The importance of the regulatory environment

 

Regulation is vital to ensure that policyholders can feel confident buying insurance products. Inappropriate regulation, however, can have a significant impact on the ability of insurers to function effectively and sustainably and to supply the insurance products that individuals and businesses wish to purchase. Against the background of growing public debt and ageing populations in developed economies, with the resulting strains on state social welfare and taxation systems, it is increasingly important to ensure that the regulatory environment supports a wellfunctioning private insurance sector. The product development and pricing strategies of companies are often driven by the regulatory environment in which they operate. Individual companies can be affected by regulation that is unsuitable for their business. International groups can be affected by inconsistencies in regulatory environments that can even lead to corporate restructurings. Below are just four examples of areas in which regulation can affect the optimal functioning of the insurance market. They show how important it is that all the possible implications are considered when regulations are developed or revised. 

Enough capital, but not too much 

Insurers need to be able to provide cost-effective insurance to policyholders while also holding sufficient capital to pay claims. It is vital that the capital that insurers are required to hold is proportionate to the risks they are taking; the regulatory requirements should inspire consumer confidence but should not be overly prudent. Should companies be forced to hold excessive capital, there is the risk that the additional costs could be passed on to policyholders through higher premiums, that products could be redesigned to offer fewer guarantees and benefits to policyholders, or that products could be withdrawn altogether. This could potentially result in individuals and companies buying less insurance and therefore retaining more risk themselves, with detrimental consequences for society and the economy.

Recognising the long-term value of insurance  

The size of the private pension market held by insurance companies is significant. Insurers are also major long-term institutional investors. Should regulation discourage insurance companies from holding long-term assets, this could affect the insurance industry’s ability to provide efficient savings and pension products. It would likewise reduce the industry’s role as a long-term investor in the financial markets and thus its crucial role as a stabiliser of market volatility. Any reduction in the level of savings or private pension provisions could result in increased costs for social welfare systems and could have an impact on the wider economy. 

Differentiation, not discrimination 

The fewer restrictions placed on the number and type of rating factors that insurers can use, the more competitive and innovative they can be. This benefits both policyholders and society as a whole, as shown in the previous section. Such risk assessment does not constitute unfair discrimination, in fact quite the opposite. Differentiation is the fairest way to ensure that the premium charged accurately reflects the risk. It is also the fairest way to ensure that a maximum number of people can be offered insurance at an affordable price. Risk assessment is not only economically efficient, it also helps to reduce moral hazard and adverse selection, as shown in the example of smokers and non-smokers on p8. The person seeking insurance will always know more about their risks than the insurer. Nevertheless, the risks to the insurer can be minimised through appropriate risk assessment and information collection. This benefits all insureds. If legislators impose restrictions on the information that can be gathered or used by insurers, perhaps in order to avoid perceived unfairness, insurance companies may charge higher premiums to policyholders in order to compensate for the higher degree of uncertainty surrounding the risks they are taking on. Here it is also important to mention the importance of the collection and free dissemination of data, such as ensuring public access to local authorities’ data related to flood risk. 

Freedom to insure what is insurable 

As we have seen, risk assessment and risk-based pricing in a private market not only enable insurers to set fair premiums but also enable them to innovate and develop new or more sophisticated products for existing or emerging risks. Such insurance markets are the most dynamic and cost-effective. Any regulation to make specific types of insurance compulsory should therefore always be carefully considered, as despite being well-intentioned it could actually have the opposite effect to that intended; ie stifling innovation and economic efficiency.

An effective regulatory environment is the key to successful operation of the insurance market. To be effective, the regulation needs to fully take into account the unique characteristics of insurance.