The Decline of Certainty

by Eugene Anderson and Alice Oshins

The underlying assumption of insurance buyers is that, in the event of a loss, a claim will be paid in full. If insurance is seen as less than reliable and certain, its perceived value drops, dramatically. Why? Because certainty—or rather, the quest for certainty—is the main reason for insurance. Despite the fact that we know nothing in life is truly certain, we continue to buy insurance, primarily because it makes us feel more secure.

Economists Richard and Barbara Stewart have carefully analyzed this assumption as it relates to insurance purchasing and have determined that certainty is no longer likely or even feasible. In their article, “The Loss of the Certainty Effect” (Risk Management and Insurance Review, May 2001), they assert that while “the insurance buyer’s belief that claims will be paid is essential to the value of what insurers sell . . . recent changes in the insurance business have placed a cloud over the assumption of certain payment, particularly for large commercial buyers of property/casualty insurance.”

The individual wrongful denial of claims, when taken cumulatively, is leading to a loss of the so-called certainty effect. This loss, the Stewarts believe, could ultimately bring about the demise of insurance companies as we know them. “From an insurer’s point of view, denying coverage for large claims has become an effective—perhaps even necessary—strategy. Insurance companies have economic incentives not to pay. The damage to any one insurance company when it wrongfully denies a claim occurs some time in the future, whereas the benefits of refusing to pay a claim are immediate. From a policyholder’s point of view, the cost of collecting a claim has gone up and the reliability of insurance has gone down.”

If insurance were seen by buyers as less than certain, the Stewarts argue, the resulting discounting of its value and buyers’ willingness to pay for it would be drastically impacted.What, then, are the remedies for the loss of certainty? One approach is increased disclosure. An insurance department in a market conduct examination, or a court in a punitive damages trial, could require an insurance company to disclose its handling of all comparable claims.

Or insurers could make claims payment practices a competitive advantage. The industry could develop benchmarks and other measures of insurers’ claims performance. Such a competitive free market could force all insurers to adopt similar industrywide practices.

Another approach is for risk managers to use securitization—the purchase of a bond that is wholly or partly forgiven if a designated proxy for a catastrophe, such as a hurricane, occurs. This liability derivative’s worth depends on having as little basis risk and counterparty risk as possible.

The Stewarts admit that these approaches, and others like them, are “unlikely, difficult, and not certain to succeed.” But the biggest failing of any potential remedy is the possibility that participants in the insurance transaction—insurers, brokers, policyholders, regulators, lawyers, courts and commentators—will do nothing to alleviate the loss of certainty. If these groups deal only with individual claims and not with preventing the loss of the certainty effect, the Stewarts fear, it will resolve itself in a downward spiral with dire consequences for both insurers and their corporate clients. Eventually, corporations could decide that having commercial insurance has little or no advantage and seek alternatives.

How could something so vital to public service become irrelevant? The short answer is that the insurance profession, with its long history of public service, has become the insurance business. As Ross Davidson writes in the Journal of Insurance Regulation, “The courts have identified [insurance] as a business ‘affected with the public interest.’” The industry, however, appears to no longer see itself as a faithful servant of the people, with countless disputes in many coverage areas making it the single largest user of the civil justice system.

The very essence of risk is providing coverage (a certainty) for unforeseen events (the uncertain). In following a quest for their own certainty, insurers have paradoxically created their own uncertain future.

Eugene Anderson is the founding partner of Anderson Kill & Olick P.C. in New York. Alice Oshins is an attorney and director of corporate communications at TIAA-CREF in New York.

Published Risk Management Magazine, February 2003

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