Announcement: SOA congratulates the new FSAs for June 2019.

A Horse of a Different Color

A Horse of a Different Color
by Tom Bakos

This article offers an in–depth explanation of what insurance is and how it is regulated.

This is not about horses, really. It's about insurance and what insurance is. And, it's about the role that innovation plays as it dances through our business lives adding color to our worn and drab collection of insurance products ... presenting challenges we might not have imagined.

But, back to horses for just a minute or so. "What color should a horse be in order for it to be a horse?" Well, you might respond, "a horse is a horse, of course," and color will not change that fact. For horses, that kind of logic may work. But, in the field of insurance, a horse of a different color can find itself on the wrong side of the fence. In keeping with the strong use of imagery so far, think of it as a regulatory fence or, if you prefer, a hurdle. Insurance law and regulation are often thought of as hurdles rather than as fences since hurdles, unlike fences, are temporary obstructions intended to be overcome. There is always a way around or over a hurdle for those with innovation and optimism in their souls.

Innovation which creates insurance of a different color must often overcome many hurdles in a highly regulated area of practice like insurance. Innovation, of course, is the result of a problem solved. The interesting thing is that while you might think that a solution to an insurance problem is insurance, the intelligent designers of our world of insurance may not have anticipated your evolutionary solution. It may not be in their books (their laws and regulations) yet, because insurance laws and regulations tend to be reactive–relating to what is. So, anyone involved in innovative problem solving in the insurance industry must always go back to the basics and wonder: Is it a new form of insurance I have just created ... or is it something else?

Defining Insurance–The Basics
Thinking like an inventor, one would like to have as broad a definition of insurance as possible that is not overly broad. That is, one wants a definition that captures the "essence" of insurance and nothing more. I suggest that the following definition contains all of the essential elements: Insurance is a process through which the financial consequences of a contingent event are transferred from one entity to another for the payment of a premium. This definition has all of the essential basic elements: a contingent, or insured, event; an insurer; an insured; and a premium.

A contingent event is an event that is uncertain with respect to its occurrence, timing or severity. That is, a contingent event is uncertain with respect to any one or more of these factors. The uncertainty of the event occurring implies that the insured entity generally has no control over the occurrence of the event, its timing, or its severity. Another word used to describe this is: fortuitous.

Uncertainty is an important characteristic for insurable contingent events. The more certain an event is, the less insurable it is, generally. For example, often the financial consequences of pregnancy are insured although "pregnancy," per se, is not considered an insurable event since it is not really uncertain with respect to its occurrence or timing. However, since there is uncertainty surrounding its severity, insurance is more likely to be provided for complications resulting from pregnancy. So, the uncertainty of an event implies that it is insurable and that insurance may be necessary in order to offset adverse financial consequences.

Another example: finite insurance in which the uncertainty of the financial consequences being transferred from the insured to the insuring entity are limited in some way. Often, when some sort of retroactive effective date and calculation is involved, an important element of this definition of insurance, uncertainty, is eliminated all together. With no uncertainty in the picture, this definition would not allow that type of structure to be called insurance.

The entity providing the insurance is called the insurer. The entity receiving insurance protection is called the insured, or the beneficiary in some forms of insurance like life insurance. The existence of insurance is recognized by the formation of a contract between the insurer and the insured. We can assume that there is agreement between the insured and the insurer in the formation of the contract, and the premium completes the deal. An insurance contract is called an insurance policy. The insured contingent event defines the type or kind of insurance. See the box for how the New York Insurance Law defines "insurance contract" and, by implication, "insurance."

Insurance is typically designed to pay a benefit for a loss and has no value if a loss is not suffered. The loss is expressed in dollar terms equated in some way to the financial consequences the occurrence of the contingent event has on the insured. As can be seen at the end of section (1) of the New York definition, the concept of "insurable interest" is added as a legal requirement.

Some forms of insurance have intermediary or temporary values (for example, whole life insurance cash values) created by the way premiums are structured relative to the underlying risk. And some forms of insurance, annuities and Universal Life for example, have unbundled investment components that are essential parts of the insurance contract. Variable life and annuity products have further blurred the line between insurance and investment by making, in their form and use, the investment components more than just incidental.

More Law
In a highly regulated environment, a broad definition of insurance is not all that insurance innovators must deal with. State insurance laws contain sections that define specific "kinds of insurance." These kinds of insurance are, vaguely, related to the contingent events that, historically, have established themselves as events with insurable interest. See the side bar from Florida statutes for examples of the kinds of insurance that state insurance laws recognize. The insurance laws of Florida and other states describe more completely the details of the kinds of insurance that fit into these broad categories and, generally, have a catchall or miscellaneous provision that anticipates that these descriptions may not be all inclusive.

An innovative new "kind of insurance" might have some difficulty fitting in under these statutes. For example, the insurance of glass "against loss or damage from any cause" is a form of casualty insurance anticipated under Florida statutes (and New York, by the way, and other states, I assume). However, the insurance of sheet plastic glass substitutes like Plexiglas, for example, is not mentioned in the law under "kinds of insurance." It may be determined, I'm just guessing, that Plexiglas is similar enough in purpose and use to glass to be included as insurable under the glass category or it might be considered insurable under the miscellaneous category. As silly as this may sound, someone who innovates in the area of insuring glass substitutes or replacements would have to consider that.

Of course, the importance of being specific about what is insurance and what is not is to make clear exactly what comes under the regulatory authority of the state insurance departments and what is properly regulated someplace else, if at all. If a determination is made that something is insurance, then the law will influence, determine or affect whether it is a form or "kind of insurance" that is allowed. Not everything that might properly be considered "insurance" under state statutes is necessarily allowed or legal. Innovative product developers, therefore, need to be prepared to address this issue and make the point that the new form of insurance they may have developed satisfies an important insurance need not contemplated by existing insurance law.

And More Law–Variable Products
Of course, other insurance law and regulation and tax law and regulation affect insurance products. These too are written in a reactive environment and very seldom are written in broad terms that anticipate or can accommodate all new kinds of insurance, benefit structures, premium structures or insurance approaches that innovators may find to solve insurance problems.

Consider the development of variable products and, in particular, what is now called variable universal life (VUL). This new, innovative product design even touched on SEC law and regulation and required a great deal of additional innovation, law and regulatory change, as well as an accommodating investment environment in order to find commercial success.

The SOA Specialty Guide (Z–1–97) provides a historical perspective on the variable product innovations that occurred during a long period of development beginning in the late 1960s. Unit based products developed earlier in other countries because those other countries did not have the hurdles faced by actuaries in the United States–the insurance laws and regulations of 51 jurisdictions and investment laws and Securities and Exchange Commission regulations (including the Securities Act of 1933, the 1934 Securities Exchange Act, and the 1940 Investment Company Act). Some of us may remember the great debate between the New York Life "fixed premium design" and the Equitable "additions" design that were presented as ways to fit variable life insurance into the existing statutory valuation methodologies of the time.

It wasn't until the mid 1980s that VUL began to show it had a potential for commercial success. Certainly, one reason was that by that time enabling law and regulation had developed for this new innovative product type. This occurred, probably, because VUL was considered to have a public benefit–unlike other innovative product types that successfully engineered themselves around existing law (I'm thinking Deposit Term), but were not considered by some to have much in the way of socially redeeming value or virtue. These types of innovative products, which are perceived to be bad for the public, create a reactive law or regulation change that, effectively, outlaws them.

But of course, with respect to VUL, in addition to enabling legislation, technology progressed in the early 1980s to the point that unbundled Universal Life type products, which were the base of a VUL design, could actually be illustrated on personal computers just reaching the market. And, they could be implemented and administered on new data processing systems developed for that purpose. In addition, the equity markets cooperated by showing themselves to be the place to be.

The VUL product concept serves as a good historical example of the point that new product design can stretch the concept of what insurance is. VUL, in particular, infused life insurance products with even more investment than they ever had before. The pushing of the investment border in insurance products, eventually, provided the impetus to add a definition of life insurance into tax law (IRC §7702). So, that is one more definition of insurance that insurance product innovators must contend with, at least, on the life insurance side.

Insurance as an Investment
Not only are life insurance products being infused with investment components, the life insurance product itself is becoming an investment with the development of the life settlement industry and the secondary market it is creating for life insurance policies. This is not surprising, really, because many life insurance agents for years have been presenting to their clients, the insureds, illustrations that calculated a "return on death benefit." These interest rate returns showed their clients how much more they would make on their life insurance "investment" if they died earlier rather than later. It was only a short step to the concept of selling this death benefit investment to a third party.

It should be noted that innovations related to life settlements are a high proportion of the insurance business methods being patented or seeking patent protection in the last few years. Among these innovative problem–solving approaches are techniques to securitize a group of policies purchased as life settlements so that investors participate in the results of a pool of risks and not in individual life settlement policies. At the other end is a technique for individuals to offer, via an Internet market, their own life insurance policies to the highest bidder. All through this, life settlements have been getting scrutiny from regulators and others, but still remain a strong new facet of the life insurance industry.

In addition to new terms being coined, like Investor Owned Life Insurance (IOLI), new products have been developed to serve the new insurance needs of investors in this market. Insuring a life or buying a life insurance policy already issued on a life, even one with higher than originally expected mortality, is still a contingent event in that it involves uncertainty with respect to timing. Buyers, or investors, in life insurance products through the life settlement market, re–price the life insurance policies they buy and evaluate the return on their investment in terms of when they expect the death proceeds of the policy to be paid. In effect they are assuming a "survival risk" that triggered, first, a Lloyd's syndicate approach to insurance (the Goshawk syndicate that has since abandoned this type of insurance) and, recently, a newly patented survival risk insurance business method that actuarially prices the survival risk and enables accurately priced survival risk insurance that effectively transfers the "survival risk" from the investor to an insurer.

Life settlements are not the only inventive use of a life insurance policy's death benefit as a funding mechanism–premium financing arrangements, for example, that rely on the ultimate payment of a death benefit to repay the loans made to pay for the insurance. In addition, some Corporate Owned Life Insurance (COLI) programs have been designed that use death proceeds to fund other employee benefits and rely on the death benefits during an accumulation period to offset some of the premium cost.

So a death benefit isn't just a death benefit any more.

On the Horizon
In a sense, the combination of individual life insurance policies into a pool is, effectively, "securitizing" them, that is, aggregating insurance policies into a negotiable security. But there are other inventive new approaches designed to replace insurance that involve securitization techniques. One patent issued in 1997 (#5,704,045) is for a means to securitize property loss risk by having investors put up funds to cover 100 percent of the potential financial loss that might be caused by the occurrence of a catastrophic contingent event like a hurricane, for example. In effect, the concept allows "investors" to replace traditional "insurers" as the ultimate risk taker in an insurance environment in which there are not enough traditional insurance risk takers. The investors make money because they get their investment back with interest provided by the premium "insureds" pay into the pool.

Obviously, the investors also stand to lose or earn little in years in which a hurricane or other insured catastrophic damage in the region insured is high. However, as pointed out in the patent, the invention anticipates aggregating risks into pools to take advantage of the insuring principle known as the "law of large numbers." The invention also describes a "hedging" mechanism for investors who have a financial stake in the catastrophic event and the cyclical financial effect a catastrophic event can have on their business. For example, a building materials manufacturer or supplier located in a region often hit by hurricanes might hedge its business risk by becoming an investor in this securitization pool. A natural hedge exists in this since when hurricane damage causes the insurance/securitization scheme to provide lower than expected returns, the investor's business income is increased if the investor is in the building supply industry.

Over the Horizon
So, do you have a horse of a different color or is it an appropriately colored something else like a zebra ... or an elephant? Or, maybe what you have is a zebra of a different color. While insurance product innovation may be pushing the boundaries of insurance towards investment, it may also be pushing the boundaries of investments. A secondary question might be: Is what I have developed an investment? See the box for what the SEC thinks of as a "security" or investment. If your insurance product, a variable annuity for example, guarantees minimum values for any cash or cash equivalent that can be drawn out of the product despite what happens in the investment market, have you created a new form of investment?

We are learning not to talk about in public much of the innovation now going on in the insurance industry for fear of giving away too much information to our competitors. Even when patents or patent applications provide protection, it is often a good idea to stay mum. A head start is always an advantage no matter how fast you, your horse, or your zebra can run. So, this will have to be a take home question: What are you doing today that stretches the boundaries of insurance ... or investments?

Tom Bakos is a consulting actuary for Tom Bakos Consulting, Inc. He can be contacted at tbakos@bakosenterprises.com or 970.626.3049.