March 09, 2015

Drawing the Line Between Gambling and Finance:
Part II—Insurance: Gambling on Catastrophe

Note:  This is the second article in a series looking at the legal connections between gambling and finance. The first article introduced the legal concept of aleatory contracts. Links to subsequent articles can be found at the conclusion of this article (when available).

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Types of Insurance

Insurance is probably the most familiar and ubiquitous of the aleatory contracts. People face a variety of significant financial risks, such as house fires, car accidents, injuries and illnesses, or even the loss of income from the death of a family member. People can protect against these large, even catastrophic, financial losses by purchasing property insurance, casualty insurance, health and disability insurance, and life insurance, respectively.

Just about any risk can be insured, for a price. Most individuals rarely need anything more than “off the shelf” personal lines of insurance (e.g., homeowners’/renters’ insurance and auto insurance), along with health and life insurance. Businesses tend to carry “off the shelf” commercial lines of insurance, usually including at least a basic group of insurance coverages for commercial property, automobile, general liability, and workers’ compensation. Businesses also will take out additional insurance tailored to their particular business needs. Common commercial insurance coverages include aircraft, product liability, fidelity and surety, professional liability (a/k/a malpractice insurance), directors and officers, and inland marine policies (which ironically usually have nothing to do with either the ocean or soldiers).

Individuals or businesses having special risks not covered by a standard policy can obtain insurance by use of an endorsement or rider which expands coverage under a standard policy; this generally requires special underwriting review, additional premium, and special conditions or limitations on coverage. Particularly large or unusual risks often need to be insured via a special policy specifically written for the risk, often referred to as surplus lines insurance. Lloyd’s of London is famous for this type of specialty underwriting, often insuring singers’ voices or athletes’ bodies, as well as movie productions and rare art and jewelry. Insurers will write policies for events as silly as a hole-in-one at golf, or as difficult to predict as weather. For those individuals who are at risk (mostly teens in bad movies), there is even insurance available in the event the insured is abducted by aliens or turned into a vampire or werewolf.

Insurance as Wagering

An insurance contract essentially operates like a wager. The person purchasing insurance is betting a small amount of money (the “premium”) that a particular event will occur (e.g., his house burns down), in which case the insurance company will pay him the policy “benefit” (here, the value of his house. Given the asymmetrical financial arrangement—small premium, large potential benefit—how does the insurance company make money?

Insurance companies rely on two concepts to set the correct premium for a given insurance policy—underwriting and risk pooling. Underwriting looks at a variety of factors—e.g., geography, age, gender, type of business—which have been found to statistically correlate with the particular risk being insured, charging a greater premium for insuring more risky insureds. For example, a college-aged single male with multiple moving violations on his driving record is more risky to insure than a middle-aged married woman. Conversely, a middle-aged female smoker with diabetes would pay a higher life insurance premium than a healthy college-aged male. And some geographical regions will have a greater or lesser overall risk of car accidents or mortality.

In some respects, underwriting is analogous to a sports book operator setting a wagering line on a proposition ("prop") bet. Unlike traditional sports wagers on the winner of a game, the point spread, or point totals (over/under bets), prop bets are one-off wagers on individual occurrences in a game. For the recent Super Bowl, gamblers could bet on props such as the length of the national anthem, which player would score first, and which player would be named MVP. The research the sports books put into setting those odds at a level which would attract action while still giving the house a profit is essentially the process of underwriting.

Insurance Company as Casino

Still, even with underwriting, it is impossible to predict whether any particular individual risk will occur. In other words, while we know young men are more likely to be in car accidents and older smokers are more likely to die, we can’t predict which specific individuals will be in a car accident or die. Even if an insurer properly underwrites a particular risk, random chance may strike and require the insurer to pay off the policy benefit at a large loss.

Insurance companies avoid this risk by implementing risk pooling. Risk pooling harnesses the law of large numbers, which essentially states that over a large number of trials, a probabilistic outcome will approach its expected value. By writing thousands of similar insurance policies, an insurer can spread the risk of losses over the entire block of policies, and hope to experience losses commensurate with its underwriting assumptions.

In risk pooling, insurance companies operate in a fashion analogous to both pari-mutuel wagering books and standard casinos. In pari-mutuel betting, all wagers are pooled together and the house commission (a/k/a “vig”) is taken out. The remaining pooled funds are paid to winning bettors in a proportional manner. Insurance companies similarly pool premiums and pay off “winners” (those who have insurance claims due to an insured loss) with premiums from "losers" (ironically, those who did not suffer a insured loss). The insurance company keeps the remaining funds—known as “underwriting gain”—to cover expenses and for profit. [FN1]

The pari-mutuel wagering analogy breaks down to a degree, however, because a pari-mutuel book will never take a loss paying off winning wagers. An insurance company, by contrast, can have instances in which, for a particular policy year or for a particular block of policies, the paid claims exceed the premiums charged. This type of “underwriting loss” situation is actually rather common in the property insurance field, where one or several large-scale events—hurricanes on the Southern or Eastern coasts, tornadoes in the Midwest, fires or mudslides in California—cause both widespread and high-dollar losses. Insurance companies deal with short-term underwriting losses in several ways: viewing underwriting gain/loss over time (i.e., a block of policies may be unprofitable in individual years yet profitable over ten or twenty years), raising renewal and new issue premiums to recoup losses, and entering into reinsurance arrangements (discussed in Part III of this series).

Given the potential for underwriting loss over the short-term, the use of risk pooling in insurance has a stronger analogue in casino operations. On any given individual wager, the casino knows it has only a small statistical edge. The casino can’t predict which individual wagers will win or lose, or which individual gamblers will walk out with a profit or a loss. Further, casinos can experience short-term losses when a large single bet pays off (e.g., a slot jackpot), or when the casino experiences significant negative variance on wagers by high rollers (Vegas casino gaming revenues are notorious for significant swings from the performance of its high-stakes baccarat tables). But the casino does know that the more wagers it takes, the closer its profits will reflect its weighted average expectation for the built-in house advantage.

Like a casino, an insurance company is indifferent to whether any particular policyholder “wins” or “loses”. In fact, no insurer can predict which of its insureds will “win”—i.e., suffer a loss and be entitled to benefits in excess of the premium paid. The insurer operates by assuming that it has properly underwritten and priced the block of policies such that in the aggregate the total premiums charged will, over time, exceed the total benefits paid. The larger the risk pool, the closer the insurance company’s experience for the block of policies will track with its actuarial projections.

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[FN1] An insurer also makes money on its investment portfolio. The funds ("reserves") held by the company to back its in-force insurance policies and expected claims are invested, predominately in high-grade bonds, along with some other types of permitted securities and assets (state insurance regulators monitor these investments closely for both risk and liquidity). The return on the investment portfolio is included in the setting of premium and expense charges for policies, keeping premiums and expense charges lower than would otherwise occur in a strict risk pooling arrangement. Income from the investment portfolio, rather than underwriting gain, has become the primary driver of profits in modern insurance.

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Additional articles in this series (links will be added as each section is posted):

Part I—Meet the Aleatory Contracts

Part III—The Reinsurer, the Bookmaker, the Poker Pro Staker

Part IV—Derivatives and Daily Fantasy Sports

Part V—Hedgers and the Law

Part VI—Speculators and the Law

Part VII—Risk Creation v. Risk Management

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