get an extra bonus of $20 every time they successfully sold this feature to a new car buyer — whether they need it or not.

In other words, car dealers do have something to hide from you and the bundled package only benefit sellers but not necessarily buyers.

Underwriting Advantage in Bundled Policies

Working with packaged policies has another (subtle) advantage for insurers for underwriting purposes.

What is underwriting? It is the process of evaluating and assessing the risks associated with insuring a particular individual or entity, and determining the appropriate premiums to charge based on that assessment.

In other words, it is all about knowing customers or potential customers. The more insurer knows potential customers, the better they can come up with the right price for premium.

By bundling policies, insurers can gain a more complete view of the customer’s overall risk profile, which enables them to price the policies more accurately.

For example, if an insurer offers both home and auto insurance, they can analyze the customer’s driving record and credit history in addition to information about their home, such as its location and age. This information allows the insurer to assess the customer’s overall risk and set premiums accordingly more accurately. The insurer can also better predict the likelihood of claims related to both policies, which helps them manage their risk exposure.

Bundled Policies Are More Common Than We Think

You don’t have to wait for your insurance agent to offer you a bundled policy, some policies were born to be bundled. The best example is Business Owners’ Policy or commonly called BOPs, which is a type of commercial insurance policy that bundles together several different types of coverage into one package.

Typically, a BOP will include property insurance, liability insurance, and business interruption insurance. By bundling these coverages together, insurance companies are able to offer a comprehensive insurance solution for small and medium-sized businesses at a lower cost than if the policies were purchased separately.

Additionally, purchasing a BOP can be a more convenient and streamlined process for business owners, as they only need to manage one policy instead of several. The policy can be customized to meet the specific needs of the business, and the coverage can be adjusted as the business grows and evolves.

A BOP is customizable, because BOPs are designed to be tailored to the specific needs of a business. Businesses can choose the coverages they need and adjust their policies as their needs change.

It is designed primarily for small and medium-sized businesses. However, it can also be a good insurance option for larger businesses that do not have complex insurance needs.

Another common type of bundled policies is umbrella policies. All umbrella policies are bundled policies. An umbrella policy is a type of insurance policy that provides additional liability coverage beyond the limits of the primary insurance policies. It is called an umbrella policy because it provides coverage that “sits on top” of the primary policies, like an umbrella. An umbrella policy is considered a bundled policy because it covers multiple underlying policies, such as homeowners insurance, auto insurance, and other liability policies. It provides an additional layer of protection for businesses or individuals who may face significant liabilities that exceed the limits of their underlying insurance policies.

Tags Auto & home policies, Bundled insurance policies, Business Owners Policy BOP, Consumer stickiness, Gimmick, Joint probability of independent events, Risk management, Transparency, Umbrella policy, Underwriting

Property Insurance

How to Fight and Win Wildfire Crisis

Post author By Jay Jiyuan
Post date March 6, 2023

The Takeaways

Wildfire risk costs many condos and townhouses under homeowner association or HOA the accessibility to property insurance, or they must pay a significantly higher price to be covered.
Pushing insurance to state sponsored insurers like Fair Plan is not a sustainable solution.
Wildfire mitigation (clearing vegetations near house) is one way to increase insurability but we need high tech solutions as well.
It’s good that California Department of Insurance asks insurers to give discounts to home hardening and wildfire resilient communities.
New solar cells printed on fabrics offer light weight, flexibility and high efficiency on generating solar energy.
We can hit three birds with one stone by coating solar fabrics with fire retardant so they can generate solar energy, protect roofs, houses, porches, yards and detached buildings and significantly reduce insurance cost. The point is to make fire safety to pay for itself by generating and selling solar power to the grid.

Shocking News in California on the Insurance Side

I’ve just written a post on fighting flood a few days ago and now the news from the Triple-I newsletter shocked me from somewhere closer to home, with a title that seems harmless: “California senate pushes to stabilize the homeowners insurance market.”

When you click it and read it, however, the contents are really nothing less than being shocking. The report started with the sentence that “Homeowners insurance prices in California are skyrocketing with the increased threat of wildfires.”

But to hear the word “skyrocketing” is not enough, you need to see the prices to fully appreciate the change and impact.

This report in early 2022 tells us that “there were an average of 62,805 wildfires and an average of 7.5 million acres impacted annually,” in the years from 2011 to 2020.

There is someone living in a condo in San Diego County, who owns a townhome in an HOA (Home-Owner Association) with 186 others. “During our HOAs last insurance renewal we were notified that we would not be renewed due to proximity to high fire risk areas.”

The policy they started with was $54,000 a year (apparently this is for the so called “master” insurance policy for the entire complex, which HOAs often buy for the common areas like swimming pool, gym, parking lots, gates, landscape, parks and playground, clubhouse, trails, common building and lighting), but now the annual premium for this year is $293,000, a more than five time increase, which led to an emergency assessment to each unit owner to cover the cost of that new premium amount.

From another planned community in Anaheim Hills:

“In 2020, Horizons paid $39,000 for property and fire insurance,” Hayes said. “This year, we are going to pay out $417,000 plus interest,” which is more than 10 times higher.

In another report published on February 16, 2023, Farmers Insurance dropped coverage on more than 1,000 condo owners in San Diego due to wildfire risk.

Limited Fire Insurance Options

When someone lost private fire insurance, they can temporarily use the state’s Fair Plan, a non-profit insurance plan, which is meant to be the insurance of last resort. Fair Plan offers plans that are however not large enough to cover HOAs.

The insurance industry is not too keen on solutions that include state-run insurance programs, like Florida’s Citizens Property Insurance, or California’s Fair Plan that provides fire insurance as a policy of last resort.

One correspondent named Ruiz from Insurance Information Institute (or Triple-I) is quick to point out why insurance companies are not renewing policies on large condo complexes.

“Inflation has really driven up the cost of building,” she said. “Since 2017, we’ve seen a huge increase in the numbers of wildfires and the losses from wildfires.”

When it comes to solving the condo insurance crisis in California, Ruiz mainly talks about wildfire mitigation, like clearing brush and hardening homes.

Policy Incentive for Fire Safety

But future solutions are coming, Ruiz said. Beginning in April, the state will start looking at lower insurance rates as a reward for fire mitigation.

“So the California Department of Insurance has asked all the admitted insurance companies to file new rating structures that would include discounts for home hardening, and community wildfire resilience,” said Ruiz.

“After the changes go through with the Department of Insurance, there will be more insurance available to condo associations, condo owners, and the insurance market will be in a much better place,” Ruiz predicted.

Help at the Federal Level

Within the past year, the Biden Administration has increased efforts to make the job of firefighters safer and better. They’ve done this by signing reform laws into place that drastically increase the compensation for firefighters, change their status to full time employees in many circumstances, and make it easier for them to access mental health services.

In the Biden Administration’s proposed FY2022 budget, there was a significant amount of discretionary dollars earmarked to make new technologies available to firefighters. These technologies could go a long way to making every firefighter more connected, more informed, and better prepared for when disaster strikes, and they’re called into action. Some of these technologies could also make it easier for firefighters that are isolated or injured to be found and rescued.

New Tech Fire Solutions

Here are some of the technologies that the Biden Administration could make available to firefighters, and how they could make a difference in wildfire situations:

Internet of Things (IoT) technologies and sensors

Testing of wildfire detection sensors is currently being spearheaded by the Department of Homeland Security (DHS) Science and Technology Directorate (S&T). According to Jeff Booth, Director of S&T’s Sensors and Platforms Technology Center, “These sensors will provide early alerting capabilities in high-risk areas where detection and alerting aren’t currently available.”

By identifying wildfires in geographically remote, high-risk areas more rapidly, firefighters can begin fighting and managing fires before they grow incredibly large and increasingly dangerous. They can also engage fires before they spread to areas where personal property and lives could be put in danger.

Mobile Mesh Networking

Mobile mesh networking can enable the use of communications and situational awareness tools off the grid in places where other terrestrial networks don’t exist.

This means that firefighters will be able to share information and see each other’s locations even in isolated, remote locations. They can also be used to spread connectivity over a wide geographic area and to each individual without a single, centralized piece of equipment that can be compromised and fail. This means they can deliver resilient and redundant communications that is always available to the firefighter.

Finally, mobile mesh networking can be a low-cost alternative to connecting IoT (Internet of Things) devices. Instead of each individual sensor requiring its own expensive cellular connection – or incredibly pricey satellite connection – mobile mesh can be used to connect IoT devices over a wide geographic area with no recurring cost. This can help accelerate fire focused IoT programs, and enable the government to extend them to more areas at a lower cost to the taxpayer.

Household Self Protection

We have all seen big airplanes dropping red fire retardant powder off the sky over the fired areas. This video shows a preventive alternative before fire starts — without using an airplane. It allows households to spray fire retardant through home or garden hoses on vegetation and yard before fire season.

You do need to spray it every year and it costs $20,000+ a mile for a 20 ft wide zone along power lines or roads. The other potential side effects is environmental or human risk, as fire retardant may have health hazards over human bodies as this video shows.

An Innovation in Solar Panel

Speaking of the home based solutions, one seemingly unrelated development from the MIT One Lab is the creation of solar films that is very thin, flexible, light and yet 18 times more powerful per kilogram than the rigid solar panel that is supposedly capable of turning any surface into a power source. The solar cells are entirely printable, using ink-based materials and scalable fabrication techniques.

While the solar cells are thin and printable, they do have problems. Standing by themselves the solar modules are not easy to handle and can easily tear. The MIT team needs to find a lightweight, flexible, and high-strength substrate to attach their solar cells to.

An ideal material—a composite fabric that weighs only 13 grams per square meter, commercially known as Dyneema, fits the purpose perfectly. By adding a layer of UV-curable glue, they adhere the solar modules to sheets of this fabric. This forms an ultra-light and mechanically robust solar structure.

Hitting Three Birds with One Stone

At this point the idea hits me: If we coat Dyneema with fire retardant chemicals before the MIT solar cells are attached to it, we will produce flame safe and solar capable structure and then install it on rooftops, we will hit three birds with one stone: Home based energy generation, home fire safety and homeowner policies at lowering cost.

ChatGPT, when asked, gives the following answer on the feasibility of fire retardant coating:

“Yes, Dyneema can be coated with a fire retardant coating. Dyneema is a high-strength synthetic fiber that is often used in applications where flame resistance is important, such as protective clothing and equipment for firefighters, military personnel, and industrial workers.

“There are various types of fire retardant coatings available in the market, including intumescent coatings and ablative coatings, which can be applied to Dyneema fibers to enhance their fire resistance properties. These coatings work by either expanding and forming a protective barrier when exposed to heat or charring to insulate the fibers from further heat exposure.”

In terms of the cost, ChatGPT has the following to say:

“Dyneema is a high-performance fiber that is known for its exceptional strength, light weight, and resistance to abrasion and tearing. The cost of Dyneema can vary depending on the specific application, the manufacturer, and the quantity purchased.

“As a general guide, Dyneema is typically more expensive than traditional materials like nylon and polyester. The price of Dyneema can range from several dollars per yard for small quantities to several hundred dollars per yard for industrial-grade products.

“However, it is important to note that the high cost of Dyneema is often offset by its superior performance, durability, and lifespan. Dyneema is often used in applications where strength and reliability are critical, such as high-performance sails, body armor, and climbing equipment, where the high cost is justified by its benefits.”

I would say for high cost neighborhoods and upper scale houses, Dyneema will have a market demand there. For affordable housing and student housing on campus, on the other hand, other fabrics would work better as long as it is transparent (to allow sunlight to penetrate to the solar cells) and flexible (for easy deployments on rooftops, corners, porches, front yard, detached buildings and backyard. Bear in mind that in the long run the cost for Dyneema will be paid off by the energy it generated, so even affordable housing projects can sometimes choose the longer lasting fabrics.

Again, the beauty of this solution is to potentially make fire safety to pay itself, through generating and selling home generated solar energy, and significantly reduces insurance cost.

The good thing is that many roofs in California already have solar panels installed. All we need to do now is to add another very strong home safety reason to install more. Doing so will make an immediate difference in home finance, because insurance companies will be much more willing to cover your house with fire retardant roofs and front yard and backyard. This would apply especially well to all condos and townhouses or anywhere with an HOA, who will no longer be rejected for master insurance policy by a private insurer.

Maybe in the future all solar panels will be fire retardant by default!

Tags Dyneema, Fire retardant, Homeowner Association HOA, Homeowner insurance, Internet of Things IoT, Mobile Mesh Networking, Solar cells, Wildfire