The Wall Street Journal published an article on Sunday titled “Low Rates Are Tormenting Insurers – And Their Customers”. The insurers that are most tormented are old people. And in an unexpected way, scientists and engineers might have a solution.
Here’s the article’s thesis:
- Interest rates are low now, and have been that way since the Great Recession
- Insurance companies rely on high interest rates to make money
- When insurance companies don’t make money, they squeeze their policy holders
How exactly do insurance companies rely on high interest rates to make money? Their business model depends on the difference in time between when you pay them a premium, and when they pay out a claim. That time difference affords insurance companies two huge advantages:
- A dollar in premiums is worth more than a dollar in paid out claims, because of inflation. That’s the time value of money argument.
- Because they hold premium dollars for some time before paying out claim dollars, insurance companies can temporarily invest those premium dollars. Insurance companies keep the returns they make on those investments.
That’s the business model of insurance companies. Well, there’s the obvious element that insurance companies try to find pools of buyers that collectively pay in more than they get paid out. But the two points above are unique to insurance companies.
If you want to read about the financial nuts and bolts of this business model, read any of Warren Buffett’s letters to Berkshire Hathaway shareholders. Berkshire Hathaway owns some premier insurance companies. Warren Buffett isn’t shy about explaining how they work, and why Berkshire performs so well.
Why are old people uniquely affected? Because they have long-term care policies. And long-term care policies are sensitive to interest rates over long periods of time.
Interest rates have been low since the Great Recession. That’s a problem, because interest rates track the return on the safest investments the economy has to offer. Near zero interest rates mean that safe investments are returning next to nothing. And for companies that rely heavily on safe investment returns, like insurance companies do, that’s a huge problem.
Imagine you run an insurance company. You know you have a pretty simple business model, even though there’s enormous complexity around understanding your risks and trying to set premiums accordingly. What are you going to do? How are you going to improve your financial performance in a sustained low interest rate environment?
The answer is pretty clear. As I see it, you have three options:
- Charge more in premiums
- Limit your payouts
- Make riskier investments
The premiums minus payouts math should be clear. Grow your income (premiums), cut your costs (payouts), and you’ll improve your profit.
The riskier investment piece is dicey, because you’re paying a price to chase better returns. You can never be sure exactly how much you’ll have to pay out in claims at any given moment. That means you can’t survive wildly volatile investments that might give you better returns in the future, because near-term liquidity is so important.
The risky investment angle is an article in itself. It’s a big part of how the Great Recession came to be. The Wall Street Journal article is about the premium minus payout angle. And that’s where old people get squeezed.
Long-term care policies are risky for insurance companies. You negotiate those terms when you’re young(er), and you collect those payouts when you’re old(er). Large blocks of time invite a lot of risk. And for policies that pay out right now, the cumulative risks have eaten away at the profitability of insurance companies.
Basically, when they crafted these policies, insurance companies expected to earn much better returns on their investments. The Great Recession changed the game. Lower than expected returns have eroded profit dollars. And because large insurance companies are beholden to their shareholders, they have to respond.
The Wall Street Journal article talks about how insurance companies are forcing old folks to pay more to get the same payouts. In other cases, these companies are forcing old folks to take smaller payouts to keep their existing premiums.
That’s a tough situation. And one of the main causes is the lack of safe, attractive investment opportunities for insurance companies.
How can scientists and engineers help?
Innovation. We need disruptive new technologies, and means to deliver these technologies to the market. Old people are depending on us.
This story shows the limits of financial engineering. Sure, insurance companies can find ways to raise premiums or limit payouts. They can add new surcharges. They can change their mix of offerings to try to offer more of the higher-end stuff, and less of the lower-end stuff.
But there’s a limit to that kind of engineering. You can only eliminate so much inefficiency. And the more you cut, the more strain you put on the relationships you have with existing customers.
That’s why we need innovation. We need it for all the obvious reasons, but we need it for some nonobvious reasons too. One nonobvious reason? Helping old people get long-term care.
Innovation helps companies deliver huge chunks of value to customers. When customers pay for that value, companies have fuel for growth. That’s how you break free of a low interest rate environment with few attractive investment opportunities. You change the game.
Trust me, I know how easy it is to write those words. There’s not an innovation recipe. It’s kind of magical, frankly. But it’s not impossible. Scientists and engineers are on the frontlines of this battle.
I like to think about the broader impacts of what we do for a living. Yes, we help the companies we work for succeed. That success doesn’t come in a vacuum. The success of one company can have a domino effect, where other companies succeed as a result.
Spread enough success throughout our economy, and old people won’t have to worry about paying more for less care than they expected. That’s kind of cool, right?