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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

Did You Know? Life insurance

Insurance for Properties & Protecting Life

Post author By Jay Jiyuan
Post date February 27, 2023

The Takeaways:

Property insurance and life insurance are two major categories with different purposes, for different people, and covering different things.
A trend of late is to see property insurance rate moving up, while real life insurance rate going down.
One important but little known way of predicting insurance cost is to look at reinsurance cost insurance firms pay to reinsurance company.
More competition, advanced technology for underwriting, increased life expectancy, better risk management and more informed consumers, these all contribute to a lower cost of life policies.

Property Insurance vs. Life Insurance: An Overview

Did you know one way to divide insurance business is to separate them into property insurance and life insurance? Yes that’s true and property and life insurances make up the biggest categories, in addition to a few other “biggies” like commercial insurance, liability insurance and health insurance.

Property insurance is about protecting physical assets (e.g., personal homes and personal belongings, businesses building and business properties, vehicles) against financial losses from covered perils (i.e., direct causes of loss that your insurer will pay you for) like fire, theft, weather damage and natural disasters. They differ from life insurance in two ways: What they cover and for whom. Simply put, (1) property insurance is always protecting properties while life insurance is always protecting loss of human lives; and (2) property insurance is always designed for property owners, while life insurance is mostly designed for the loved ones of the policyholder, occasionally for the policyholder themselves.

Note property and property insurance are not always the same. It is easy to think of property insurance as for autos and homes. After all, for most families the biggest asset is the house. But insurance terminology does not always work that way. Strictly speaking property insurance does not cover everything related to your house or autos. Remember property insurance only protects property owners? That means whenever your insurance pays money to someone else, that part of coverage belongs to liability insurance, not property insurance.

Consider an easy example: Say you were driving under influence, and you hit Joe’s car, your auto insurance will pay Joe for his bodily injury and his car damage. That money received by Joe is not strictly from your property insurance but rather your liability insurance, even though the same (comprehensive) auto policy of yours will cover both.

Life insurance, on the other hand, protects financial loss caused by the loss of human lives, not physical properties. While property insurance protects property owner(s), life insurance mostly protects others — your loved ones — although it can protect oneself (i.e., the policyholder, see more details below).

Because life insurance mostly protect your loved ones, “death benefits” is a big term that appears in all life insurance policies. This is for a good reason: Death benefits often are the biggest chunk of insurance payment. It is called death benefits because they must be paid after the policyholder is dead, only to beneficiaries (i.e., recipients of insurance payment).

But death benefits are not the only benefits in a life insurance policy. Sometimes we can receive “living benefits” that are unique in two ways: They are paid to policyholders themselves rather than to their loved ones, and they are paid when policyholders are still alive.

This is a topic for another day, and I will not get into details in this post. What I will say is a quick fact that term life insurance can have living benefit as well, contrary to a misconception some may have. For example, a terminal illness rider is typically included automatically on term life policies, providing a lump sum payment if the policyholder is diagnosed with a terminal illness and has a life expectancy of 12 months or less.

Insurance vs Reinsurance

One of the reliable ways for predicting how much premium you and I will pay for our insurance policies is to look at reinsurance cost for the insurance companies like in this report of January 2023.

Many if not most of us have never heard the word “reinsurance” before, or have but did not bother to dig deeper into it. It sounds more complicated than insurance and yet seems to be one of those things that we can afford to ignore in our lives.

In truth, reinsurance has lot to do with how much you and I will pay for our insurance premium. Let me explain. Reinsurance is simply insurance of the insurances, and only insurers or insurance companies can and will buy it, not individuals. That said, the way it works is the same: We pay premiums to the insurers for the right to receive insurance payment in case we have financial loss due to the agreed perils or direct causes of loss. Insurers also pay premium to a reinsurance company so that if during catastrophic events there are more claims than the insurers can pay, they will ask reinsurer to pay it.

Reinsurance is especially important for catastrophes like earthquakes, hurricanes, floods, wildfires, and volcanic eruptions. Human-caused catastrophes can include industrial accidents, terrorist attacks, wars, and pandemics.

Catastrophes could be disasters for any particular individuals, businesses and governments alike. But they are especially bad news for insurance companies as they bring significant financial losses for insurance companies that are unable to cover the costs of claims made by policyholders.

Insurance industry has a quantitative threshold for an event to be designated a catastrophe “when claims are expected to reach a certain dollar threshold, currently set at $25 million, and more than a certain number of policyholders and insurance companies are affected.” According to this article by Triple-I.

You probably think insurance companies all have a deep pocket that can survive any catastrophes with no problem paying insurance claims. In truth, some insurance companies are pretty vulnerable to disasters, which is why you often hear the news that some insurers got themselves into insolvency, meaning they run out of money to pay the claims from their policyholders or clients.

By buying reinsurance, insurance companies transfer some of the risk they have taken on by insuring their customers to another insurer.

From Reinsurance Cost to Insurance Cost

Here is what ChatGPT has to say about how reinsurance premium is related to our own insurance premium to be paid to our insurer.

“Yes, generally higher reinsurance costs can lead to higher insurance premiums for customers… When reinsurance costs are higher, it means that the insurance company is paying more to transfer its risk to another company. To make up for this added cost, the insurance company may pass on the cost to customers in the form of higher insurance premiums.”

Of course, there are many factors that can affect insurance premiums, like the level of risk being insured, the insurer’s expenses, and competition in the insurance market. But reinsurance cost is one of the major factors because it is the cost for the insurers to do business, which is always significant just like in any other business.

But how does reinsurance firm determine how much it will charge insurers? It is not much different from how an insurer determines our premium. The key factors are risks involved, past frequency and severity of claims made, plus industry trends and the overall cost of risk across insurers, allowing reinsurers to set more accurate prices for their coverage.

ChatGPT tells us the following: “If reinsurance rates are high, it may indicate that reinsurers are pricing their coverage more cautiously, which suggests that the overall cost of risk in the insurance market is high. This can lead insurance companies to increase the premiums they charge customers to compensate for the increased cost of risk.”

“Overall, while reinsurance rates are not the only factor that insurance companies consider when setting premiums, they can be a useful indicator of the overall cost of risk in the insurance market and may play a role in determining the prices that customers ultimately pay for insurance coverage.”

Property Insurance Rate Goes Up, Real Life Insurance Rate Down

ChatGPT tells us the following that “it appears that property insurance rates are indeed on the rise in the US. A report by Gallagher Re shows that property catastrophe reinsurance rates for loss-hit US accounts increased by between 45% and 100% at Jan. 1 renewals, indicating a significant increase in rates for property insurance policies in some areas. This trend of increasing property insurance rates is also supported by a recent analysis by Bankrate.com, which found that the average homeowner spends about 1.91% of their household income on home insurance, a figure that has been rising over time.”

This report in Business Insurance cites a report from Amwins Group Inc as saying: “Property markets will remain hard with no softening in the foreseeable future.” “Due to the challenges in the property market, however, reinsurers are being ‘extremely cautious’ with all their capacity.” The reason for property insurance market getting tough is “the combined effects of a major hurricane making U.S. landfall in five out of the last six years, wildfires engulfing thousands of acres, unprecedented winter storms and Midwest flooding. All ‘have played a major role in hardening the insurance marketplace.’”

What about life insurance premium? ChatGPT tells us that the trend of premiums for life insurance policies has remained relatively stable in recent years. This may not sound exciting but wait for taking inflation into account: Life insurance prices remained relatively the same throughout 2021 despite inflation and an increase in death claims. The average monthly cost of a $250,000 policy only increased by a small amount from January 2021 to December 2021.

Combining the above I’d say the “real” (i.e., inflation adjusted) life insurance premium has gone down.

While there is no specific data provided for California, it is likely that the trend of stable premiums applies to the state as well.

It should be noted that while the cost of premiums may remain relatively stable, they can still vary depending on factors such as age, gender, and health status.

Explaining the Decreasing Real Life Insurance Cost

ChatGPT offers several reasons why life insurance rate may go down (with my edit):

Improved Health: One of the primary factors that influence life insurance premiums is the health of the policyholder. If you have made positive lifestyle changes that have led to improved health, such as quitting smoking or losing weight, then you may be eligible for lower premiums. Note this is an individual specific reason, although modern medical technologies can certainly benefit anyone.
Increased Competition: As more insurance companies enter the market, there is greater competition to offer more affordable policies. This can lead to lower prices for consumers as companies try to attract more business.
Lower Risk: Insurance companies base their premiums on risk factors such as age, health, and lifestyle. If these risk factors decrease over time, then insurance companies may lower their premiums accordingly.
Advances in Technology: With advancements in medical technology, it has become easier to diagnose and treat various illnesses. As a result, life insurance companies may be more confident in their ability to predict the life expectancy of policyholders, and this can lead to lower premiums. The other reason is the use of technology in underwriting, such as using Google Maps for homeowner policies and wearable devices for monitoring personal fitness.
Economic Conditions: Finally, economic conditions can also impact life insurance costs. If interest rates are low, for example, insurance companies may need to lower their premiums in order to remain competitive and attract new policyholders.

Tags Catastrophes, Death benefits, Insurance cost, Liability insurance, Life insurance, Living benefits, property insurance, Reinsurance

Did You Know?

How to Protect Myself During a Trip? What Insurance Will Cover Me?

Post author By Jay Jiyuan
Post date February 24, 2023

The Takeaways:

There are numerous ways for your trip to go wrong. Most Americans however are likely not interested in buying trip insurance.
Common reasons for saying “no” to travel insurance include safe trip before, low cost trips and saving money. Safe trip before does not mean safe trip today or tomorrow, as insurance is mostly about covering unexpected events.
Travel insurance mostly protects oneself — during the trip, with coverages ranging from trip cancellation, travel medical insurance, lost or damaged baggage, emergency evacuation and travel accidents.
The most unique feature of travel insurance is not necessarily low coverage payment but short duration: It ends when the trip ends, although sometimes they offer short extension. For this reason, having travel insurance is not enough for most people, as we need longer lasting and more comprehensive insurance like auto insurance, homeowner insurance and life insurance.

The Scaring News from the US Airports

Did you know that roughly 18 guns were seized every day at US airports last year? It is true according to the Transportation Security Administration (TSA) that intercepted 6,542 guns last year, which translated to roughly 18 guns per day, at airport checkpoints across the country.

Guns are not the only thing to be worried. Today on February 23, 2023, the news says a brutal winter storm is walloping the entire country coast to coast. Flights are cancelled, highways closed, “trapped drivers in cars, knocked out power to hundreds of thousands of people and prompted the first blizzard warning in Southern California in decades — and the worst won’t be over for several days.”

The Low Prevalence of Travel Insurance

Travel insurance is not the most popular choice for most American travelers. In a survey of more than 1,200 Americans planning on traveling (during the pandemic), only 23% would definitely buy insurance and 21% might do so. 56%, the majority, had no plan to buy any travel insurance.

Insurers were still happy to see these figures because the thought was that in this particular study “most imminent travel looks to be family- and friends-oriented — and perhaps less expensive and closer to home — may account for the lack of interest in trip insurance.”

A more recent study published by Business Insider in 2023 of 971 US adults however shows that explanation is not strong. “About 62% of travelers surveyed did not purchase travel insurance; of those travelers, 35% said their primary reason to forgo insurance was because they’d traveled before and never needed it. About 19% said they didn’t think their trip was expensive enough for insurance, and about 14% said they were trying to save money. About 13% said travel insurance never occurred to them.”

These reasons revealed the typical mindset not just on travel insurance but insurance in general.

Should We Forego Travel Insurance Because We Had Safe Trip Before?

I asked the above question to ChatGPT, and it comes back with the following:

“No, you should not forego travel insurance simply because you have had safe trips before. Even if you have been lucky in the past, unexpected events such as natural disasters, medical emergencies, and cancellations can still occur and ruin your trip. As a rule of thumb, if you are spending more than $5,000 on a trip, it is considered a big-ticket purchase, and travel insurance is recommended to protect your investment.”

I agree that “big ticket” travel plans (those above $5,000) should be covered by travel insurance, although smaller ones should as well. Remember in the earlier report about 19% said they didn’t think their trip was expensive enough for insurance? That is a myth. Short trips are associated with smaller airplanes and there can be cancellation and unexpected events just like big trips.

Considering that the travel insurance cost on average of 6% of the total travel cost, for a trip that costs $200, the travel insurance part only takes $12 from you. This differs significantly from the $300 you would have to pay for a $5,000 trip.

A Deeper Question about Insurance

There is a deeper reason for buying insurance, including travel insurance: Insurance is about unexpected events or accidents, designed to protect us from financial losses resulting from accidents, illnesses, natural disasters, and other unforeseen circumstances.

This is why you still need to buy travel insurance even though your previous trips were all safe.

Ask yourself if you can expect all future trips to be safe just because the previous trips were safe. If the answer is yes, then you don’t need to buy insurance from now on. But of course the answer has to be no, like what they say for investment: Past successes does not guarantee future success.

What about expected events? Well, most of them will NOT be covered by insurance. You know your car needs maintenance in the future, so your car insurance will not cover that. Similarly, you know you will need to replace your roof due to normal wear and tear, so your homeowner policy will not cover that.

This is not saying insurance excludes all expected events. For example, some health insurance policies may cover routine medical care or preventative services, even though these events are expected to occur. This is risk management of your insurer because routine medical checkups help reduce the loss for them — and for you.

What Do You Get from Travel Insurance

Once again from ChatGPT we have the following list:

Travel Medical Insurance: This type of insurance provides coverage for medical emergencies and expenses that may arise while you are traveling. It can cover things like doctor visits, hospitalization, and emergency medical transportation that’s not covered by your regular health insurance plan.
Trip Cancellation Insurance: This type of insurance provides coverage if you need to cancel your trip due to an unforeseen circumstance, such as a medical emergency or a natural disaster. Sometimes “cancel for any reason” is provided as well.
Personal Accident Insurance: This type of insurance provides coverage for accidental injury or death that occurs during your trip. This is a first-party coverage, meaning for yourself rather than for anyone else.
Emergency Evacuation Insurance: This type of insurance provides coverage for emergency medical evacuation if you are injured or become seriously ill while traveling and need to be transported to a medical facility. You could be taken to the nearest hospital or flown home if necessary when you’re injured, or you get sick on a trip.
Travel Insurance with Medical Coverage: This is a comprehensive insurance policy that combines several types of coverage, including medical coverage, trip cancellation coverage, and other travel-related coverage. It provides more extensive protection than a single policy and can be customized to fit your specific needs.

In many ways, travel insurance is like car insurance with a focus on self-protection rather than protecting “third party” or anyone else involved in an accident.

Note in addition to the above list, other coverages are possible like lost, stolen or damaged baggage & personal belongings, rental car damage and even finding a lawyer abroad.

Cancellation Insurance vs Free Hotel Night(s)

Don’t confuse trip cancellation insurance with free hotel night(s) provided by airlines. The former means you can get your booking money back even for non-refundable expenses like airfare, hotel bookings, and tours if for unexpected reasons such as illness, injury, death in the family, natural disaster, or other covered reasons you had to cancel your trip. The coverage may also apply if you have to interrupt your trip and return home early due to covered reasons.

Cancellation insurance can be purchased as a standalone policy or as part of a comprehensive travel insurance plan.

On the other hand, free hotel night(s) provided by airlines when a flight was cancelled has little to do with insurance. instead it is a benefit by some airlines to their customers who experience flight delays or cancellations due to reasons within the airline’s control, such as mechanical issues, crew scheduling, or weather. In reality, airlines do that even for reasons beyond their control, like bad weather conditions.

Travel Insurance for Foreign Trips

What about your plan for a foreign trip? I asked ChatGPT and here is what I got:

“If you are planning to travel abroad, it is important to consider purchasing travel insurance to protect yourself in case of injury or illness during your trip. Here are some types of insurance that can provide coverage for injuries sustained during a foreign trip:”

Travel Medical Insurance: This type of insurance provides coverage for medical expenses that you might incur while traveling abroad. It typically includes coverage for emergency medical treatment, hospitalization, emergency medical evacuation, and repatriation of remains in case of death.
Accidental Death and Dismemberment Insurance: This type of insurance provides coverage for accidental death or permanent disability resulting from an accident that occurs during your trip.
Personal Liability Insurance: This type of insurance provides coverage for damages or injuries that you might accidentally cause to others while traveling abroad.
Trip Cancellation Insurance: This type of insurance provides coverage for non-refundable expenses if you have to cancel your trip due to a covered reason, such as illness or injury.

As you can see, the coverage are basically the same as domestic coverages, even though the way ChatGPT presented may have created an impression that only foreign travel insurance will cover accidental death and dismemberment insurance as well as personal liability insurance. The truth is both domestic and foreign travel insurance can make those coverage available.

As the news told us earlier, death or dismemberment insurance can be even more important in this country than in foreign trips given the number of guns intercepted at the airports within this country.

Looking at the Big Picture

Do not forget the big picture in which travel insurance is just a small part, and normal and travel insurance can be related to each other.

If your “normal” liability insurance policy includes coverage for personal liability, it may cover you while you are traveling. For example, if you accidentally injured someone while on vacation or damaged someone else’s property, your liability insurance may cover those for you. However, if you are traveling internationally, your liability insurance policy may not provide coverage in certain countries or may have limited coverage.

Life insurance may be related to travel insurance as well. Some travel insurance policies may offer coverage for accidental death or dismemberment, which could be seen as a form of life insurance. Additionally, some life insurance policies may also offer travel benefits, such as emergency medical coverage while traveling abroad.

There will be overlapping between the two. That said, life insurance is a long-term insurance designed to provide financial protection to your loved ones in the event of your death, while travel insurance is designed for the traveler. Life insurance is also intended to cover a broad range of expenses, such as funeral costs, outstanding debts, and the loss of income that your loved ones would experience after your death.

It is not that travel insurance policies only pay small amounts in the event of financial loss. The payment amount for death in travel insurance for example can range from a few thousand dollars to several hundred thousand dollars, depending on the policy and the level of coverage you have chosen.

On the other hand, some small life insurance policies, especially term life insurance (those covering for a fixed number of years up to 30 years), typically have face values (i.e., the amount they will pay your beneficiaries or your loved ones) starting at around $25,000 or $50,000.

So payment amount is not crucial as one can always pick and choose the amount of payment desired for both travel and life insurance. The most important feature for travel insurance is its relatively short coverage duration. Once the trip is over then typically the coverage is over, although some travel insurance policies may have a coverage extension period that provides limited coverage for a specified number of days after the trip has ended. For this reason, we typically need both travel insurance and life insurance.

Tags ChatGPT, Guns in the airport, Life insurance, Low prevalence, Short duration, Travel insurance, Travel medical insurance, Trip cancellation insurance, Unexpected events

Did You Know?

Financial Disclosure Is Crucial for All, Here Is Why

Post author By Jay Jiyuan
Post date February 22, 2023

The Takeaways:

Mormon church and affiliated non-profit settled SEC charge with $5 million for hiding its vast investment portfolio, valued at $32 billion in 2018.
The requirement to file timely and accurate information on Forms 13F applies to all institutional investment managers, including non-profit and charitable organizations.
Although securities claims are major coverage under the Directors & Officers (D&O) insurance policies, many insurance contracts have exclusions, limits or deductions that make cases like SEC settlement difficult to receive D&O payment.

The News Involving the Mormon Church

Today on February 21, 2023, news has it that “The Church of Jesus Christ of Latter-day Saints, the leading Mormon denomination, and a nonprofit operating under it will pay $5 million to settle SEC charges that the church failed to disclose its relationship to shell companies.”

Turns out that “Ensign Peak Advisers Inc., the Utah-based nonprofit that manages the church’s investments, hid the size of the church’s equity portfolio under 13 limited liability companies — including 12 “clone LLCs” — from 1997 through 2019.”

“The nonprofit also failed to file Forms 13F, which are required to disclose the value of certain securities overseen by investment managers, according to the SEC. The forms were filed in the name of the shell companies, instead of Ensign Peak Advisers.”

More Interesting Details of the Case

The above CNBC report missed a few interesting details that were told by this report from Forbes. First of all, the whole case was disclosed by a whistleblower, David Nielsen—a member of the church and former Ensign Peak investment manager, who filed a complaint to the IRS in November 2019 and made the church agree to pay $1 million, while Ensign Peak agreed to pay $4 million.

Another interesting detail: The same whistleblower Nielsen “tipped the IRS that the firm had amassed $100 billion in a little-known charitable fund it collected from donations. None of that money had been spent for 20 years.”

Even more interesting is the potential motive behind hiding the huge funds. “Nielsen said the firm’s leader had instead suggested to staff that the church intended to keep the money for the ‘second coming of Christ,’ which, according to Mormon teachings, will be marked by war.”

How interesting is that for the church to prepare for highly unusual time when Chris himself is coming back to the world.

Similar Case Before

Turns out that this is not the first time Mormon church got itself into trouble with SEC. ChatGPT tells us another similar but smaller case:

In September 2021, the Church of Jesus Christ of Latter-day Saints (commonly known as the Mormon church) reached a settlement with the U.S. Securities and Exchange Commission (SEC) regarding allegations that the church had misled its members about a $100 billion investment fund it had established. As part of the settlement, the church agreed to pay $250,000 to the SEC.

The SEC had alleged that the church had created a non-profit entity, Ensign Peak Advisors, to manage its investment funds and had told members that the funds were being used for charitable purposes. However, the SEC claimed that the church had not disclosed that it was also using the funds for other purposes, such as building a shopping mall in Salt Lake City.

The church denied any wrongdoing in the settlement and stated that it was happy to put the matter behind it. The settlement does not include any admission of guilt or liability on the part of the church.

Nobody and No Cause Can Justify Financial Disguise

The question is, can a case of “noble” cause or causes (e.g., reserving a huge fund for the second coming of Jesus Chris) be used to justify for financial in-disclosure?

The answer must be “No,” otherwise there won’t be SEC action and payment of million dollars for settlement.

More generally, the same laws and regulations must apply to everyone in the society to make it powerful. If there is to be exceptions, they must be pre-installed and pre-stated. Otherwise the laws will have no “teeth” and people will find all kinds of excuses to be exempted from the laws.

D&O or E&O, Which Is Right for Me?

Most if not all entities (organizations, firms, agencies, even individuals) will buy commercial insurance, which can mean either Directors & Officers (D&O) insurance or Errors and Omissions (E&O) insurance. Both D&O and E&O are liability insurance, which is a type of insurance protecting individuals or businesses from being legally liable for something such as malpractice, injury, or negligence — but not intentional wrongdoings.

How do these two insurances differ from each other?

D&O insurance, which again stands for “Directors and Officers” insurance, is designed to protect the personal assets of company directors and officers in the event that they are sued for a wrongful act in their capacity as a director or officer of the company. It typically covers claims related to alleged breaches of fiduciary duty, neglect, errors or omissions, or misleading statements made by the insured person in their capacity as a director or officer of the company. D&O insurance is meant to protect individuals and organizations from management decisions that result in legal actions against them.

On the other hand, E&O insurance, also known as “Errors and Omissions” insurance, is designed to protect businesses from financial losses due to claims of inadequate or negligent work. It covers claims related to professional services, such as errors or omissions made by a professional, breach of duty, or failure to perform professional services. E&O insurance is typically purchased by businesses that provide services to clients, such as lawyers, doctors, or financial advisors.

Simply put, D&O is covering decision makers of an entity, while E&O is covering the entire entity.

Notice that some professionals just have oneself plus one or two staff members, like an attorney’s office or a financial service agency, protecting the entire entity therefore is like protecting the one principal.

Is Mormon Church Likely to Be Covered?

The Mormon church case fits D&O insurance better because it is the decision makers of the church that is directly responsible for the financial disguise. Now that the Church paid its money to SEC, could it file a claim with the insurer to ask payment for its loss of multi-million dollars? More importantly, will the insurer agree to pay for the Church?

This is a good case to ask ChatGPT for, which gives the following answer:

“It depends on the specific terms and conditions of the insurance policy in question.

“Some insurance policies may provide coverage for SEC settlements or fines, while others may not. Typically, insurance policies will have exclusions for intentional or criminal acts, which may include securities fraud or other violations of securities laws that could lead to SEC settlements.

“Additionally, even if an insurance policy does provide coverage for SEC settlements, the coverage may have limits or deductibles that could affect the amount of reimbursement the insured entity ultimately receives.

“If an entity is concerned about whether its insurance policy would cover SEC settlements, it should review the policy’s terms and conditions, and consult with its insurance broker or legal counsel.”

Basically the answer says the church may have a hard time to ask for D&O payment from its insurer. ChatGPT is right that we really need to take a look at the original policy to decide.

Difficulties with Securities Claims

Assuming the Church bought D&O insurance, then “securities claims” are a common type that can be covered under D&O insurance.

Securities claims generally arise when shareholders or investors allege that a company or its directors and officers have made misrepresentations or omissions in the company’s financial statements, public disclosures, or other communications related to the company’s securities. These claims can also arise from alleged violations of securities laws or regulations, such as insider trading or market manipulation.

The above statement fits well with the Mormon case: The Church did misrepresent the financial statements, did not follow the public disclosure rules and regulations and potentially violated securities laws or regulations, which explain the SEC involvement.

Under a D&O insurance policy, coverage for securities claims typically includes legal defense costs and damages that may be awarded to claimants in lawsuits or settlements. Of course, as pointed out by ChatGPT earlier, coverage may be subject to certain exclusions and limitations, depending on the specific terms of the policy.

Now let’s say the D&O policy the Mormon church bought did not exclude legal defense costs, meaning the insurance company must pay to cover the legal cost for the church. The only complication is that the case never went to court but settled outside the court. Should the insurer pay the $5 million to cover the church?

We don’t know the answer for sure because we have no access to the original insurance contract or policy. However, by looking at similar cases it does not seem good that the D&O insurer will pay that $5 million. Here is a historical case similar to the case we are talking about.

This legal article discusses a case involving the auto rental firm Hertz Global Holdings in 2013 that was settled in 2021.

A plaintiff (i.e., the one who filed lawsuit) shareholder filed a securities class action lawsuit against Hertz and certain of its directors and officers in the District of New Jersey. In September 2014, the SEC issues a formal order of investigation that specifically stated that the SEC had “information that tends to show” violations of the securities laws and authorized SEC officials to issue subpoenas for witnesses and documents. In December 2018, Hertz entered a settlement agreement with the SEC, which provided for a $16 million penalty. Hertz claimed to have incurred $27 million in connection with the investigation. Hertz sought to have its D&O insurers reimburse the company for its costs incurred in connection with the investigation.

Unsurprisingly, Hertz’s insurers denied coverage for the company’s investigative costs. The defendant insurers filed a motion to dismiss the coverage lawsuit on the grounds that the company had failed to state a claim for breach of contract.

Guess what made the insurer so sure and won in the end? Turned out there was a phrase in the insurance policy that defined securities claim specifically as “a Claim, other than an investigation of an Organization … alleging” violation of securities laws or regulations. This is the language that used by the judge to against Hertz and in favor of the insurer. The judge made it clear that if something is specifically excluded in writing, it must be honored in the court of law. Simple like that. The Mormon case does not fit exactly with Hertz’s because this time we have a whistleblower and the SEC investigation never really started before the church decided to settle by paying the money. What the insurer is most likely to argue is that the church intentionally committed something wrongdoing, which is excluded by most, if not all, insurance policies.

Tags Directors & Officers insurance, Errors & Omission, Financial disclosure, Mormon church, Non-profit organization, SEC settlement, Second coming of Christ, Whistleblower

Did You Know?

When a State Has 80% Homeowners Lawsuits in the Country, How Can We Do Better in Risk Management?

Post author By Jay Jiyuan
Post date February 18, 2023

The Takeaways:

Risks are inevitable, losses don’t have to be — if we do risk management right.
One-way attorney fees and assignment of benefits (AOB) are the two big legal loopholes pushing up insurance cost and lowering down private insurance affordability and availability in Florida.
Four technological platforms or tools are very useful in risk management: ChatGPT, Smart Contract, Internet of Things (IoT) & Tango. Together they have the potential to revolutionize insurance business by significantly reducing insurance costs and increasing fare & efficient insurance coverage.
ChatGPT will be trained to read and explain lengthy and complicated legal documents such that ordinary citizens can quickly understand the gist of a 200-page contract. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.)
Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems.
Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting really smarter contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement.
Internet of Things (IoT) will establish a field monitoring network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys.
Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.

This is a more detailed (and longer) version of my proposal for the “In2Risk23” Conference to be held on October 5-7 in Washington D.C. by the CPCU Society of the Insurance Information Institute or the Triple-I as it is called.

Bad & Then Good News from Florida

Don’t get me wrong, I only have California state insurance (and financial) license so what happens in Florida does not really concern me. Yet insurance everywhere bears similarities, and it doesn’t hurt to learn from the mistakes in another big state like Florida.

The Insurance Information Institute (Triple I), one of my favorite sources of insurance related information, has recently issued a two page news brief on Florida Property /Casualty (P/C) Insurance crisis. It tells us the bad news first, and then some good news.

Perhaps the best way to start a story is by providing some quick statistics: “Florida accounts for nearly 80% of the nation’s homeowners’ insurance lawsuits, but only 9% of all U.S. homeowners’ insurance claims are filed.”

Wow, there are disproportionally way more insurance lawsuits than other states adding together! As a result of excessive or runaway lawsuits, it “costs every Florida household more than $5,000, and the state more than 173,000 jobs annually,” according to the American Tort Reform Foundation’s “Judicial Hellhole” report.

So what’s going on here?

“Legal system abuse and misuse of assignment of benefits ‘are creating a lose-lose, contributing enormously to the net underwriting losses for the few remaining insurers in the state,’ said the Triple-I CEO Sean Kevelighan.”

The CEO only talked about assignment of benefit or AOB problem in Florida, another is “One-way attorney fees” to be discussed later in more detail.

The good news is that, as the above briefing points out, “Reforms put in place in the closing weeks of 2022 and proposed in the first quarter of 2023 suggest Florida is now quite serious about fixing the fraud and legal system abuse that have contributed to the state’s insurance crisis.”

The Underwriting Losses in Florida

Let’s look at another shocking figure from Florida:

“Florida’s homeowners insurers cumulatively incurred net underwriting losses of more than $1 billion in both 2020 and 2021 and expect larger losses for 2022 when year-end results are tabulated.”

The figure of $1 billion loss in Florida has to be placed in the context of national figures to make more sense. According to this report, “In 2021, the insurance industry experienced a $3.8 billion net underwriting loss, after a $5.2 billion underwriting gain in 2020.” In other words, the entire country had a gain in 2020 when Florida had a loss, and of the national loss of $3.8 billion in 2021, Floridan contributed $1 billion, more than 25% of it.

One crucial term in the above news is “underwriting losses.” According to ChatGPT, “Underwriting loss is the financial loss incurred by an insurance company as a result of the claims paid out to policyholders being greater than the premiums collected from those policyholders. In other words, underwriting loss occurs when an insurance company pays out more in claims than it receives in premiums.”

Simply put, underwriting losses happen when insurance companies have to pay out more money for insurance claims than they received from policyholders’ premiums. You don’t have to be a genius to figure out that is not good.

To be sure, insurance companies make money in several ways, not just from premium. Therefore, underwriting losses are not the only factor to determine the company’s overall financial health. Investment income is another major source of revenue.

When an investment company receive policyholder’s premium payment, they won’t let the money sit there collecting dust. Instead, they invest the premiums to security market to generate additional income.

In addition, operating expenses such as salaries, rent, and marketing costs can also affect an insurer’s bottom line. If an insurer has high operating expenses, it may be more challenging to achieve profitability even if its underwriting results are strong.

Still, other things equal, having an underwriting loss is definitely not a good news.

Trouble with Assignment of Benefit AOB

Assignment of Benefits or AOB is common primarily in property & casualty insurance but also in others like healthcare insurance. it is a legal agreement that involves the transfer of insurance benefits from the policyholder to a third party, such as a contractor or healthcare provider.

It seems to be a harmless arrangement. For example, say you have some illness and your physician successfully treated you. If that illness is covered by healthcare insurance, you know you will be reimbursed. So instead of you paying the physician and then get reimbursed from your insurance, you can choose to assign your physician to get all the insurance payment because he did all the job and earned it, right?

The answer is not that simple. While AOBs can be useful in certain situations, they are generally not recommended because they can lead to a variety of problems for both the insured and especially the insurer (i.e., the insurance company).

A main problem is insurance fraud. In some cases, contractors or healthcare providers may exaggerate the cost of their services to get paid for work they never did. Or they can perform unnecessary work in order to increase their profits, sometimes charging the patients with free medicines they received from marketer, for example.

I know this happens a lot in China, where hospitals over-examine patients because those imported medical equipment (e.g., an MRI scanner) cost a lot of money and hospitals don’t want the machine sitting there collecting dust. Doctors ask most if not all patients to have a medical imaging done first, even though it is clearly not necessary for some, and the procedure sometimes costs enough to send a family back to poverty!

Another issue with AOBs is to make it difficult for insurance companies to manage their claims because there is a third party involved in the claims process. The insurance company have to verify the work that was done and to ensure that the costs are reasonable. Delays and higher costs become common.

The bad news is that ultimately it is the insured person will bear the extra cost due to AOB. If the third party performs work that is not covered by the insurance policy, the insured person may be responsible for the additional costs.

Problems with One-way Attorney Fee

Another major problem in Florida that reduces insurance affordability and availability is the so called “One-way Attorney Fees,” also called “fee shifting.” This determines who is responsible for the litigation cost and to pay the attorney(s) involved in the case.

One-way attorney fees are meant to shield policyholders from legal bills if they need to sue an insurer, but critics say attorneys and contractors exploit the law to file unnecessary suits with the goal of collecting attorney fees.

The Triple-I briefing has this to say: “Before the reform, state law required insurers to pay the fees of policyholders who successfully sued over claims, while shielding policyholders from paying insurers’ attorney fees when the policyholders lose.”

Here is how one way attorney fees work: Policyholder can sue their insurer at limited risk for legal fees. If they win the case, insurance company will pay for their attorney fees; but if they lose, they will only pay their own attorney fees and let insurance company pay their own.

Honestly, the name “One way attorney fees” may have created the impression that win or lose the policyholders won’t have to pay for any legal cost, and insurer will take care of that. That is not true. A better way is to call it “asymmetric attorney fees,” where the asymmetry exists in demanding for more financial responsibility from insurance company such that if they lose the case, they will have to pay for attorneys for both sides. But if they win, they cannot ask policyholder to do the same for their legal cost — although policyholder still must pay for their own lawyer(s).

Such a legal arrangement is not out of line but rather reasonable. After all, insurance companies have a deeper pocket than an insured.

But perhaps this is one of the things where the rule looks fine on paper but not so in practice. The reality is that there are way too many lawsuits filed by policyholders against insurance companies. As a result, several private insurance companies either had closed down or packed up to leave Florida.

What are the problems? There are several:

Increased Litigation against insurance companies, caused by the asymmetric (i.e., lower) financial responsibility for policyholders than for insurance companies. We have marginal or meritless legal dispute that people just hope to extract a favorable settlement from the insurance company.
Difficulty in estimating claims costs, a relatively minor problem: One-way attorney fees can make it difficult for insurance companies to estimate the total costs of a claim, as it is challenging to predict the outcome of a lawsuit, which determines whether the insurance company will have to pay the plaintiff’s attorney fees.
Higher Settlements: One-way attorney fees can push up settlement amounts for claims. This is because insurance companies may be more willing to settle claims, even if they have a good chance of winning in court, to avoid the possibility of having to pay the plaintiff’s attorney fees in the event of a loss. This means settlement is better than attorney fees.

Going from Florida to the Nation

Florida insurance crises are basically supply sided problems. I mean look at how many private insurance companies left or shut down there. But if we look around the entire country, you’ll find insurance losses across lines but especially in Property & Casualty.

Prove to yourself by entering the search phrase “News about insurance underwriter loss” and you will see many headline pieces. For example, “Private U.S. property/casualty insurers saw a $5.6 billion net underwriting loss in the first nine months of 2021,” according to this report on February 15, 2022.

State Farm provides another example, as its main auto unit generated $8.6 billion in underwriting losses through the first nine months of 2022.

One obvious solution is to raise insurance rates. This USA Today report tells us that auto insurance rate will go up this year. “Drivers nationally are spending an average of 2.93% of their income on car insurance this year, based on an average annual premium of $2,014 for full coverage insurance.” and “car insurance rates increased by nearly 14% between 2022 and 2023, compared with an overall rise in yearly inflation of 6.5% in December.”

What about California? “Progressive recently received approval for a 19% rate increase for those renewing their policies or buying new ones.”

Risk Transfer & Risk Management

In insurance business, there is a familiar saying that risk is inevitable, loss does not have to be — if we do risk management right.

Compared with raising price, risk management is a more efficient, sustainable and proactive way of lowering insurance cost and ensuring just and fair coverage for losses.

ChatGPT says the following: “Risk management and risk transfer are two different approaches to managing risks, and each has its own advantages and disadvantages. However, risk management is generally considered a better approach than risk transfer for several reasons:

Retaining Control: Risk management allows an organization to retain control over the risks it faces. By implementing risk management strategies, an organization can identify and assess potential risks and take steps to mitigate or avoid them. In contrast, risk transfer involves passing the risk to another party, which means giving up control over how the risk is managed.
Cost Effectiveness: While risk transfer can be a quick solution, it can be more costly in the long run. Risk transfer often involves paying premiums to an insurer, which can add up over time. Risk management, on the other hand, can involve implementing cost-effective measures to reduce the likelihood and impact of a risk.
Tailored Approach: Risk management allows an organization to tailor its risk management strategies to its specific needs and circumstances. This can result in more effective risk management than a one-size-fits-all approach, which is often the case with risk transfer.
Reputation: In some cases, risk transfer can damage an organization’s reputation, particularly if the transfer is seen as an attempt to avoid responsibility. In contrast, implementing effective risk management strategies can enhance an organization’s reputation by demonstrating a commitment to responsible and proactive management.”

The above answer provides a good overview of why risk management is better than risk transfer (i.e., insurance). However, the best approach is to do both risk management AND risk transfer. We cannot bet entirely on risk management because there are things out of our control. But we can do everything in our power of control to reduce and/or control risks. I propose the followings along that line:

The key to risk management is to empower employees and/or clients to quickly and easily learn the right and crucial things to improve risk reduction. The term “risk management” sounds like only managers are the stakeholder but that’s not the case. The best risk management is to mobilize all employees and clients to get the job done. Reaching that goal requires first and foremost modern technological tools.
ChatGPT, Smart contract, Internet of Things (IoT) & Tango are the four most important technologies for risk management with the potential to revolutionize insurance business by proactively and significantly reducing insurance cost and making insurance sustainable. Of the four, ChatGPT is likely to play the most important role because it is approachable by ordinary employees and clients. All we need to do is to expand its functionality to make it useful to professionals.
ChatGPT will not just give everyday texts for fun but will be trained professionally to understand, and then to explain, complicated legal documents such that even ordinary citizens can comprehend the gist of a 200 page legal document. This will significantly reduce the currently indispensable role of human attorneys (they may be needed to proof check the ChatGPT answer but that should not take very long.) The key is to reduce our reliance on the middlemen like attorneys by empowering the end users.
Another ChatGPT development is customized, always on, mobile and industry- or even firm-specific ChatGPT. The program will be locally pre-trained by records of past risks and past losses, and then provide intelligent and insightful answers to inquiries of all employees in dealing with new but similar problems. Localized and customized ChatGPT can do many things faster, better and cheaper.
Smart contract associated with blockchain will effectively reduce the problem of legal system abuse, over-crowed or jammed court rooms, long waiting lists of scheduled litigations — by drafting nothing less than really “smarter” contracts that are filled with very detailed, context specific “what if” terms and conditions (ChatGPT can help draft and interpret the document), taking into account all relevant historical cases and eliminating extra spaces for misinterpretation and post hoc litigation, while keeping the feature of automatic execution of a predetermined agreement. The idea is to work with a better beginning to save time and energy toward the end.
Internet of Things (IoT) will establish a field surveillance network at critical junctions of business operation to record objective evidence admissible to the court of law, deterring frivolous lawsuits and prevent predatory practices of trial attorneys. Even with caseload remaining the same as before, having historical field evidence will still speed up the litigation process.
Tango is the easiest and most intuitive training tool for employees by providing step by step guides with intuitive screenshots every step of the way that everyone can understand and easy to follow. In the future new employee orientations will be mostly done by watching Tango generated PDF files. Numerous risk management field guides can be developed with context specific Tango flowcharts to reduce the chances of misbehavior and mishandling.

Tags Assignment of benefit, Blockchain, ChatGPT, Empowerment, Florida, Internet of Things, Middlemen, One-way attorney fees, Risk management, Smart contract, Tango

Did You Know?

What Exactly Are Securities?

Post author By Jay Jiyuan
Post date February 21, 2022

Lately when I met my friend James in the UC Berkeley soccer field, he would ask me how my security exam preparation was going. (A quick update: I have stopped taking or preparing for securities exams as I will never find a “sponsor” for getting my securities license even if I pass all the exam. The rule requires examinee to find a financial entity as a sponsor before even taking the exams.) We would both laugh at the word “security,” and would use the “quote and quote” sign around it. We both feel that word is a significant misnomer, almost like calling a jail a “freedom house.”

All Securities Involve Risk

A nice way to think of securities is to add two letters “In” to the front, turning it into Insecurities. This is an easy way to remember that security always involves risk. The minute when risk is gone, securities are no longer securities.

But securities are more than risks. For example, gambling and skydiving are risky but there is no such a thing called “gambling securities.” There must be something else in securities that gambling does not have.

Securities Have Voluntary Ownership Liquidity

How about “easy transferability,” meaning securities not only involve risk but the risk is easily transferrable, like selling your shares of Apple or Google stocks to someone else. This may not seem a big deal, but keep in mind not all risks are easy to transfer.

Gambling risk is again a good example. You can’t, sometimes won’t, sell your bet to someone else the minute when it is your turn to place the bet. Similarly, when you have a losing bet, nobody else is willing to buy the bet from you and pay for your loss.

Easy transferability leads to high liquidity, which is a good thing. But why are securities more liquid than others? I have seen nobody talking about it. In my view, it is ultimately because when some people see risk, others smell chances to gain. It is the different opinions, positions and perspectives that make the ownership of securities highly liquid.

Put differently, when somebody is ready to sell his or her securities, there will be somebody else standing ready to buy them. This creates a perpetuate market for securities, where buyers meet sellers for transactions and exchanges. It is also for this reason why the initial issuer of the security sees no need to limit the transferability of the securities.

From Liquid Ownership to Investment Contract

Unlike risk that is associated with most if not all things in life, transferability is associated with investment contracts. It is the latter that fully associated with the legal definition of securities.

Investment contracts have a formal interpretation from the authority no lower than the US Supreme Court itself.

This blog provides interesting legal and historical discussion. “Most states follow two U.S. Supreme Court cases when interpreting ‘investment contract’ under their state securities laws. The Court interpreted ‘investment contract’ under federal securities laws as ‘(1) a contract, transaction, or scheme whereby a person invests his money (2) in a common enterprise, and (3) is led to expect profits solely from the efforts of the promoter or a third party’ (‘Howey Test’). The Supreme Court later modified the third requirement, holding that in spite of the term ‘solely,’ what is necessary is only ‘a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others’ (‘Forman Test’).”

In plain English, an investment contract starts from a person investing his or her own money to an entity called “common enterprise” by the Court. This person is not necessarily doing charity (although charitable investment cannot or should not be excluded) but is driven by a reasonable expectation of financial gains from the investment. Such an expectation in turn is made reasonable by the efforts of third party entrepreneurs (or the blander term “promoter” by the Court).

To be honest, the Howey and Forman tests are not perfect. For one thing, Karl Marx would argue that the common enterprise can grow not because of the managerial efforts but because of workers or employees. To the extent that innovations and actual work are done by the latter more than the former, Marx has a point. Better yet, we don’t have to single out efforts by one group of agents. We can simply accept the fact that an entity cannot grow without joint efforts of all relevant agents.

The other point missed by the Court is the profitability of an entity depends not solely on the entity itself but its surrounding environment like the market, government regulators, geological endowments, legal system, competitors, infrastructure and logistics, historical trend, industrial landscape, even global environment nowadays.

The final point the Court missed is the ownership liquidity. This is a big miss because it is the ability for one investor to sell his or her shares of any stock s/he owns to another investor that creates the secondary stock market. I will come back to that later.

Still, the formal legal tests (putting the Howey & Forman together) are good enough as a working model for us to understand what exactly securities are. The biggest contribution is to raise the definition of securities up from more generic factors of risks and liquidity to more specific terms.

What Can We Learn from the Investment Contract?

The key criterion for securities is not risk, which is too ubiquitous to be uniquely linked with securities. Most financial transactions bear risks so do most non-financial activities (like hiking, camping and driving).

Similarly, ownership transferability alone is not sufficient. If you think of it, currencies beat securities hands down in ownership transferability or liquidity. The minute you spent money on the phone bill, the BART ticket, the gas to your car, or groceries from Trader Joe, some money will flow out of your wallet and into someone else’s hand. Yet we usually don’t call currencies securities.

This is not saying that risk and transferability do not matter. On the contrary they matter a lot. Risk for example plays a crucial role in separating securities from non-securities like whole life or term life insurance policies, fixed annuities, IRAs and retirement plans. All these financial instruments carry little risk, unlike securities.

Similarly, ownership liquidity helps set securities apart from other financial products where ownership is more or less fixed, such as, once again, the IRAs, social security, insurance policies. But let’s consider something else: employment contracts. When someone is hired by a firm, the contract is limited to that person only. You won’t hear the story that someone signed the contract with Apple or Google and then change the name on the contract to his or her sister or brother as his or her replacement.

The same goes to college enrollment. When UC Berkeley admits Lily, only Lily can come to study there, not her friend or relative. Nobody can buy the seat in the classrooms or the bed in the dorm from Lily, no matter how much money he or she is willing to spend — because the college would never grant the transfer. For this reason, employment contracts and college contracts are never securities.

Notice the similarity of a college contract with security contract. Here we have an individual (the student) who invests his or her money and time into an entity (the college), with the expectation of future gains (including financial gain) from the investment, just like in the security contract. Also, the university hires management term to run and to grow the place, just like in a security contract. What is missing is the ownership liquidity.

The Test of Passive Income

But there is something else that is missing. Let’s continue with the college and employment contracts and put them under the light of Howey & Forman tests. The thing that is in the securities contract but not in the college or employment contract is passive gains.

In order to understand this element, I will cite this blog that has an excellent reading of the Howey test as “a three-question test used to determine whether a financial instrument will be considered an ‘investment contract,’ and therefore, a security.

1. Is there an investment of money with the expectation of future profits?
2. Is there investment of money in a common enterprise?
3. Do any profits come from the efforts of a promoter or third party?

If the answer to these questions is ‘yes,’ then the asset is considered a security.”

The element I want to talk about for securities is the third question, which spells out a term of passive gains or passive income. The investors put in the money and then let the management, or the “promoters” using the terminology of the Supreme Court, do the job for them. They do not have the time nor the expertise to run the entity. They just want to see the gains in the end — or quit if no gain.

This does not fit the college nor the employment contracts. When one is hired by the firm or accepted by the college, one is expected to earn the credits or the wage by trying one’s best. Passivity has no value here and can only get one trouble and failures in career or in education.

In sum, securities must satisfy simultaneous criteria of risk, liquid ownership, individuals investing in entities with reasonable expectation of profits or gain but without active efforts of third party management.

A Test of Cryptocurrencies

All this discussion may sound informative and educational, but does it have any link with the real life we are living in?

The answer is yes. This blog by SoFi provides a good example how definition of securities matters in real life, especially on how to categorize the nascent cryptocurrency market.

Let’s define commodity first, so that we can better understand the debate on whether cryptocurrencies are commodity or securities. According to this Wikipedia page, “a commodity is an economic good, usually a resource, that has full or substantial fungibility: that is, the market treats instances of the good as equivalent or nearly so with no regard to who produced them.” The term is further divided into hard commodities through mining like gold, silver, helium and oil, versus soft commodities through farming like wheat, rice, coffee and cotton.

Are cryptocurrencies like Bitcoin to be placed in the basket of commodities or securities? This is not a light question. We all know the government has much stricter regulation over securities than commodities, which explains why “some cryptocurrency industry executives as well as enthusiasts have pushed for the market to be categorized as a commodity market, and not a security.”

Of course, we can’t just listen to enthusiasts in our determination. What about the Howey test? The Sofi blog believes “cryptocurrencies are designed to be decentralized so, like commodities, don’t produce a return from a common enterprise. Some officials seem to agree. For instance, SEC Chairman Jay Clayton has indicated that Bitcoin is not a security.”

On the other hand, there are reasons to treat cryptocurrencies like securities, “like when they’re issued like stock in ‘initial coin offerings.’ These are capital-raising processes for blockchain or crypto-related businesses.”

But I see little dilemma in the case. Cryptocurrencies should be treated as commodity, but crypto-related business or financial products should be treated as securities. The recently issued Bitcoin ETF available to the US investors is a perfect example of crypto securities. This is the same idea as commodity futures contracts are not securities, but commodity options contracts are.

Another consideration is that regulation over cryptocurrencies can be light because the market is mostly participated by speculative investors who are sophisticated and accredited. Even SEC offers exemption to any securities on the private placement as long as they are purchased mostly by accredited and institutional investors, who do not need much governmental oversight or protection. However, with the introduction of products like Bitcoin ETF, regulators must step in to protect isolated, private and non-accredited investors.

Green pattern background

The Takeaways:

Securities are risky investment contracts with transferrable ownership among investors who all expect to gain profit from the investment. Investors offer capitals for people in the enterprises to try best to create value for the investors. Securities exist not just in primary market between investors and enterprises but also between investors in the secondary market.

Bird with flight path

Financial knowledge gives you wings. You can fly high like this bird!

Tags Common enterprise, Cryptocurrencies, Forman test, Howey test, Investment contract, Ownership Liquidity, Passive income, Risk, Securities, US Supreme Court