In response to the insurance industry’s shortcomings, the public sector has increased involvement with high-severity risks, such as flood and terrorism, and in markets disfavored by private insurers. In October 2021, the United States Department of Treasury announced an investigation into the insurance sector’s ability to support the economy considering associated climate-related financial risks.
In recent years, the private insurance sector has deployed new strategies to address increasing insurance coverage deficiencies. Parametric policies, which are marketed as a supplement to traditional insurance policies, are one such innovation. A parametric policy is triggered upon a described “parameter” in the policy, and a claim payment is automatically made upon occurrence of that event. The policyholder has a specified time (one year for example) to certify they sustained losses of at least the amount paid by the parametric policy. However, no actual physical damage to the insured property is required, and carriers do not conduct an investigation to verify that claimed losses are tied to the policy parameter. This arrangement pushes the boundaries of insurance closer to gambling and wager contracts.
Creative solutions are required to close the growing uninsured gap and avoid government intervention in natural catastrophe insurance, similar to what has occurred with flood and terrorism exposures. However, insurers must carefully implement changes in close concert with the government to ensure they do not revert to the speculative wagers historically passed off as “insurance.”
The Modern Insurance Industry Draws Its Roots from a History Steeped in Gambling
In the United States, the insurance industry has gained an uber-conservative, stuffy, and dull reputation in society. This perception, accurate or not, has not always been so prevalent. Much of the modern-day western insurance industry traces its roots to seventeenth-century England and Lloyds of London. Lloyds of London remains a vibrant marketplace for insuring risks to this day. However, at its inception, Lloyds of London looked vastly different than it does now.
In the late 1600s, coffee houses in London served as central meeting spaces to discuss business, news, and gossip. Many coffee shops gained reputations within “particular trade, profession, class party, or nationalit[ies].” One such coffee house was owned by Mr. Edward Lloyd, originally located on Tower Street. The first record of Mr. Lloyd’s establishment is in the London Gazette in February 1688, in which an ad was placed offering a reward for the return of five stolen watches.
Mr. Lloyd’s coffee shop was located in London’s headquarters of “maritime commerce,” which was frequented by “able Tradesmen,” “Seafaring Persons,” and “foreigners who first practiced marine insurance in England.” This perhaps fortuitous combination is credited as the genesis for Lloyd’s association with marine insurance. Lloyd’s coffee house continued to gain notoriety, and, in 1691 or 1692, Lloyd relocated his establishment to the corner of Lombard Street and Abchurch Lane, to serve as the “meeting place of merchants of the highest class.” Lloyd’s coffee house increasingly became associated with maritime industries, holding sales of ships and inventories. Lloyd’s “personal activity and intelligence . . . was proved in the course of a few years by an event of special interest, the establishment by him of a weekly paper furnishing commercial and shipping news.” The paper, “Lloyd’s News” was published for less than a year, with seventy-six editions in total. While short-lived, the paper further raised Lloyd’s notoriety and association with marine activities. The general form of the newspaper was revitalized in 1726 and was eventually re-named to “Lloyd’s List,” which exists to this day.
In the summer of 1720, London was “infected” by a gambling “disease,” which originated in France in 1718–1719. “[D]upes and rogues marched arm in arm, everybody speculating wildly, seriously believing to be able to acquire wealth in a day by passing bits of paper from hand to hand.” Some of the schemes involved “insurance” products, including insurance for “increasing Children’s fortunes”; “Assurance of Female Chastity”; and “Assurance from lying” to name a few. Coffee houses were used as the meeting place for speculators to carry out their deals.
Marine insurance, designed to protect against damage to ships and cargo, also existed among the various schemes, but was viewed as the “most practical.” In 1720, English parliament granted exclusive marine insurance underwriting rights to two companies, the London Assurance Corporation and the Royal Exchange Assurance Corporation. However, the statute also “declared that any private . . . person or persons shall be at liberty to write or underwrite any policies . . . for, or upon any ship or ships, goods, or merchandises at sea. . . .” The two chartered companies initially struggled, which pushed much of the marine insurance market toward private individuals (or “Underwriters”) such as those that frequented Lloyd’s coffee house, which were excepted from the statute. Lloyd’s continued to develop its marine insurance market share and legitimacy in the late 1730s through publication of Lloyd’s List—distributing marine and shipping intelligence.
However, Lloyd’s coffee house was not immune from practices involving speculative schemes. Alongside the “legitimate” and “practical” business of marine insurance, “there came to intrude . . . adventurers of all kinds, some of them speculating in hazardous schemes, and others mere gamesters.” For example, wagers were placed on political elections, public figures’ lives, foreign politics, and war.
Wager policies, as they were called, were common in the 1730s and 1740s. The distinction drawn between “insurance” and “wager policies” was that “in policies upon interest (‘insurance’), you recover for the loss actually sustained, whether it be total or partial: but upon a wager policy, you can never recover but for a total loss,” because the risk is all or nothing. Lord Mansfield, an eighteenth century English judge, recognized insurance as “a contract of indemnity, and of great benefit to trade.” However Lord Mansfield also felt use of insurance “was perverted by its being turned into a wager.” Many insurance products departed from traditional societal benefits, and “instead of confining the business of insurance to real risks, and considering them merely as an indemnity to the fair dealer against any loss which he might suffer in the course of a trading voyage . . . the practice of insuring ideal risks [without proof of interest] . . . was increasing to an alarming degree.” The policies, “having no reference whatever to actual trade or commerce, were very justly considered as mere gaming or wager policies, and therefore the legislature thought it necessary to give them an effectual check.”
Activities within Lloyd’s did not go unnoticed by lawmakers and the “effectual check” came with the Marine Insurance Act of 1745, “which sought to put an end to the practice of wagering disguised by marine policies.” The Act labelled wager policies as a “mischievous kind of Gaming or Wagering, under the Pretence of assuring the Risque on Shipping, and fair Trade, the Institution and laudable Design of making Assurances, hath been perverted; and that which was intended for the Encouragement of Trade and Navigation, has . . . become hurtful of, and destructive to the same. . . .” The law prohibited all forms of insurance where assured parties did not have an insurable “interest” in the subject matter. Passage of the Marine Act of 1745 apparently did not entirely dissociate gambling from insurance activities. Clearly, Lloyd’s had earned a reputation within London, with the London Chronicle writing in 1768 that “[t]he introduction and amazing progress of illicit gaming at Lloyd’s coffee-house is among others a powerful and very melancholy proof of the degeneracy of the times.”
Lloyd’s recognized its own shortcomings and the perhaps inevitable involvement of the Crown, following passage of the 1745 Marine Insurance Act. Initially, in 1771, a group of Underwriters branched off to form “New Lloyd’s” with the intent of distancing themselves from the disreputed practices of “Old” Lloyd’s. After several years of failing to identify a suitable permanent home, “New Lloyd’s” was formally established in 1774. At the first “New Lloyd’s” meeting in March 1774, the following resolution was passed: “Shameful Practices which have been introduced of late years into the business of Underwriting, such as making Speculative Insurances on the Lives of Persons and on Government Securities.” The resolution went on further to recommend that “Insurers in general will refuse subscribing such Policies, and that they will show a proper Resentment against any Policy Broker who shall hereafter tender such Policy to them.” “New Lloyd’s” was started with a clear stated goal of moving away from its historical “illicit gambling” past.
While the Marine Act of 1745 required policyholders to have an “insurable interest,” the statute did not specify what was considered an insurable “interest.” Clarification was provided in an 1806 English Court decision (Lucena v. Crauford), holding an insurable interest as, “a right in the property, or a right derivable out of some contract about the property, which in either case may be lost upon some contingency affecting the possession or enjoyment of the party.” This holding provided an initial legal definition of insurable interest, which remains a foundation of insurance today.
Marine insurance continued to develop largely through common law decisions, until the Marine Insurance Act of 1906. This act codified substantive principles of marine insurance developed through common law since the 1745 Act. The 1906 Act included an explicit definition of “insurable interest,” incorporating wording from the Marine Act of 1745 and concepts from Lucena v. Craufurd. The Act is still largely in force today.
Despite historical efforts to clean-up speculative activities, Lloyd’s carried a reputation as a gambling house as late as 1907, with the New York Times dubbing Lloyd’s the “Greatest Gambling House in the World.” The New York Times associated Lloyd’s with bets placed on trial outcomes, “the calamity of [birthing] twins or triplets,” political outcomes, and “the smallpox scare.” The Times wrote that “[m]arine risks are the one class of insurance officially recognized at Lloyd’s.” However, a subset of individuals within Lloyd’s were involved in “specialty” insurance, that “take the odd risks, for which the agency is the world’s market.” Such specialty policies were considered “entirely a matter of good faith and credit, and Lloyd’s as a body assumes no responsibility.”
In an effort to bolster the effectiveness of the Marine Insurance Act of 1906, the Marine Insurance Gambling Policies Act was passed in 1909. The Act imposed criminal penalties on individuals violating the civil components of the Marine Insurance Act of 1906, including insurers and brokers who knowingly placed policies in violation of the 1906 Act. Apparently, no prosecutions occurred under the 1909 Act, but the law may have deterred any residual gambling elements within Lloyds.
Insurance Development in the United States Initially Occurred During the Colonial Era and Primarily Grew out of the English Approach
The property insurance industry in the United States developed in a “compartmentalized fashion.” The first known insurance office located within the pre-revolution United States was opened near Philadelphia in 1721, which underwrote marine insurance. The market for insurance coverage expanded, and the first fire insurance company in the United States was “The Friendly Society for the Mutual Insuring of Houses against Fire,” which was in existence from 1735 to 1741. However, the first truly successful insurance company started in 1752, the “Philadelphia Contributionship for the Insurance of Houses from Loss by Fire,” established by Ben Franklin. Initially, these insurance products included coverage only for fire.
The scope of coverage afforded by insurance policies broadened as society matured. New products were developed to include coverage for boilers (1866), automobiles (1898), and crops (1938). In 1945, Congress passed the McCarran-Ferguson Act, effectively turning regulation of the insurance industry over to individual states. In 1950, the first homeowners’ policy combining multiple lines of coverage was introduced, and included “Fire, Extended Coverage, Theft, Personal Liability, and Medical Payments.” Coverage broadened further when “all-risk policies” (covering losses unless specifically excluded) gained popularity in the late 1950s “to meet the complexities of present-day living in our country.” In 1968, the National Flood Insurance Act was passed, providing federal flood insurance coverage, and, in 2002, the Terrorism Risk Insurance Act was passed, providing federal terrorism insurance coverage.
Basic Principles of Property Insurance
Insurance products are designed as a risk transfer mechanism. One party (the policyholder or “insured”) shifts the uncertain impacts from a fortuitous loss event to a third party (typically the insurance company). To accomplish this goal, the policyholder makes a payment (“premium”) to the insurance company, in exchange for the insurer’s promise to pay the policyholder if a stipulated event listed in a contract (“policy”) occurs. The amount of premium payment is determined based on the insurer’s evaluation of the risk presented by the subject of insurance. Property insurance is generally designed to cover real and personal property assets of the policyholder, as defined in the contract.
Insurance companies approach underwriting activities consistent with the law of large numbers theory. A premium is collected from many policyholders, with the idea that only a comparatively small number of parties will incur a loss requiring payment. In part, insurance carriers accomplish this result by ensuring their overall book of business has an adequate spread of risk, which may be accomplished through physical geographic spacing or diversification of insured industry classes, thereby mitigating “adverse selection.”
Some Argue the Modern Approach to Insurance Still Meets the Legal Characteristics of Gambling
Despite the insurance industry’s changed approach following legislation regulating ties between insurance and gambling, some theorists maintain modern insurance is still gambling proper. Others have argued insurance is the exact opposite of gambling, because insurance moves from an uncertain situation (a risk of loss) to a certain outcome.
Analyzing the Traditional Insurance Components to the Elements of Gambling
As previously outlined, an insurer assumes the risk of a fortuitous loss event occurring to its insured. The insurer issues a contract with a promise to pay in exchange for the insured’s payment of premium. Gambling “consists of three elements: consideration, prize and chance.” The insured’s “consideration” is the premium that they are obligated to pay to the insurer. “Chance” equates to the fortuitous risk of loss. Finally, “prize” is an insurer’s payment in the event the fortuitous event occurs. On first glance, the usual insurance arrangement appears to fit within the legal elements of gambling.
Typical Insurance Policies Are Not Viewed as Gambling Due to Requirements of Insurable Interest, the Principle of Indemnity, and Public Policy Reasons
Historical legal development of insurance has “tried to distinguish insurance contracts from gambling with requirements such as a valid insurable interest” and indemnification. An exception for public policy purposes is also advanced as an argument, given the societal benefits of risk pooling.
Requiring Policyholders to Hold an Insurable Interest in the Insured Risk Prevents Purely Speculative Arrangements
The principle of insurable interest, as drafted in the English Marine Act of 1745, defined in Lucena v. Craufurd (1806), and further codified in the English Marine Act of 1905, remains a staple in modern insurance. One of the primary purposes of requiring an “insurable interest” is to prevent gambling. Additional policy factors include diminishing “moral hazard and the temptation to fraud” and “reflect[ing] the nature of insurance as an indemnity.” Insurable interest ensures the policyholder is subject to a loss, before they are paid by the contract. Without requiring insurable interest, an individual could secure an insurance policy on property in which they have no financial stake—a neighbor’s house, for example. If an event covered by the insurance contract occurred to the neighbor’s house, the policyholder would be paid without having suffered any economic loss. In this hypothetical, the premium (consideration), “insurable event” (chance), and claim payment (“prize”) would clearly equate to gambling.
Indemnification Is the Second Core Principle That Distinguishes Insurance from Pure Gambling
Historically, the doctrine of insurance was consistently linked to the principle of indemnity. Indemnification provides that, after suffering a loss, a policyholder is placed back into the position they were at the time of loss, and not any better. To use an example, if a two-thousand square foot, average grade home is completely destroyed by a fire, an insurance policy will “indemnify” the homeowner by paying for a like kind and quality home.
Since insurance claim payments are indemnity-based, the policyholder is only “made whole” and not bettered. This restriction places an insurance claim outside the scope of gambling’s “prize” element. Prize is frequently defined as winning something of value or “a gift, award, or other item or service of value. . . .” If the policyholder has suffered a loss, and the insurance policy only places them back to the position that they were at the time of loss, then there is not a “prize” on a net basis. Therefore, indemnification payments do not satisfy the “prize” element, and, thus, insurance policies are not gambling.
Aside from the Protections of Insurable Interest and Indemnity, Insurance Is Afforded an Exception from the Heightened Scrutiny of Gambling Laws as a Matter of Public Policy
Insurance provides a degree of certainty and stability for individuals and the economy alike. “A risk-averse entity is willing to pay more than the expected loss to transfer a risk to another entity better able to pool the risk.” When a policyholder suffers a loss, they turn to their property insurance policy to pay for losses incurred. Without the policy, many homeowners may not be able to rebuild their house and continue paying a mortgage on property that no longer exists. Banks are unwilling to accept a mortgage or will only lend funds on unfavorable terms if adequate insurance is not in place on a property.
From a business perspective, insurers provide capital and certainty to companies recovering from devastating losses. Insurers also provide confidence to institutions lending to individuals and businesses. Premiums paid by policyholders are reinvested into the economy, spurring development. As a society, we rely heavily on the strength and stability afforded by the insurance sector to drive economic growth and provide a means of recovery after suffering catastrophic losses. As a matter of public policy, society has dissociated traditional insurance products from gambling, given the significant economic benefits.
Despite Well-Established Principles and Public Policy Differentiation Between Insurance and Gambling, Gambling Laws Frequently Include a Specific Exception for Insurance Products
Insurance policies so closely resemble the technical legal elements of gambling that legislatures and enforcement agencies have drafted specific carve-out language for insurance contracts from gambling laws and guidance. For example, the 2006 Unlawful Internet Gambling Enforcement Act specifically excluded “any contract for insurance” from the definition of a “bet or wager.” Arizona excludes “contracts of indemnity or guarantee, life, health or accident insurance” from its definition of “gambling.” Minnesota’s Alcohol and Gaming Enforcement Division has published guidance confirming insurance policies are not considered “bets,” despite depending on chance. Including specific exceptions for insurance within gambling regulations suggests government views insurance as encroaching on gambling.
Increasingly, Property Insurers Are Not Adequately Responding to Society’s Exposure to Risk and Economic Needs
The Swiss Re Institute has compared global economic catastrophe losses to global insured loss from 1980 to 2020. Its research identifies an alarming trend of uninsured losses increasing in recent years. Uninsured losses averaged less than $30 billion (inflation-adjusted) annually in the 1980s, steadily increasing to $100 billion in the 1990s, and peaking at $143 billion in 2018.
Businesses Impacted by Catastrophic Losses Are Likely to Suffer from Long-Term Economic Impacts and May Close Altogether
The historical perception of insurance providing stability and capital to recover from disasters is becoming less of a reality. According to the Federal Emergency Management Agency, approximately twenty-five percent of businesses do not reopen after a disaster. Additionally, companies suffering a catastrophic loss have shown a long-term negative impact to stock pricing. In a recent study, large publicly traded companies that reported financial losses from a catastrophic event suffered shareholder losses of approximately five percent. The study findings suggest investors are considering impacts from natural disasters in investment decisions and attributing damage to “poor management” as opposed to a traditional view of “bad luck.”
Insurers Are Underestimating the Financial Impact of Climate Change, Which May Lead to Market Volatility
Natural catastrophes, such as hurricanes, floods, wildfires, and tornados, have a significant impact on property insurers’ profitability. In 2020, the United States was subject to twenty-two separate natural catastrophes, each exceeding $1 billion (USD) in costs, with a cumulative total cost of $95 billion (USD). In 2021, twenty separate billion-dollar weather and climate-related events occurred, totaling $145 billion (USD).
Natural catastrophe impacts have pressured insurers’ bottom lines. Underwriters are heavily scrutinizing risks and declining to underwrite those with unfavorable natural catastrophe exposure. Those that are not rejected outright have stricter policy terms and conditions imposed, while the premium is simultaneously increased. Policyholders end up paying more in absolute dollars for less coverage (narrower terms, lower limits, and higher deductibles), contributing to the uninsured gap identified by the Swiss Re Institute. Property insurance premiums are projected to triple by 2040, in large part due to ongoing natural catastrophes.
Even with the current state of the property insurance market in upheaval, the industry may still be underestimating the impacts of climate change by up to fifty percent, according to a recent study conducted by S&P Global Ratings. While the majority of study respondents consider climate change in their price modelling, only one third assign a specific component of pricing to climate change. Climate change pricing appears to account for up to ten percent of the rate charged on average. Effects of climate change are anticipated to add thirty to sixty-three percent to insured catastrophe losses. Insurance carrier underestimations may continue forcing insurance market volatility and uncertainty for insureds.
The problem is twofold. First, scientific studies have confirmed a direct tie between climate change and catastrophic weather events. The frequency and severity of natural catastrophe events have significantly increased in recent years due to climate change. Second, population growth is rapidly increasing in regions subject to the risks of extreme weather.
Hurricanes Are Increasing in Intensity and Frequency, Creating Higher Claim Payments for Insurers
Nine of the top ten costliest hurricanes in the United States have occurred since 2004, even when adjusted for inflation. Hurricane Katrina (2005) was the most expensive, with overall estimated insured losses of approximately $87 billion (USD). Insurance industry catastrophe modelers have estimated climate change has incrementally increased insured losses from hurricanes by eleven percent. Additionally, annual hurricane wind losses are projected to “increase an additional 10 to 19 percent by 2050.”
The Magnitude of Flood Damage Is Increasing Due to Increasing Sea Levels and Changes in Precipitation Patterns
According to the Insurance Information Institute, the top ten costliest floods in the United States have all occurred since 2001. Hurricane Katrina (2005) was the most expensive, with overall NFIP paid losses of approximately $16.2 billion (USD).
Rising sea levels are contributing to the increase of coastal flooding. However, non-coastal areas are not immune to flooding risks. The increase in flood losses is also attributed to a rise in precipitation extremes. Up to one-third of flood damage costs since 1988 are a result of “historical precipitation changes.”
Wildfires Are Increasing in Frequency and Affecting a Larger Geographic Area
Wildfires are occurring with more regularity and are considered by the insurance industry to be the fastest rising driver of insured risks. Eight of the top ten most expense wildfires have occurred since 2017. Experts point to a combination of warming average global temperatures, rapid development in formerly natural areas, and poor fire management strategies as the reasons for increased wildfire losses.
Population Growth Is on the Rise in Regions of the United States Exposed to Natural Catastrophes
Economic growth, urbanization, and insurance penetration are all factors driving anticipated insurance costs. Based on data from the U.S. Census Bureau, there has been an increased concentration of housing units in catastrophe-prone areas. Many of the areas with the highest population growth are subject to the threat of natural catastrophes. Florida and Texas are geographically vulnerable to hurricanes, while California, Nevada, and Arizona are vulnerable to wildfires.
Renewable Energy Projects Are Being Disrupted by Insurance Costs and Lack of Capacity
The United States is currently undergoing a clean energy revolution, investing approximately $55 billion (USD) in renewable energy projects in 2020. The Inflation Reduction Act is slated to provide $369 billion in clean energy improvements, on the heels of the Infrastructure Investment and Jobs Act $65 billion commitment. Solar installations are anticipated to increase by thirty percent in 2021, with similar growth forecasted in 2022 and 2023. The United States Energy Information Administration projected approximately 39.7 GW of new renewable energy capacity additions in 2021 alone.
Ironically, natural catastrophe exposures are impacting the insurability of renewable energy developments. Frequently, renewable projects are in high-hazard areas, including locations along the coast that are exposed to hurricanes. Additional concerns include hail and tornado losses to projects located in the Midwest. These exposures cause insurance carriers to closely scrutinize renewable projects. Frequently, lower policy limits are imposed, and pricing is exorbitant. This approach is influencing investors’ evaluations concerning the viability of proposed renewable projects.
In Response to the Private Insurance Sector’s Historical Shortcomings, the Government Has Increased Involvement in the Insurance Marketplace
With the evolving landscape of risk exposures, the government has “progressively intervened” by compensating losses not insured by private insurance carriers.
National Flood Insurance Program
The National Flood Insurance Program (NFIP) was created in 1968 by passage of the National Flood Insurance Act. Congress identified a need for federal intervention due to the widespread impacts of flood disasters and inadequacy of flood coverage provided in the private market. As of 2018, the federal government insured approximately ninety-five percent of all residential flood policies. According to the Federal Emergency Management Agency, who administers the NFIP, approximately one percent of properties account for twenty-five to thirty percent of flood claims. Approximately half of “frequently flooded property” have received payments worth more than their value. These payments have contributed to the NFIP’s $20 billion (USD) of debt, “despite regularly borrowing from the U.S. Department of the Treasury.”
Terrorism Risk Insurance Act
Historically, private insurers in the United States included coverage for terrorism within standard property policies. However, this provision changed after the September 11, 2001, terrorist attacks. Property insurers paid over $45 billion (USD) in losses following the September 11 attacks, for a peril not generally anticipated by insurers’ modeling. In response, private industry began to exclude terrorism from property policies. Congress reacted to the change in market conditions by passing the Terrorism Risk Insurance Act (TRIA), which provided a federal backstop for terrorism risks. TRIA was initially designed as a temporary solution, to allow the private markets to properly assess the terrorism exposure within the United States. To date, TRIA has been renewed four times and is authorized through 2027.
Communicable Disease
Insurance coverage for pandemics and communicable disease is currently evolving. COVID-19 has significantly impacted the entire world, including businesses within the United States. Many companies turned to their property insurance policies for coverage following shutdowns. Insurers have resisted extending coverage for policyholders’ COVID-19 losses in most situations. This area has been heavily litigated, with more than 2,502 insurance coverage-related lawsuits filed.
Lawmakers proposed bills in several states that would have required insurers to cover business interruption losses retroactively, irrespective of policy language. Unsurprisingly, this approach has been met with strong resistance from the insurance industry. None of the proposed retroactive proposals has been enacted to date.
COVID-19 impacts have exposed a coverage gap in private insurance markets. The insurance industry and government officials have discussed solutions to address the risk posed by future pandemics. One legislative proposal gaining traction, the “Pandemic Risk Insurance Act of 2020” (PRIA), closely aligns with the approach taken by TRIA.
Public Sector’s Tolerance for Adverse Selection
Increasingly, government is being burdened with uninsurable, high-severity risks that private insurance markets are unwilling to cover. This burden invites the question—how long will government and taxpayers agree to being subject to adverse selection, while allowing private insurance carriers to insure the “benign” exposures? Recent developments suggest that changes may be on the horizon.
State Intervention
In the past few years, California has experienced increased levels of wildfire activity. To limit their exposure, insurance carriers attempted to retreat from the market, making it more difficult for California residents to secure insurance. In 2019, California’s Insurance Commissioner placed a one-year moratorium on insurance carriers cancelling or non-renewing policies in wildfire-exposed areas. Similar moratoriums were declared in 2020 and 2021. This moratorium has forced private insurance companies to maintain coverage in areas that they otherwise would have abandoned—leaving the risk of loss to residents and government.
Federal Intervention
In the United States, insurance is primarily regulated on a state level. However, the federal government also monitors the industry through the Federal Insurance Office (FIO), which is located within the United States Department of Treasury. Following President Biden’s 2021 Executive Order on Climate-Related Financial Risk, the FIO released a request for information on the insurance sector’s ability to support the economy and associated climate-related financial risks. The FIO has invited public comment in three specific areas: supervision and regulation of insurers; disruption of insurance coverage in markets susceptible to climate risk; and engagement of the insurance sector in advancing climate-related goals.
To Address Uninsured Gaps and Consumer Demand, the Private Insurance Industry Has Introduced Products That Have Expanded Historical Principles Distinguishing Insurance from Gambling
As previously outlined, three primary characteristics distinguish insurance from gambling: the principle of indemnity, the requirement of insurable interest, and public policy considerations. Insurers’ products have evolved with societal demands, but some coverages introduced violate the traditional view of indemnity. Justifications for insurance that “improves” a policyholder’s position are based on public policy balancing considerations. Further, American society has become much more accepting of gambling as entertainment, as opposed to an amoral sin. Increased cultural tolerance of gambling “is also reflected by changes in insurance policy construction.” As new insurance products are introduced, public interests and values will need to be weighed against a blurred boundary of insurance and gambling.
Certain Policy Provisions Have Evolved to the Point Where They Violate the Principle of Indemnity but Are Still Considered Insurance and Not Gambling
Replacement Cost
When fire insurance policies were introduced to the United States, claim payments were limited to an “actual cash value” basis, and a policyholder was not to “profit or advantage by reason of the loss.” Actual cash value payments were based on the replacement cost of the damaged property, less depreciation to reflect the property’s age and condition. Thus, the contract was based on a pure financial indemnity arrangement because the policyholder was placed in the same financial position that existed at the time of loss. However, an actual cash value recovery left a gap between the claim payment and cost to rebuild an identical structure, which was borne by the policyholder.
In the 1930s and 1940s, courts “began to impose replacement cost coverage on policies with actual cash value terms,” because policyholders could otherwise not afford to rebuild. The change in valuation approach was accepted in the market, and, by the 1950s and 1960s, replacement cost coverage was considered “standard” in most property policies. Policyholders could now “profit” from a loss because the value of an aged asset would be exchanged for a new, undepreciated asset. The principle of pure financial indemnity was replaced by a principle of functional indemnity.
Code Upgrade or Ordinance and Law
An additional example of insurance violating the traditional theory of indemnity involves “code upgrade” or “ordinance and law” coverages. Frequently, if significant repairs are required to a structure, building officials will require compliance with current building codes. The increased cost of construction to comply with current codes can be significant, particularly for buildings constructed prior to enactment of widespread building ordinances. Historically, insurance policies adhering to a purely financial indemnity approach would not pay for code-upgrade costs because an insured would otherwise profit from an improved structure. However, as more stringent uniform building codes were adapted, policyholders were left with an increasing uninsured gap. For example, after Hurricane Andrew in 1992, many policyholders discovered that their coverage was insufficient to rebuild because it did not pay to comply with the current, more robust building code. In response, Florida’s legislature mandated availability of code upgrade coverage within homeowner’s policies. Many insurance policies now include code upgrade coverage within their standard contract or as an add-on option. As a result, policyholders can “profit” from code upgrade coverages, similar to the functional indemnity idea tied to “replacement cost” coverage.
The Insurance Industry Has Recently Expanded Use of Parametric Insurance Products, Pushing the Boundaries of Insurance Closer to Gambling
Parametric insurance is a recent innovative product introduced by the private insurance market, partially in response to the growing uninsured natural catastrophe gap. Insurance carriers are selling parametric products as supplements to traditional policies, where the “standard” market is not able to provide adequate coverage. Parametric insurance varies significantly from traditional “indemnity-based” insurance policies.
Comparing Parametric Insurance to “Traditional” Property Insurance
One of the primary differences between parametric insurance and traditional indemnity-based insurance is the payment process. Indemnity insurance involves a claim investigation, whereby the policyholder is paid only for their actual loss sustained, after proving damages to the insurance company. In contrast, a parametric policy payment is binary and for a pre-determined amount stipulated in the policy—not unlike wager policies of the eighteenth century.
Second, the parametric policy is not necessarily triggered by loss or damage. Physical loss or damage is a condition precedent to payment under an indemnity-based property insurance policy. A parametric policy does not require any physical loss or damage to be activated. Instead, parametrics are triggered by a specified event or “parameter” as defined in the contract. For example, an earthquake parametric policy might pay-out if an earthquake of a specified magnitude strikes, as measured by the United States Geological Survey, at a defined location. All variables are defined in the policy at inception. Once the parameters are satisfied, the contract automatically pays out. A lengthy claim adjustment process associated with traditional indemnity insurance is not necessary. The policyholder simply submits a statement, or “proof of loss,” attesting they suffered losses equal to or above the payment amount. Any economic loss is recoverable under a parametric policy, in contrast to a traditional property policy which limits recovery to specific types of losses.
From a policyholder perspective, parametrics offer multiple advantages. They are easy to understand and predictable. Little effort is required during the underwriting and claim processes. Claims are promptly settled as payments are issued automatically. The primary disadvantage for policyholders is basis risk, or the difference between the loss incurred and the policy payment. If a policyholder suffers a large loss, the parametric policy payout may be inadequate to address all damages if other insurance is not in place.
From the insurance company’s perspective, parametric insurance has several advantages to the traditional model. Insurers’ operational expenses are significantly reduced. There is not an extensive underwriting process, based on specific characteristics of the subject property. Rather, the premium rates are based on analysis of “objective” data. The coverage trigger is based on a metric outside of the policyholder’s control and is measured by a credible third-party. As a result, claim investigation expenses are nearly eliminated. Lower expenses allow insurers to offer parametric products at more competitive pricing compared to traditional insurance.
Potential Issues with Gambling
Some may argue parametric insurance is simply the progression of insurance products evolving to meet societal expectations, like replacement cost valuations and code upgrade coverage. However, parametric products are undoubtedly testing the boundaries between insurance and gambling. Parametric insurance does not require any physical damage, and the lack of any meaningful claim investigation by the carrier risks a complete abandonment of the principle of indemnity. The “proof of loss” requirement remains the only gatekeeper for distinguishing parametric insurance from gambling. In practice, “showing proof of a loss isn’t necessarily cumbersome,” with drone images and customer text messages accepted as sufficient proof. Some policies are even advertised as not needing to prove expenses. Other parametric policies are marketed as “flight delay insurance,” which automatically and immediately pays out if a flight is delayed as little as two hours. These examples suggest the “proof of loss” requirements are inconsistently required in the marketplace. As a result, parametric insurance products risk becoming outright gambling, not unlike the wager contracts developed in eighteenth century London.
Insurers Must Expand Use of Innovative Products, Such As Parametric Insurance, Because Indemnity-Based Insurance Products Alone Are No Longer Meeting Societal Needs
Traditionally, the business model for insurers in the United States has been reactive in nature, with premiums incrementally increased commensurate with the risk present. This process makes sense purely from a market perspective; the higher likelihood the carrier must pay a claim drives the need for additional premium dollars. However, this approach has a breaking point, as evidenced by the ever-increasing uninsured gap, and insurance regulators agree that society “can’t exclusively insure our way out of” climate-related catastrophes. The insurance industry must continue to explore new creative solutions, outside of the traditional approach.
Insurance regulators say the industry can develop innovative products designed to improve societal resiliency and reduce the economic protection gap, but a fine line must be walked. On the one hand, if insurers do not take adequate action to address the uninsured gap, they risk more direct involvement from government-controlled insurance solutions, as seen with terrorism and flood. On the other, if insurers push modern-day versions of wager policies, conflicts may arise with gambling laws. As such, the insurance industry must work closely with legislators and regulators when developing products to address societal needs in the present-day environment.
Conclusion
The insurance industry has a critical role to play in making society more resilient to the impacts of climate change. Existing products, such as parametric insurance, are a good first step to closing the current uninsured gap. However, insurers must be vigilant in maintaining an indemnity-based approach, which is often cited as the key distinction between insurance and gambling.
Insurance also differs from gambling based on public policy considerations. Society and government have tolerated previous insurance innovations that blur the insurance-gambling line when there is a public benefit. Parametric policies may be seen as the natural evolution of insurance products, required to meet society’s needs. However, a public-private partnership is necessary to implement improvements to traditional insurance and ensure new products do not run afoul of gambling regulation.
Climate change, flooding and disasters are not going away. A focus on innovative insurance solutions will provide society with access to more affordable insurance, close the current uninsured gap, and keep insurers profitable.
