Here a story from Arthur Postal of National Underwriter about Allstate and Nationwide bucking an industry trend and supporting some form of Rep. Gene Taylor’s proposed Multiple Peril Insurance Act. The bill, as I wrote about last week, has come under fire from the American Insurance Association, which raised concerns that it would be too costly and wouldn’t accomplish what it is intended to do.
The story says Michael McCabe, Allstate senior vice president and chief legal officer, sent a letter to Taylor saying "We support the concepts contained in [the proposed bill], if properly constructed and implemented . . . ."
Here’s more from the story about McCabe’s letter:
He wrote that the “private insurance mechanism is not well suited to low-frequency, high-severity events.”
He explained, “We need a better system in our country to deal with major events, one that would leverage a stronger public-private partnership as part of an integrated and comprehensive solution.
This concept of low-frequency, high-severity losses is central to why insurers exclude certain perils like flood and earthquake, and deserves a thorough explanation. Fortunately, J. David Cummins and Neil A. Doherty of the Wharton School, University of Pennsylvania, explained this stuff a while back in a scholarly paper much better than I could, so I’ll let them do the talking. Here’s their explanation, to which I’ve added some emphasis to make it easier to read:
1) High-frequency, low-severity losses. These are losses that are numerous and small relative to industry resources. A good example is automobile collision losses. Although such losses may be considered a serious financial hardship to the individual insured, they are very small relative to the resources of the industry. Moreover, there are large numbers of such losses, most of which are statistically independent, meaning that the occurrence of any one accident is not usually associated with other, related accidents. For types of insurance where there are many statistically independent losses, insurers can exploit the statistical property known as the "law of large numbers.” The law of large numbers essentially says that when large numbers of statistically independent events are observed, the average loss becomes highly predictable. Or, in other words, the chances become small that the actual observed losses will deviate from expected losses by an amount which is large relative to the overall expected value of loss. This is the type of loss the insurance industry handles most effectively. By pooling together the losses of many individuals with statistically independent risk exposures, the industry is able to charge premiums which reflect the expected or average loss plus expenses and a relatively modest charge for risk bearing. The industry’s equity capital is more than adequate to absorb any adverse fluctuations in losses of this type.
(2) Low-frequency, high-severity losses. The second major type of loss is the type represented by large catastrophes, i.e., events that occur infrequently and are large relative to the resources of the insurance industry. This type of loss is much more difficult for the insurance industry to handle because the usual pooling mechanisms do not apply. The events are simply not sufficiently frequent for the law of large numbers to operate. For this type of loss, the insurer is essentially in the same position as the policyholder in the usual insurance transaction, i.e., the insurer faces a loss that amounts to a high proportion of its resources and that is highly uncertain or unpredictable. Low-frequency, high-severity losses cannot be handled effectively by the insurance industry acting alone. However, these losses can be diversified by pooling them with other economic events that are not usually the subject of insurance . . . .