Insurance Float, Penalty Interest and Standards of Reasonability

Transcription

1 Insurance Float, Penalty Interest and Standards of Reasonability A Financial Analysis of the Use of Float by Property-Casualty Insurers and the Reasonability of the Texas Penalty Interest Rate Robert P. Hartwig, PhD, CPCU Clinical Associate Professor of Risk Management, Insurance and Finance Co-Director, Center for Risk and Uncertainty Management Darla Moore School of Business University of South Carolina JANUARY P a g e

2 Insurance Float, Penalty Interest and Standards of Reasonability A Financial Analysis of the Use of Float by Property-Casualty Insurers and the Reasonability of the Texas Penalty Interest Rate Robert P. Hartwig, PhD, CPCU University of South Carolina 1 JANUARY 2017 The Promise to Pay: A Promise Kept The promise to promptly and fairly indemnify policyholders under the terms of purchased insurance contracts is at the core of the trust-based relationship that insurers maintain with their customers. Without faith that insurers will fulfill their promises, insurance has no value. In 2016, property-casualty insurers alone paid nearly $400 billion in claims, large and small, to millions of policyholders across the country a sum equivalent to more than two percent of national GDP. Telling Float from Fiction In the financial literature the term float typically refers to the difference between the cash balance on a company s books and the balance as shown in its bank accounts. The difference is accounted for by recognizing that not all payments that the firm has made (e.g., checks that have been written) for the goods and services it has purchased have been presented to the firm s bank for payment. In the interim, this sum the float is temporarily available to invest and earn interest. 2 Investing the float is a normal part of a company s cash management procedures. A related but meaningfully different concept known as insurance float applies to insurers. There often exists a lag between the time that an insurer establishes a reserve for a claim that has occurred and the time that the claim is fully paid and closed. During the interim, the insurer will invest the funds the float and earn investment income from the assets held. This situation is common because for some types of claims, including workers compensation or medical malpractice, the insurer may be paying the injured party over a long span of years even decades. For such long-tailed lines of insurance, the earnings from investments can be material. For shorter-tailed lines of insurance, including personal auto and property lines (such as homeowners and commercial property coverages), the interval between the emergence of a claim and payment is much shorter, hence reducing the opportunity to earn investment income. In either instance, the insurer invests whatever cash is available. It is critically important to realize that all else being equal, higher interest rates lead to lower insurance rates. This is because insurers explicitly factor expected investment earnings into their rate calculations. Hence, while insurers benefit 1 Clinical Associate Professor of Risk Management, Insurance and Finance and Co-Director of the Center for Risk and Uncertainty Management, Darla Moore School of Business, University of South Carolina. 2 Ross, Stephen A., Randolph Westerfield and Bradford D. Jordan. Fundamentals of Corporate Finance. 11 th ed. pp New York, NY: McGraw-Hill, Print. 2 P a g e

3 from insurance float through investment earnings, policyholders benefit through lower insurance rates. Again, the investment of insurance float is a normal part of an insurer s cash management procedures. Some critics of the industry have alleged that because the opportunity to earn investment income increases as the lag between the filing and payment of a claim increases, that insurers have an incentive to delay or even deny claims. The argument reveals a fundamental miscomprehension of how insurers operate and manage their claims functions. An insurer s claims operation is not a money center function. It is a customer service function. In practice, insurers, like other businesses, must operate in the best interests of their customers to succeed. As described below, the prompt payment of claims is an integral and necessary operating function of every successful insurer. An Insurer s Financial Strength Depends on the Quality of Claims Operation An insurance company, to be successful, must establish and maintain its financial strength and handle its claims fairly and expeditiously. An insurer s financial strength and the strength of its claims operation are inextricably linked. No insurer over the long run can maintain its financial integrity without also maintaining a strong claims operation. Exemplary claims service, including the prompt and fair payment of claims, constitutes one of the key elements of competition between insurers. Insurance is a ferociously competitive business and any insurer that consistently falls short of its promises to policyholders including the promise to pay claims in a timely manner risks losing them to competitors. The quality of a company s claims operation defines its market reputation more than any other factor. Losing customers is exceedingly expensive for insurers. The typical auto insurer, for example, spends between $500 and $800 to acquire a new customer. 3 Contractual, fiduciary, competitive and other factors all incent insurers to satisfy their customers in the handling of claims. Regulators, too, routinely monitor the claims operations of insurers, providing policyholders with an added layer of assurance. Policyholders in all fifty states are protected by Unfair Claim Settlement Practices Acts. Among other things, these statutes specify the maximum length of time that can transpire before a claim must be settled, with special provisions governing the treatment of disputed claims. In all cases, regulators seek to ensure that a fair and transparent process exists and operates in the best interests of policyholders. Float: A Financial Analysis Delaying claims for the purposes of earning additional investment income is not financially advantageous to the insurer. There are two key determinants in this analysis: i. Investment Yields: For delaying a claim to be advantageous to an insurer, the return on the withheld funds must be sufficient to offset all costs associated with delay, including 3 William Blair Equity Research, Auto Acquisition Cost Report Update: Expense Structure a Key Growth Differentiator, May 25, P a g e

4 losses associated with new customer acquisition and potential litigation, mediation or arbitration costs. ii. Customer Acquisition Costs: Loss of a customer is arguably the highest probability cost incurred by an insurer that delays claims for the purpose of earning additional investment income. These costs are typically high for property-casualty insurers and will increase with the length of delay. Investment Yields As a first analysis, it is instructive to examine the actual investment returns available to insurers, taking into account the possibility that delays in claim payments will invariably lead to a loss of customers and high costs to acquire new customers to replace them. When a claim occurs, insurers establish a reserve to pay the expected future costs of the claim. The funds are invested at the prevailing rate of return available for new investments, known as the new money yield. The new money yield, as the name suggests, is the yield available on assets at current market prices that are suitable for the claim reserve being established. It is important to note that the claim reserve is recorded as a liability on the insurer s books and must be held in highly-rated, highly liquid funds. This requirement greatly limits the universe of potential investments available to insurers. As a practical matter, the vast majority of insurer investments are held as cash or cash equivalents, short-term securities or shorter-maturity bonds. The quality, liquidity and maturity structure of insurer investment portfolios assures that funds will be available to pay claims as they arise but also act as an implicit barrier to achieving anything other than fairly low yields. It is clear from Figure 1 that the new money yield has plunged over the past decade, in large part due to the Federal Reserve s efforts to stimulate economic growth by keeping interest rates persistently low. In 2015, that yield was 1.7 percent, close to its lowest level over the past 30 years (see Figure 1). Indeed, given that the core rate of inflation was 1.8 percent in 2015 according to the U.S. Bureau of Labor Statistics, the real (inflation-adjusted) return on new money was actually negative 0.1 percent. In other words, the funds allocated to establish reserves actually lost value in 2015 after accounting for inflation. The notion that insurers would want to delay claims for a few months only to earn negative real returns would seem to defy economic logic. A simple example will help to illustrate the point that there is no economic incentive to delay claims for the purposes of earning additional investment income. Assuming the current new money yield of 1.7 percent and a claim totaling $10,000 that is delayed for six months, the insurer would earn, in theory, $85 on the float. Assuming a 35 percent marginal corporate tax rate, the earnings are reduced to approximately $55. If the insurer delays the claim for one month, its earnings on the float are barely $9 after taxes. Would an economically rational insurer risk losing a customer that it paid $500 or more to acquire for $9 or even $55? The answer is no because the probability of loss of that customer is high and increases with the length of delay, resulting in a negative rate of return for the insurer in virtually every circumstance. This point is demonstrated in the following section. 4 P a g e

5 Customer Acquisition Costs Using the example of acquisition costs ranging from $500 to $800 for auto insurers, and assuming that the probability of a policyholder leaving an insurer increases with length of delay, it is straightforward to demonstrate that there is essentially no possibility that an insurer would gain from systematically delaying claims. In fact, the opposite is true. Table 1A illustrates this point. The table shows expected new customer acquisition cost to the insurer associated with the probability of losing a customer for delays ranging from zero to six months, for acquisition costs ranging from $500 to $800 per customer, before applying any offsets for investment income earned by the insurer during the delay. An insurer with customer acquisition costs of $500 and a delay of six months, for example, can expect to incur costs of $200, which is equal to the 40 percent probability of losing the customer as a consequence of the delay multiplied by the insurer s acquisition cost of $500 (i.e., 0.40 x $500 = $200). Auto insurers often cite customer retention ratios in the neighborhood of 90 percent. Hence, the probability of losing a customer is approximately 10 percent in a given year under normal competitive conditions. In a competitive market poor claims service, including the delay of claims payments, will put the insurer at a competitive disadvantage, increasing the probability that a customer leaves. In Table 1A, the assumption for the purposes of this example is that the probability that a policyholder leaves increases by five percentage points for each month of delay. Table 1A indicates that insurers will sustain an expected loss for every combination of customer acquisition cost and probability of customer loss. But are the conclusions of this analysis changed by the inclusion of investment earnings derived from insurance float? Specifically, does the inclusion of float offset expected customer acquisition costs thereby making intentional delays profitable for the insurer? The answer is no. This important finding is displayed in Table 1B, which shows that insurers could still expect to lose money for every length of delay across the full range of customer acquisition costs even after investment earnings from float are applied to the expected losses from customer attrition. To illustrate this point, we use the hypothetical $10,000 claim example from the previous section in which a claim is delayed for six months with the insurer earning an additional $55 in after-tax investment income. Table 1B clearly indicates that delaying a claim remains a money-losing proposition for the insurer, which displays the loss to insurers after accounting for investment earnings derived from the investment of float. Even for an insurer with low acquisition costs of $500 per customer, and despite the additional $55 in investment income, the expected net loss to the insurer is still $145. This figure is calculated as the difference between the insurer s $55 in additional after-tax investment earnings and its expected customer acquisition cost of $200 (i.e., +$55 - $200 = -$145). Again, the $200 expected acquisition cost incurred by the insurer is based on a 40 percent probability that the customer will leave as a result of the six-month delay (i.e., 0.40 x $500 = $200). For an insurer with high acquisition costs, the losses are larger still. If the insurer s acquisition costs are $800 per customer, the expected loss to the insurer following a six-month claim delay is $265 (i.e., $320 = -$265). Even short delays can be very costly to the insurer. With a delay of just one month (implying a 15 percent probability of customer loss) and the lowest possible acquisition cost of $500, the insurer still loses $66, calculated as the difference between the insurer s after-tax investment gain of approximately $9 (one 5 P a g e

6 month s investment earnings on float at 1.7 percent) and its expected customer acquisition cost of $75 (i.e., +$9 - $75 = -$66). Indeed, for every combination of length of delay and customer acquisition cost in Table 1B, the insurer can expect to lose money. This demonstrates the point that a strategy of systematically delaying claims in order to earn additional investment income from insurance float is not one that any economically rational insurer would adopt. The expected rate of return associated with the delay of claims is negative based on all reasonable assumptions related to the probability that a customer leaves and the additional customer acquisition costs incurred. The analysis holds true even if the probabilities that a customer leaves are greatly reduced. Table 2A shows the expected customer acquisition cost incurred assuming that the insurer retains 92 percent of their customers with no delay (8 percent probability of customer loss), increasing by just two percentage points for each additional month of delay (compared to increments of five percentage points per month in Table 1A). Once again, the inclusion of investment earnings from float does not alter this conclusion, as displayed in Table 2B. In the instance of a six-month delay and acquisition costs of $500 per customer, for example, the insurer would still lose money even though the probability that the customer leaves is just 20 percent (compared to 40 percent in Table 1A). The insurer s expected loss, despite the $55 in additional investment earning, is $45 (i.e., +$55 - $100 = -$45). 6 P a g e

7 Table 1A. Expected Cost to Insurer Associated with Claim Delays* Length of Delay (mos.) Probability of Customer Loss Expected Cost to the Insurer of a Delay for Specific Levels of Acquisition Costs (before accounting for investment earnings) $ 500 $ 600 $ 700 $ % $ 50 $ 60 $ 70 $ % $ 75 $ 90 $ 105 $ % $ 100 $ 120 $ 140 $ % $ 125 $ 150 $ 175 $ % $ 150 $ 180 $ 210 $ % $ 175 $ 210 $ 245 $ % $ 200 $ 240 $ 280 $ 320 Table 1B. Expected Cost to Insurer Associated with Claim Delays After Inclusion of Investment Earnings from Insurance Float* Length of Delay (mos.) Probability of Customer Loss Expected Cost to the Insurer of a Delay for Specific Levels of Acquisition Costs (after accounting for investment earnings) $ 500 $ 600 $ 700 $ % $ 50 $ 60 $ 70 $ % $ 66 $ 81 $ 96 $ % $ 82 $ 102 $ 122 $ % $ 97 $ 122 $ 147 $ % $ 113 $ 143 $ 173 $ % $ 129 $ 164 $ 199 $ % $ 145 $ 185 $ 225 $ 265 *Tables assume a new money yield of 1.7 percent and a hypothetical claim cost of $10, P a g e

8 Table 2A. Expected Cost to Insurer Associated with Claim Delays* Length of Delay (mos.) (Conservative Customer Attrition Assumptions) Probability of Customer Loss Expected Cost to the Insurer of a Delay for Specific Levels of Acquisition Costs (before accounting for investment earnings) $ 500 $ 600 $ 700 $ % $ 40 $ 48 $ 56 $ % $ 50 $ 60 $ 70 $ % $ 60 $ 72 $ 84 $ % $ 70 $ 84 $ 98 $ % $ 80 $ 96 $ 112 $ % $ 90 $ 108 $ 126 $ % $ 100 $ 120 $ 140 $ 160 Table 2B. Expected Cost to Insurer Associated with Claim Delays After Inclusion of Investment Earnings from Insurance Float* Length of Delay (mos.) (Conservative Customer Attrition Assumptions) Probability of Customer Loss Expected Cost to the Insurer of a Delay for Specific Levels of Acquisition Costs (after accounting for investment earnings) $ 500 $ 600 $ 700 $ % $ 40 $ 48 $ 56 $ % $ 41 $ 51 $ 61 $ % $ 42 $ 54 $ 66 $ % $ 42 $ 56 $ 70 $ % $ 43 $ 59 $ 75 $ % $ 44 $ 62 $ 80 $ % $ 45 $ 65 $ 85 $ 105 *Tables assume a new money yield of 1.7 percent and a hypothetical claim cost of $10, P a g e

9 Conclusions: The Financial Analysis of Float The preceding discussions examined the financial incentives for insurers to deliberately and systematically delay the payment of claims for the purposes of increasing insurance float and generating additional investment income. An examination of the yields available to insurers in the market revealed that such a strategy would lead to negative real rates of return for the insurer. When the possibility that customers may leave the insurer as the result of such delays is taken into account, the analysis demonstrates that such a strategy can lead to significant losses due in large part to the high costs of acquiring new customers. These findings are robust even for modest assumptions related to customer attrition and would apply to any competitive line insurance. The bottom line is that it is not in an insurer s financial interest to seek to maximize float at the expense of timely payment of claims. The rate of return to the insurer is unambiguously negative. Regulatory sanctions imposed on the insurer and reputational damage would impose additional downward pressure on the returns of any insurer adopting such a strategy. It is important to note that there are many legitimate reasons for claims to remain open for an extended period of time such as knowledge of and investigation of fraud. Yet it is attorney involvement in a claim that drives up the number of days before closure more than any other factor. In a December 2016 report by the Texas Department of Insurance (TDI) to the state s House Insurance Committee relating to hail claims, the TDI found that for claims with attorney involvement, the average number of days to claim closure was 697 a span of nearly two years compared to 95 days for claims without attorney involvement. 4 Penalty Interest Rates and a Standard for Reasonableness As discussed previously, the investment of insurance float is a normal part of every insurer s cash management operations. Yet there have been occasional accusations that insurers deliberately delay the payment of claims for the purposes of maximizing the benefit of that float. This assertion has been used for many years in Texas to justify a penalty interest rate of 18 percent the highest in the country that is imposed on insurers following a determination that a claim had not been paid in a timely manner. In this section we conduct a financial and historical analysis of the penalty interest rate in Texas and conclude that the current rate of 18 percent is unreasonable and arbitrary. (i) (ii) (iii) The rate is currently more than 10 times the new money yield available to insurers for the purposes of investing insurance float; The rate has become increasingly punitive and burdensome over the past decade, with current interest rates far lower than when the 18 percent penalty rate was adopted in the 1990s; There exists no mechanism in statute whereby the rate can be benchmarked against the prevailing level of interest rates and adjusted accordingly; 4 Texas Department of Insurance, Report on TDI s Residential Property Hail Litigation Data Call, p. 20, December 1, P a g e

10 (iv) (v) The rate is higher than those imposed by the small number of other states with insurance industry-specific penalty interest rates, and The rate is higher than other state-imposed punitive interest rates including those that apply to pre-judgment interest. The rate is also higher than penalty interest rates imposed by the federal government, including the interest rate charged by the Internal Revenue Service for the late/non-payment of federal income taxes. Texas Penalty Rate of Interest vs. Other States At 18 percent, the penalty rate of interest in Texas is the highest in the country. Only five states appear to have penalty rates that apply to matters associated with insurance claims. Figure 2 shows that the penalty rate of interest ranges from a high of 18 percent in Texas to a low of 10 percent in Tennessee, with the remaining three states Arizona, Michigan and Wisconsin at 12 percent. Texas Penalty Rate of Interest vs. Other Government-Imposed Rates Government-imposed rates of interest, including those with a punitive element, are not uncommon. They exist, for example, within regulatory statutes (as in Texas insurance statutes), the judicial system and in tax codes. Prejudgment interest, imposed by courts, and the penalty interest rate imposed by the Internal Revenue Service (IRS) on delinquent federal taxes are perhaps the best known of these latter two rates. A comparison of these two rates with Texas s penalty interest rate, as displayed in Figure 3, once again reveals the Texas rate to be an outlier. Note that even large corporations that are delinquent on their federal taxes potentially owing the government millions of dollars are charged an interest rate of just six percent, only one-third the Texas penalty rate. The IRS rate, like the Texas rate, is intended to be punitive. The major difference between the two rates, however, is that the Texas penalty rate of interest is permanently fixed at 18 percent by statute whereas the IRS-established rate is adjusted quarterly based on current market interest rates. Figure 4 shows how that IRS rate has been adjusted both upwards and downwards over time in response to the changing interest rate environment, maintaining a stable margin between the rate paid by delinquent taxpayers and a key underlying short-term federal interest rate. By periodically adjusting its penalty rate, the punitive intent of the rate is maintained but in proportion to actual market interest rates. Texas Penalty Rate of Interest vs. Key Interest Rates Another means for examining the reasonability of the Texas penalty rate of interest is to compare the relative magnitude of that rate against other key rates of interest. The Texas penalty rate at a constant 18 percent has always been high by any standard. In relative terms, however, it has become consistently higher over the years. Figure 5 illustrates this point vividly. During the 1990s, when the Texas penalty rate entered statute, the rate was typically 3.0 to 3.5 times the new money yield available to propertycasualty insurers. Today, the Texas penalty rate is fully ten times that of the new money yield. This exemplifies the increasingly punitive impact of the rate. As noted earlier (and displayed in Figure 3), the Texas rate today is also triple the IRS rate for delinquent large corporate tax payments. This gaping 12 point differential is up materially from 7 to 9 points during the 1990s. Likewise, as shown in Figure 6, the Texas penalty rate was approximately 3.5 to 6.0 times the federal funds rate. In recent years, the Texas 10 P a g e

11 rate has been 90 to 180 times that rate. This divergence with short-term federal interest rates is critically important because, as noted earlier, many punitive interest rates (including IRS rates on delinquent tax payments) are pegged to such rates. Summary The intensely competitive nature of insurance markets assures that claims service is and remains focused on the policyholder experience. Regulations governing the fair handling of claims reinforce that focus. In this paper we have demonstrated that playing the float to the detriment of consumers is not in the economic or financial interest of insurers. By constructing a simple model that considers both potential earnings on float and the probability of customer loss, it is clear that even relatively low levels of customer attrition can result in substantial losses to the insurer that swamp any incremental investment gains earned by increasing float with the intent of generating additional investment earnings. 11 P a g e

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