For Your Consideration

Folks, get ready to hear more about the McCarran-Ferguson Act in the coming days and weeks as it is now in the crosshairs of our elected representatives in Congress and may quite simply become a casualty of the health care “reform” push. I’m going to try to briefly separate fact from fiction and address some of the “spin” I’m reading in the current misguided push to repeal this federal law.

What you absolutely need to know about McCarran-Ferguson is that it allows each of the states to regulate the insurers that write business within their state. So, instead of one regulator in Washington looking at the industry, there are 50 regulators! McCarran-Ferguson also grants insurers a VERY LIMITED exemption to federal anti-trust laws. The law’s Wikipedia entry is here and if you’re particularly adventurous, here is the text of the law itself.

Now, the general effect of McCarran-Ferguson on insurers is that it allows the sharing of statistical loss data and loss experience (usually called “prospective loss costs”) over the entirety of the industries they serve. So, for example, a health insurer writing business in Washington, DC can review an amalgam of all losses of all health insurers within that jurisdiction.

McCarran-Ferguson does not allow insurers to get together in smoke-filled star chambers and price-fix the cost of coverage for the ultimate consumer. That, friends, is completely untrue, utter nonsense and political spin. Federal laws such as the Sherman Act (and other such anti-trust laws) were enacted to prevent this type of illegal activity and McCarran-Ferguson does not supercede these laws. So, to reiterate, collusion to fix prices and so called “tying” arrangements are illegal and McCarran-Ferguson does not allow them to occur, no matter what you read on the internet.

It does allow (in concert with certain legal decisions in the 1980s) insurers to share actual loss data in the aggregate.

Why this is important is because the accuracy of an insurer’s prediction of losses increases as the size of the data sample increases. In essence, the sharing of loss data increases “credibility” (both statistically-speaking and in the real world). In fact, it’s this mathematical concept, commonly referred to as the “Law of Large Numbers“, that allows insurance to be viable.

So, to the extent that losses are forecast more accurately, the premiums charged better reflect the actual exposure to loss. In plain language, fairer and more accurate pricing of coverage is possible because the insurer has a larger, more credible sample of loss data to draw upon, rather than trying to price coverage based upon its own (very limited) loss data/experience.

Further, in political parlance, one can see how McCarran Ferguson actually promotes “choice and competition” as it allows insurers which do not have experience in certain lines of coverage to offer products with more relative certainty of the losses they are likely to see. Without the relative certainty large loss data samples afford an insurer, it may simply decide not to enter new markets, thus depriving consumers of a potentially competitive choice.

Also, the sharing of loss data promotes stability of insurers, reinsurers and society as a whole as it offers greater relative certainty that pricing is adequate for the exposures to loss assumed. The singular benefit to the consumer and society is that these stakeholders can be reasonably assured that the insurer will be “there” when losses occur and are required to be paid.

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Repeal of McCarran-Ferguson will undoubtedly have many unintended negative consequences. It is not difficult to envision that restricting an insurer to its own loss data will likely cause a contraction in not only the availability but also the scope of coverage provided by insurers. Many carriers may simply cease offering certain types of insurance or cease offering insurance to certain classes of business as they cannot assess their risk adequately.

If the above occurs, it will likely increase the cost of insurance, not only becase insurers will less credible loss data to base their pricing decisions upon (and have a greater cost of uncertainty) but also because there will be aggregate less competition amongst insurers, both of which ultimately results in fewer choices for consumers.

It is said that truth is the first casualty in war. In this war of words, at least understand what the truth is.

Late September UPDATE: Apparently quite a few Americans believe as I do. According to a recent Rasmussen poll, 78% support the idea of allowing all Americans the option of purchasing the same health plan that Congress enjoys. So with support for the current incarnation of the health care “reform” at 41% approval, the question you must ask yourself is why Congress keeps pushing a plan on a populace that clearly doesn’t support the effort. I maintain that the answer lies in the concept of a “scheme of control” and fundamental loss of individual liberty. 

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Few days go by that I’m not drawn into a conversation relating to the health care debate. And today, I got an email from a friend and attorney asking my thoughts on the subject. Politically, he and I are generally diametrically opposed, but he is a great guy with a sharp and inquisitive mind. We laugh a lot when we’re together. I consider it my honor to spar with him.

His position: [It] “seems to me the big issue that has been alluded to but not really spoken expressly is shifting the health economy from a finance and profit based model to a care based model.  The reliance on insurance companies and their place in the financial sector is what has to be addressed, as well as the fact that the consumer is not choosing the provider.”

I share with you now, my complete response:

For the sake of brevity, I think the President could go a long way to “ensure choice and competition”, by the adoption of a one-page bill: one that would give the general public access to the 300 or so insurance options that the federal government employees currently enjoy. The positives should be immediately recognizable: complete portability, affordability, lack of a employer-mandated solution, no waiting period for pre-existing conditions, etc. Some great progressive ends, wouldn’t you agree?

If paying for the insurance is still an issue for some, a solution like the Earned Income Tax Credit might be appropriate- in which the federal government, either by direct payment to the provider or via the 1040 form, can help subsidize the expense. Don’t misunderstand me, I am concerned about the constitutionality of these programs, but I’m also a realist.

I am also aware of the “creeping incrementalism” social programs generally exhibit, and think there are reasonable concerns over the increasing cost of the social compact of 3 generations ago, one which has not kept up with medical advancements. In short, my opinion rests on the following posit: there can be no social programs if we’re bankrupt.

Further, I have grave issues with what amounts to “generational theft”, as I see it as immoral and unethical. It does not matter how much our government requires, it is never enough. I agree with the progressives in one specific way: a revolution is occurring and cultural battle-lines drawn. I’m not suggesting that the revolution will be one of violence, but it certainly is being televised!

Hope I haven’t offended, I’m merely relaying the truth as I see it. You deserve nothing less. I would appreciate your candid thoughts. It’s only through rigorous examination of our positions can we be certain of their value.

Should national health care be a reality soon, we will see the most important (R)evolution in a generation rapidly unfold before our very eyes: the EXTINCTION of the corporate employee and the EMERGENCE of the independent contractor. I’m sure this is not what the President and Congress have in mind of course, but while a free-market exists for human capital, it is this end that strikes me as most plausible.

Which ever version of health care scenarios wins out in the end is not at all relevant. In the end, they all rely upon workers to be classified as “employees” in order for this thing to “work”. Whether the new national health care “premium” comes in the form of new taxes, surcharges, fees or penalties, no business will stand blithely by and be gutted by legislation. Accordingly, an interesting question comes to light: what happens when the business employs a relatively few number of “employees” and contracts their work out to independent contractors?

Everyone (including the IRS) has a slightly different definition of what makes a person an independent contractor versus an employee. They all converge around the same issue, that one being the issue of control. Who controls the work product? Who controls where the work will be performed? Who control when the work will be performed? Who provides the tools in order to process the work?  Does the “independent contractor” have their own telephone number? Their own insurance? Do they invoice regularly or are they paid weekly? Is there an “arms-length” business transaction between the parties?

I think you get the point.

Ultimately, if the business assumes too much control over the worker, the worker shall be determined to be an employee…. Which is exactly why those companies that can structure their business processes to take advantage of true independent contractors in many aspects of their operation shall have a competitive advantage in the coming years. Now this may sound all horrible for the prior “employee”, now newly-minted “independent contractor” but it really isn’t: not when you stop and consider that EVERY business is in essence an independent contractor to its own customers. And surprisingly but naturally, it is this “Employee Extinction (R)evolution” © which may save our economy in the coming years, as people become their own “brands” and compete against each other in the economy for work.

Think of what this kind of (R)evolution could do to all levels of local, state and federal government! And what it could quite easily do to unions…

The progressive fascination with tinkering with 17% of our national economy will have its consequences. Some can be foreseen and some cannot. Here’s one possible consequence which future generations may hail as our President’s greatest unintended accomplishment.

For many years, I have wrestled with the idea of working for a Masters degree. Many things kept me from this pursuit: work needs, lack of time, family needs, you name it. There also was that nagging “value-proposition” problem…. I couldn’t find a Master’s program that qualified me for more than a $75,000/year middle management position. As an owner of my own business, the idea of spending the time, energy and money to obtain a Masters for a position I was over-qualified for seemed rather silly. 

Fast forward a quarter of a century….

In my risk management studies, I met an individual (hat-tip to George) who turned me on to the possibility of using the graduate credits earned from my ARM and ARM-P coursework towards a Masters degree. I began investigating this possibility and found the Salve Regina University willing to accept at least 12 graduate credits towards the 36 needed for the conferment of a Master of Science in Management with a Risk Management concentration. I will be petitioning the Dean of Graduate Studies to accept 6 additional graduate credits once I complete my Associate in Commercial Underwriting (”AU”) designation, scheduled (if all goes well) for June 1.

Almost all of the work is online and much of it self-study: right up my alley! To that end, I decided to apply. My first assignment: “Provide a detailed statement which describes academic and professional experiences which will make a contribution to your pursuit of a graduate education at Salve Regina University. Include in this statement any unique aspects of your experience relevant to your intended course of study.”

My graduate admissions statement follows:

I find it humorous that as I sit here wrestling with an appropriate application statement, I am transported back 25 years or so wrestling with my USC and NYU application statements as if it were yesterday. In that sense, my experience is circular, with everything old being new again! I am smiling because it’s “interesting” to try to sift through a quarter century of life trying to figure out what experience should be highlighted in such a statement. And by “interesting”, I mean “pointless”!

Every thing I’ve done and every person I’ve met and every experience experienced has led me to this point in time, the “here and now”. Every person helped, every person counseled, every life touched is a part of what constitutes me as me. For me to attempt to judge which experience was more important than another strikes me as folly. So let’s recap…!

NYU days were hectic. I worked full time in the family’s trucking business my junior and senior years and took night courses and summer sessions to keep up. I did not do this by choice but the family business was struggling and I needed to pull my weight. I paid for my own education and therefore understand its value. Soon after my Bachelor’s conferment, the family business failed. Shortly after that, I was married to my bride, moved and started a new job all in the span of 30 days. It was during this time that I consciously learned and accepted that the only constant in this world is change.

And many things did indeed change: I “fell into” the insurance sales business by accident and with my first home and daughter on the way, I had to figure things out very quickly. One thing I figured out quickly is that insurance sales producers could be broken down into two groups, one being so-called “social” producers, relying upon who they knew and not what they knew to make a living, or “technical” producers, those relying upon what they knew rather than who they knew. Since I didn’t have an effete, “social” background, you can pretty much guess which group I was relegated to!

I have yet to meet the person that grew up wanting to be in the insurance industry. A policeman, a fireman, an astronaut, yes, but not one insurance actuary, underwriter or risk manager. I think that this is the reason why there is such a lack of empathy, compassion and passion associated with the insurance industry. Its members think in terms of insurable risk,insurance contracts and how much the commission is going to be on the policy they just sold. After 20 years of practicing, I can tell you that the best insurance practitioners listen to people and find creative solutions to the problems faced.

At his trial for heresy, Socrates is acknowledged to have spoken “The unexamined life is not worth living”. In times of quiet, I close my eyes and allow myself to relax. In these moments of introspection, I listen and allow myself to hear what my heart is telling me. And what I’ve heard are the most important things, things that have shaped the tapestry of my life.  Among these “important things” is that I need to be a life-long learner not just to expand knowledge for its own sake or for personal hubris, but to deploy this knowledge to better the lives of others. Willingness to assist others is not enough, as it must be matched with commensurate ability.

Which is why, after 17 years from the conferment of my first professional insurance designation, I decided to listen to what
my heart was telling me and have dedicated two or so years to a remake, a refresh, a re-do. I chose the study of risk management in all its forms because it was the most natural progression from insurance. With it, I took my first steps into a much larger world. What I soon learned is that for all these years I had been applying risk management techniques and risk control mitigation in solving problems, I just never knew the language and could not articulate the ideas and solutions as well as I can now. I became aware, that despite its vast nature, just how small the world of insurance was.

Since January 2008, I have formally studied risk management at the AICPCU/IIA and National Alliance for Insurance Education and Research and have attained many acknowledged advanced technical designations. Conferment of a Masters degree in Risk Management will break down many walls to understanding, and give those whom I meet and help added comfort in my ability to adequately address the pressing problems they face.

I do not know what the future holds, but when the time comes to stand before my Maker, I do not want Him to think I’ve wasted my life, after all He’s given me.

The stack of stuff I want to share seems to be growing by the day… too much stuff and not enough time! So instead of writing fewer/longer pieces, here are a few succinct words of advice/counsel on each subject in one “omnibus” post. Hopefully, you’ll find a “nugget of joy” that’s of use to you and I can start to cut through my growing stack of stuff. So, let’s get to it…

1. Putting money in bank CD’s may seem like the safest choice today, but it might not be. You’ll be told that these things are “riskless”. They’re not. The one primary risk they don’t tell you about and that you retain (and it’s a biggie!) is inflation risk. Very simply. when the inflation rate is higher than the CD’s APR, you’re losing money. Historically, the one asset class which has a real return ABOVE inflation is equities. With stocks “on sale” at about 40% off, you might consider “buying low” today if you have the time to wait until the market recovers. I suspect that 10 years from now, you’ll wish you put every dollar you had in now.

2. Every personal insurance policy should be reviewed annually to make sure it still meets your needs. Take some time to do it. You might find that coverages can be eliminated, deductibles can be increased, insurers can be changed, etc. to reduce your insurance cost.

3. Every small-business owner should review their insurance program annually as well. If your business operates on a 10% operating margin and you save $10,000 in premium, the savings was not just $10,000- The real savings is $100,000 in gross sales you didn’t have to make just to pay the insurance premium.

4. The “annuity vultures” are out in full force. They usually take the form of “investment advisors” working for insurance agencies and especially prevalent in poor economic times, such as today. They prey on your fears that you’ll run out of money before you die which they cryptically call “longevity risk”. There’s 3 main reasons you should shun: 1. These are extremely complex insurance contracts. Most come with a 200-300 page prospectus. Unless you read and understand all those terms and conditions, be ready to get hurt. 2. Annuities are guaranteed by the issuing insurer- want to make any bets on which insurer(s) are going to survive? 3. COSTS. Depending on the insurer and the particular product being promoted du jour, the underlying costs of the annuity are outrageously high. Remember, the agent needs to be compensated for selling you this complex contract. You’re the one paying the freight.

5. If you have a private disability (DI) policy, look to increase your “elimination period” (which is a essentially a deductible measured in time, not dollars) to decrease your cost. I recently changed the elimination period on one of my DI policies from 30 days to 90 days. When the policy was originally written, I could barely afford to be without an income for 30 days. Blessedly today things are a little bit different. I saved over 25% in making this one change.

6. Our preconcieved notions and the media shape perceptions of risk. Do you really think that Congress knows how to “fix” the economy? Do you really have faith in their stewardship? Should we allow government to grow or would you prefer that industrious, entreprenurial Americans be tasked with our economic recovery?

7. Turn off CNBC. Stock market-timers have to be right not only once, but twice. Even Warren Buffett can’t do it. The stock market-timers “Hall of Fame” is an empty room.

8. Remember, it’s all relative. All assets are being repriced. Globally. There’s no place to hide. Forget U.S. Treasuries with their 0.01% interest rate. Invest in your own education. You want security? Look in the mirror. It’s the only place in this world that you’ll find it.

9. Worry only about the things you can DIRECTLY control. Everything else will take care of itself and you’ll save yourself a lot of heartache.

10. Continue to fund your 401k. If enough people opt-out, these tax deferred programs will go away and that’s not a good thing.

11. If you’re in business (or work for one), don’t forget to advertise and market the goods and services you provide. Your competitors aren’t and it’s a great time to steal market-share from them.

12. You may have noticed the increase in advertising by gold sellers, I know I have. Before buying, understand that gold has a ZERO expected rate of return, as it produces NOTHING. Gold has no intrinsic value, only the value we ascribe to it. You’re also going to need to buy A LOT of it to make it “worthwhile”. Where you gonna put it all?

13. Taking medications (legal ones, that is)? Want to try to save some dough? Live in NJ? Try www.njdrugprices.nj.gov for an online prescription drug registry. Prices for a one month supply can vary widely, even within the same zip code. It works surprisingly well.

14. According to John Montgomery, Founder and Portfolio Manager of Bridgeway Funds, there have been nine bear markets since 1940. The average time for the stock market to “recover” to its previous high is 13 months (excluding this current bear market). 13 Months- a little over 1 year. Of course, this time may be different but know that historically speaking, if you can keep your head when everyone has lost their’s, you’ll be well-rewarded.

15. THIS IS NOT THE GREAT DEPRESSION, PART TWO. We do not have 25% unemployment and the only thing we stand on lines for are HDTVs, not bread! Don’t “buy” the doom and gloom the media is “selling”. It’s all meant to manipulate.

Go live your life. Smile and be grateful.

OK, as of today, the Fed has said to Lehman, “NO SOUP FOR YOU!“, and they are now at the mercy of a bankruptcy court. Merrill Lynch ceases to exist as an independent investment bank and will be swallowed up by Bank of America.

Now, we are witnessing the potential of the bankruptcy of AIG, American International Group. This potential collapse is so breathtakingly overwhelming it is difficult to find the words to express its impact.

As of the moment of this writing, the Fed is trying to help orchestrate a $100 BILLION DOLLAR “bridge” loan package to give AIG time to sell assets to stave off bankruptcy and it is EXACTLY this moment that we come to understand the magnitude and utter failure of AIG management who should not have allowed things to escalate to this point. I think in the future there will be entire business management classes and curricula devoted to the study of events surrounding this epic failure.

But the talking heads are missing the point. It doesn’t matter if/how financing for AIG gets arranged today or tomorrow, the damage is done. Credit analysts in the bond markets have marked AIG’s bonds to junk status and the rating agencies have put AIG on “credit watch negative”, which is a precursor to severe ratings downgrades. In essence, perception is reality and many smart people do not expect AIG to survive as it exists today.

But the biggest problem doesn’t rear its ugly head until January 1, 2009 when AIG’s reinsurance treaties expire. Reinsurance is essentially insurance for insurance companies. If the company cannot negotiate renewal of its reinsurance treaties, it  cannot survive as an insurer and will be forced to terminate all in-force policies, citing loss of reinsurance. This is the insurmountable issue as I see it today.  The question of the day is: What reinsurance companies will be willing to “belly up to the bar” for AIG?

Prudence dictates that individuals AND businesses review their exposure to AIG. This is not just an academic exercise. I would urge a review of insurance policies in force as soon as practicable. For individuals that may mean annuities provided by American General, life insurance policies and/or auto policies with 21st Century or AIGDirect. These matters and questions should be reviewed and discussed with your agent. For corporate risk managers or financial controllers: I would direct your insurance broker(s) to provide an assessment of exposure and immediately begin the remarketing of coverage in the event the unthinkable occurs.

That being said, there probably is only ONE person alive who has the gravitas with regulators, capital markets, and reinsurers to “right” the AIG ship: the deposed ex-Chairman of AIG, Maurice “Hank” Greenberg. I believe that only his direct stewardship will assuage these parties. Let’s see if the AIG board has the brass b@lls to bring him back.  Of course, that exposes another long term personnel risk management issue for AIG: life after Hank. But that is an issue for another day. Today is the day AIG needs its Chairman back.

These are truly momentous times. I, for one, will keep my eyes on January 1, 2009 and hope for best (but plan for the worst).

Quick Update as of 4:45PM EST: It appears that Mr. Greenberg has been rebuffed by AIG management (video in link). In this interview today, Mr. Greenberg (who was ousted from AIG over 3 years ago) was asked what “went wrong” and from his perspective, “what happened?”

Mr. Greenberg replied, “I think several things. I think risk management controls either disappeared or were weakened. There wasn’t attention being paid to the accumulation of risk. I felt there was a determination to grow without the right controls in the financial sector of the business. Many things went wrong.”

OK, today let me drop a little insurance strategy on you to help you “evaluate your insurance premium savings quantitatively by increasing your risk retention”.

Got that? That’s a real “fancy-pants” way of saying, “save money by increasing your deductible”, but now you can sound important-like and impress your insurance-geek friends. Just one word of caution: don’t try that one at a party unless you’d rather be alone.

OK, bad insurance humor aside, it’s commonly known that by increasing your deductibles will generally lower your cost of insurance. But today, I’ll give you a strategy to analyze the premium savings to see if it makes sense to take on more risk.

It’s important to understand that insurance is provided by an insurance company on a “cost plus basis“. What that means is that very smart mathematics types (known as “actuaries”) figure out the dollar amount of the frequency and severity of losses that the insurer is likely to have to pay for the risks they assume. Think of this number as just the “pure” loss amounts, without any expenses associated with them. Let’s call that number “X”.

Once that’s done, the financial bean-counter guys and gals get together and add in the costs the company must bear to administer their customers’ losses, such as employing people and costs of adjusting and paying for the losses. Let’s call that number “Y”.

Then finally, once that’s done, the management types (you know, the one’s dressed in suits) add a cost which represents the percentage of profit they want to make. Let’s call it 10%. So the cost of insurance is figured like so: (X + Y) * 1.10.

Sounds too simplistic? It’s closer to reality than you think.

OK, so let’s go back to our generally misunderstood actuary friends (they need love, too). They know that if you take a $100 deductible instead of a $1000 deductible, their frequency of loss will increase, because you’ll be tempted to put in that $250 loss claim now. If you had chosen a $1000 deductible, they’d never see the claim. So, what do we learn from this?

By choosing low deductibles, you are trading today’s insurance premium dollars for future potential claim dollars.

The reason and logic should be clear from the example above: the company has to charge more to pay for its increased likelihood of loss, which also includes the very real and expensive loss adjustment expenses. And because you are paying premiums on a “cost-plus” basis, this is generally speaking a bad deal for the consumer because you are not only “prepaying” your small claim but you’re also paying for the insurance company’s costs and profit-margin targets.

If I haven’t lost you yet, here’s a very simple method of evaluating whether or not increasing your deductibles is a good “buy” for you. It assumes that you have the financial capacity to pay that deductible if/when the loss occurs- Remember: the fundamental rules of personal risk management dictate that we do not take on more risk than we can handle and we never risk a lot for a little.

So with those caveats aside, here it is: If today’s premium savings can “pay for” the difference in deductibles within 3 years, it’s probably a good idea to increase the deductible (assume more risk) and take the premium savings.

Say you have a policy with a $250 deductible that costs you $1000 per year. Your agent advises that the premium would decrease to $750 if you chose a $1000 deductible. So your out of pocket premium savings is $250/year (nice!), but your out of pocket risk has increased $750 (not so nice). Since the annual premium savings of $250 * 3 = the difference in our deductible ($750), it’s generally a good strategy to increase the deductible.

Of course, if you do have suffer a loss within 3 years, you’ve “lost the bet” so to speak, but it’s sting is tempered by your retaining the first year’s premium savings. On the other hand, any loss 3 or more years in the future has paid for itself. Actually, and then some, since premiums tend to rise more or less, every year. The percentage rate increase will be less with a $1000 deductible for example, than a $250 deductible, in keeping with our example.

Now that you got this down, call your agent, save some money (if appropriate) and then go treat yourself to something nice (some chocolate, an ice cream, maybe a new car…) because you’re now a much more savvier purchaser of insurance than you were mere moments ago.

Can’t get enough of this scintillating material, don’t forget to click here for more fun.

Well, just a flurry of activity today, isn’t it? I’m going to be away on vacation until late April/early May so I wanted to commit a few ideas that I’ve been mulling over lately to the site before I either forget them or get caught up in other things. Some concepts I have “in development” as of today that’ll have to wait for my return:

1. A line item breakdown of variable annuity costs - OUCH!

2. Why stock market timing is a bad (but pervasive) idea;

3. A discussion of “senior” seminars and the art of the “sale” - beware the siren call of the “free” steak dinner!;

4. The allure of fixed index annuities and when they are suitable;

5. Long Term Care Insurance Objections (and rational responses);

6. Within every small business owner lies the soul of risk manager;

7. Moral and ethical obligations of a fiduciary;

8. Legal considerations of the sale of securities by “captive” financial advisors/insurance agents;

9. Exploration of the concept of “Personal” Enterprise Risk Management;

10. How to reduce health insurance premiums through exposure analysis;

11. Matching bond fund durations to meet a 1-5 year financial need;

12. “If investing *isn’t* boring, you’re doing it wrong”; and

13. An exploration of personal risk control techniques.

Just a little “light” reading, huh? Also, if you haven’t already done so, please consider registering your email address (or send me an email at md at marcd.com and I’ll register for you!) so that the site updates will be forwarded automatically to you by email. Consider referring a friend to the site - we need more friends! Thanks again for your support and I’ll see you in about a week.

Let’s first get this out of the way: flood insurance suffers from what the insurance industry calls “adverse selection”, which means that for the most part *only* those people that need to buy flood insurance coverage (as required by their lender), in fact do. Some (closer to “most”) people assume that it’s already covered under their homeowners, renters or condo policies (it isn’t) or figure the risk of flood too remote to affect them. Accordingly, the law of large numbers cannot work properly. I’ve outlined 5 forgotten (or unknown) flood insurance concepts that everyone should know:

1. The primary supplier of coverage is the federal government.

It’s true- it’s called the NFIP, which stands for the National Flood Insurance Program. The government contracts with insurers to provide the coverage to you, but the costs (including claims paid) are funded by the U.S. taxpayer.

2. The definition of a flood zone: EVERYWHERE

There’s *nowhere* in the United States where a flood cannot occur. Just because your home is not in a designated flood “zone” should not give you any comfort. In fact about 30% of all flood losses occur OUTSIDE a designated flood hazard area.

3. Flood coverage includes losses from mudslides or mudflow.

If I had a dollar for everyone who told me, “I live on at the top of a hill (or on a hill) - I don’t need flood insurance”. Ask people who live in the hilly areas of California who’ve lost their homes to mudslides if they don’t need flood insurance. Remember, land subsidence (which is for the most part a fancy term for a mudslide) isn’t covered under a standard homeowners/renters/condo policy.

4. There is VERY-limited coverage for basements.

Contents of a basement is NOT covered, nor is any improvements such as finished walls, floors or ceilings. What *is* covered are things like: foundation elements, utility connections, heaters, A/C units, unfinished walls and clean-up. That big screen TV and stereo system you have in the basement is there at your own risk only!

5. Increased Cost of Construction is included (sub-limited).

This is a nice addon and automatically included for most regular flood policies. Basically, the government (through the insurer) will help you pay for building upgrades (post-loss) to reduce the likelihood or severity of a future loss. Amount of coverage available: $30,000. It’s a shame we don’t pay enough attention to prevention or mitigation pre-loss!

Now that we’re conversant with the 3 general types of risk, it’s instructive to understand the basic tenets, or “truths”, of risk management. They may seem simple in concept but you’d be amazed at how many people don’t stop to consider, forget, disregard or plainly ignore them in their daily lives.

• Don’t take on more risk than you can handle (afford to lose);

• Don’t risk a lot for a little gain;

• Consider the odds of the risk you’re taking; and

• Don’t confuse, mistake or substitute insurance for proper risk management and risk control.

Remember that many of the pure risks (risks where there only is a chance of loss) we face in our daily lives are easily handled by insurance. When I consider these tenets, I think back to an experience I had with a trucking company owner who operated a small fleet. During my initial meetings with him and review of his current insurance plan, I noticed that most of the vehicles were being insured for liability only. He explained that as a matter of policy, he took off collision and comprehensive coverages once the loans were paid off and he was no longer required to maintain the insurance coverage.

Seemed reasonable enough, but it’s important to know that many of these trucks (he had about 8 at the time) were still worth in excess of $20,000 *each* and I think we can all agree that a very large financial loss would be suffered should even a *single* truck get totaled in an accident. So, I asked the owner to explain his thought process. He shared that it was his experience that none of his trucks were ever totaled in an accident and he had saved a substantial amount of money in insurance costs throughout the years.

We got to talking more about this. I asked about where the vehicles were kept overnight. He explained that he would back them up into the warehouse dock at night and over the weekend. I asked if he considered what would happen if he woke up one morning to find that the warehouse suffered a fire and 6 of the 8 trucks were destroyed because they were so close to the building itself. He thought about it for a moment…

“I would probably be out of business“, was the response.

The owner never considered that possibility/peril and it changed the whole equation and perception of risk in his mind. Well, I don’t know about you, but I consider going out of business for a peril we can prevent or reduce to be an undesirable and wholly unacceptable outcome.

Premiums on truck collision and comprehensive coverages are *heavily skewed* to the collision portion, meaning the cost of collision coverage was about 4-5 times more expensive than the cost of comprehensive coverage. I explained that for about $300 per year, per truck, we could add on comprehensive coverage only which would cover the vehicles for “just about” every physical peril, including fire- with the exception, of course, of colliding with another object. He said his current insurance broker never had this kind of discussion with him or offered comprehensive separately.

So how does all of this relate to the basic risk management tenets? Clearly, the business owner was unwittingly taking on more risk than he could afford to take and was risking a lot for a little premium savings. He didn’t consider the odds of the risk because he didn’t even *consider* the risk! But once presented, the responsible action was clear.

And no, tenet #4 was not ignored: We discussed moving the trucks away from the building as a loss control measure, but he was concerned about vehicle theft issues and the lighting in the truck-yard was sketchy. Since it was a leased building, there were landlord issues which did not allow him to add more lighting. So, while we didn’t confuse insurance with controlling the risk, we *used* insurance as a risk transfer technique because it was economically reasonable to do so given the circumstances.

The business owner was also happy to learn that comprehensive coverage would also pay in the event one of his trucks was stolen. He said it was always a concern, but one “he lived with”. As you can imagine, his warehouse wasn’t exactly in the best part of town.

You know, I *really* don’t have an obsession with the Bear Stearns implosion, but it’s so chock-filled with cautionary tales I just can’t resist! For those who want to know the basic financing “hows” of the Federal Reserve - JPMorgan Chase deal, this is a nice, easy to understand one page illustration:

Bloomberg graphic

I think it’s fair to say that one of the areas traditional risk management gives short-shrift to is the area of “personal” risk management. Sure, major corporations employ risk managers and teams of experts to assist them survive the myriad of risks present to the “enterprise” but where’s the love for individuals?

Even the risk management educational material I’ve reviewed focuses almost entirely on corporate risk management (I guess it’s because that’s where the money is). This lends credence to my point of view, but my position isn’t set in stone. If there is a wealth of personal risk management educational material available that I’ve somehow missed, let me know. When the data change, so do I.

Let’s face it, the general public depends on insurance salespeople to act as risk managers because:

• A. The general public (and most insurance salespeople) thinks “risk management” is the same thing as “insurance”; and
• B. Most people, who are busy living their lives, don’t consider risk management concepts and techniques.

Professional risk managers wince and take a real dim view of the perception that “risk management = insurance”. They’ll tell you that insurance has a role to play in risk management, but as a financial tool to be used, nothing more. If you can only solve risk management problems with insurance, you ain’t much of a risk manager!

There’s a problem, though - insurance salespeople aren’t particularly versed in risk management techniques. (There, I said it.) They can talk to you all day about life insurance, car insurance, house insurance (you get the point), but to have an intelligent discussion on how to apply risk management techniques to *your* LIFE is not one you’re likely to be engaged in any time soon.

There are exceptions of course, but not many. While a person can obtain a Masters degree or Ph.D in insurance, they’re usually relegated to academia (or locked away, somewhere far away!). These are not your garden-variety insurance salespeople types. The industry attempts to compensate for this education gap, in part through designations such as CPCU, CLU, CIC and CRM. Admittedly, it’s a confusing alphabet soup for the general public.

I would urge you when choosing your next insurance broker or representative, strongly consider those people who have passed the rigorous education and testing requirements required to obtain the designations shown above. You’re much more likely to be able to have a conversation on risk management concepts and techniques if you do.

This brief comic video reminded me of one life insurance sales call I made years ago on a junior executive and his wife.

Despite his wife’s protestations, the guy was convinced life insurance was a waste because he wouldn’t “get anything out of it”. This type of response, while being ridiculous on its face, is a fairly common objection to owning life insurance. Not rational, but common. Of course, life insurance is not for the person being insured, but for the survivors. I explained that it was for his wife and 5 minor children, to help take care of them financially when he wasn’t around to do it. Not a particularly difficult concept to grasp, but he wasn’t having it.

I then reminded him that he had just taken a $685,000 mortgage and I was curious as to how he thought it was all going to work out for his family if he should die during the mortgage term. He answered that he never thought about it because “it wasn’t going to happen“.

It then hit me. He felt the coverage was worthless because he rationalized in his own mind that he wasn’t going to die anytime soon. Not really worrying about the sale at this point, I forced him to verbalize this more and called him on it. I told him I understood his perspective. I said, “Ray, I get it. You’re not going to die” and smiled wide. He leaned back in his chair and smiled back at me as if he won something. He responded, “That’s right“.

Since there’s no use arguing with the wind (or a cat), I could only tell him that he’d “be the first“.

Yes, I updated the site’s “look and feel” to make it a little more easy to read. I also tweaked a few words here and there. Sorry for the lack of posts, I’ve been busy attending at my first Certified Risk Management professional designation course in Windsor CT last week. I look forward to sharing some of that experience in the coming days.

Look, before we begin understand that a homeowner’s policy is a complex document. Remember, an insurance policy is a legally binding contract, so of course, it’s complex and not easy to read. It’s designed that way.

And just so we’re clear, I’m not your agent and I have no idea your particular coverage or circumstance. But writing the post just prior to this one got me thinking: Many people who bought their homeowners coverage in the last 48 months are in all likelihood paying for coverage they’ll never get to use - but think they will. Here’s the skinny, but a point of clarification first:

One of the coverages included in your homeowners policy covers the “dwelling”. In fact, in all probability, your policy declarations page will show just that: “Dwelling” and then a dollar amount indicating the limit of coverage purchased/provided. Assuming you bought replacement cost coverage (you *did* buy replacement cost coverage, didn’t you?), this limit is there (in the best cases) to accurately and adequately reflect the cost to replace the “dwelling” (or “structure”) of the home in the event of a total loss.

In many cases over the last four years, however, people had been forced by their lender(s) to purchase a dwelling limit in an amount that equaled the purchase price of the home. This amount has no bearing to the amount of coverage available under the policy. You see, the “fine print” of most homeowners policies states that the insurance company will pay the dwelling limit amount shown on the policy, but only up to the actual loss sustained! Let’s look at a brief example to help illustrate:

A hypothetical NY/NJ metro single family home, 2000 sf, owner-occupied, would currently have a dwelling replacement value of about $250,000 to $350,000 (anywhere between $125 - $175 per square foot depending on age and build quality). Let’s split the difference and go with $300,000 replacement value. The market value (pre-August 2007) of this home is: $650,000.

Here’s where the lenders missed a turn in the road and their borrowers are paying for it: The policy dwelling limit should reflect $300,000 and not $650,000, even though the mortgage amount is greater than $300,000! (It’s probably around $585,000, assuming a 10% down payment). Because the premium on a homeowners policy is based in large part on the dwelling limit, the homeowner is paying about TWICE what he should because he/she was forced into buying a $650,000 dwelling limit instead of $300,000.

AN IMPORTANT POINT: a homeowners insurance policy does not pay off the mortgage in the event of a loss- it pays the replacement value of the home ONLY, irrespective of your mortgage amount! So, don’t bother torching the home, it won’t pay off your mortgage unless the mortgage amount is LESS than the replacement value of the home - then you’ll get what’s left over after the mortgage is paid.

If you think about it (and who does, unless you’ve got much too much time on your hands), this all makes sense. You don’t want the value of the land to be included in the dwelling limit, that’s just silly. Remember, the land will still be there, even if the home isn’t. It’s doubly silly when I tell you of another “fine point” you’ll find in most homeowners policies… “Land” is EXCLUDED from coverage! Ah, those insurance company types.

In my years as a retail insurance agent, I can’t tell you how many times a lender strong-armed the borrower to insure the property to the purchase price (or at the very least, the mortgage amount). They simply would not fund the loan unless this was done. Well, times are a little tougher for the lenders these days and you just might be able to get them to see it “your way” now.

Talk to your agent and see if you can reduce your cost of insurance today.

This is great quote. Read it and just let it sink in for a moment….

“The entire real estate debacle is the fault of everybody that was involved. And it was all about greed and speed,” said Rachel Dollar, a Santa Rosa attorney who represents lenders in fraud and other cases. “The brokers wanted their commission. The lenders wanted their premiums. The borrowers wanted their homes.”

(Emphasis added by me). The direct source of the quote.

I love the way Ms. Dollar (sometimes this stuff just writes itself!) uses the word “everybody”…. Let me add some more people who need to be included in the “everybody” category…

• Real estate attorneys received payment for their closings;
• Newspapers received increased real estate advertising revenue;
• Home appraisers received payment for their (ahem) valuation reports;
• Home inspectors received payment for their services;
• Homeowners insurance companies received premiums (and still continue to get paid) based on inflated real estate values (which were required by the lender to fund the loan);
• We can add insurance agents/brokers to the line above as commissions in large part are based on the gross premium paid by the homeowner;
• Many local and state governments benefited (and continue to benefit) from inflated real estate values;

I could go on, but you get the point. In short, it’s turned out to be a big turd sandwich in which we will all now have to take a bite.

Almost every investor has a money market account (MMA) or a bond fund. Almost everyone knows these accounts are not ordinary bank accounts and thus are not insured by the FDIC. Of course, FDIC “insurance” is a bit of a canard, as there is nowhere near enough money in reserves to pay everyone who has an FDIC insured account in the event of a sufficiently large enough U.S. banking crisis.

What most people are blissfully unaware of is that a MMA is essentially a very short term bond fund. A bond is essentially a “promise to pay” a certain sum tomorrow (over time) for a certain sum today. There are many websites that explain bond funds in hyper detail (go here for a great primer) - this is the most stripped down explanation I could think of! Bonds can be offered by many entities (corporations/governments, etc.) and are used for many purposes (capital expenditures/cash flow/reserves, etc). “Short term” refers to what is essentially a bond’s duration (which is essentially it’s “repayment period”). The duration of a MMA is usually less than 1 year. Short term bond fund duration as of this writing is about 2 years. Intermediate term bond fund duration is about 5-7 years and long term bond fund duration is 7+ to 3o years.

Let’s consider ABC Company, which needs money to manufacture a new plant. It decides to sell bonds (backed by its ability to repay) to meet its needs. It becomes the bond’s “issuer”. It will pay the bond owner interest for the use of the bond owner’s money today over the duration of the bond. But consider that ABC Company is not in the best of financial shape and would have to pay an interest rate much higher to attract an investor (who is concerned with ABC Co’s ability repay its debt, which is commonly referred to as “default risk”).

So ABC Company decides to pay to have its bonds insured with a monoline bond insurer for a fee, essentially “lending” its own credit rating to ABC Company’s bonds. Without the bond insurance, ABC would (in this hypothetical example) have to pay 8% interest on its bonds, but now that the bonds are “insured”, an investor might only be able to get 5% interest from ABC Co. since the risk of default is (allegedly) far less. ABC Company “pockets” the 3% difference, less the cost of the fee to the bond insurer.

So far, everybody’s happy, right?

• ABC Company is happy, it’s paying 5% interest instead of 8%;
• The investor is happy because the bond is “guaranteed” by a triple AAA rated bond insurer; and
• The bond insurer is happy because it charged and collected the bond insurance premium.

So what happens when the bond insurer goes belly-up? It’s a reasonable question these days and while it hasn’t happened (yet) don’t mistake the improbable for the impossible.

You see, the bond insurers have taken a bite of the sub-prime mortgage mess and the losses in this market segment may cause these insurers to lose their AAA rated credit status and even worse, may bankrupt them.

So in answer to my own question, very bad things would happen. Existing bonds would lose their insured status. New bonds would not be able to become insured, increasing borrowing costs for issuers.  Investors would, in many cases, lose money (principal)  on existing bonds that go into default. The shockwaves are so vast that it’s difficult to get your head around it. Our economy relies so heavily on credit that almost every industry will be effected by this in one way shape or form. Of course, as businesses are negatively impacted, employment will be as well.

The best primer I’ve found to help explain this potential meltdown can be found here. You can’t put your head in the sand on this one.

From wikipedia, “The yield spread premium (YSP) is the cash rebate paid to a mortgage broker based on selling an interest rate above the wholesale par rate that the borrower qualifies for”. What that means in plain language: YSP is a mark-up on the interest rate charged to you over and above the rate a lender would be willing to receive.

Lenders provide rate sheets to mortgage originators (including mortgage brokers). If the originator closes your loan at a rate higher than shown on lender’s rate sheet, the lender pays a percentage of that amount (overage) back to the originator. This is over and above any other fees the originator may charge such as appraisal fees, underwriting fees, etc.

In a prepared statement to Congress in 2002, Professor Howell E. Jackson of Harvard Law School noted in relevant part that the “study indicates that the vast majority of borrowers pay yield spread premiums - on the order of 85 to 90 percent of all transactions” and that “the average amount of yield spread premiums is quite substantial, on the order of $1,850 per transaction, making these payments the most important single source of revenue for mortgage brokers.”

It’s reasonable to suspect the “substantial” YSP amount of $1,850 in the Professor’s study is woefully antiquated. Since this testimony was prepared before the housing bubble, let me give you an updated example for your review, using some reasonable NY/NJ real estate values.

• Hypothetical loan amount: $400,000
• Lender’s par rate per their rate sheet (the rate the lender would accept): 5.50%
• The rate you closed at: 6.25%
• YSP paid to originator: $12,000
• Difference in the total amount of interest paid by borrower on 30 year loan: $69,016.61.

The rule of thumb is for every 25 basis points (0.25) paid by the borrower over the par rate, 1% of YSP is created. So in the example above, about 3% YSP is created. Following the math, $400,000 X .03 = $12,000 would be paid to the loan originator.

As I understand it, there currently is no legal obligation to disclose the loan YSP to borrowers except on the final settlement statement at closing, when it is often too late to do anything about. I believe it is a moral and ethical duty to disclose prior to closing, but since greed trumps morality almost every time, I would urge you request this information before the closing date on your next mortgage.

Further, with many borrowers who bought homes in the bubble years 2003 - late 2007 looking for someone to blame, I wonder what would happen if they looked at the mortgage originator and lender as a prospective target? Perhaps an argument could be made that the lender/originator was “unjustly enriched” for failing to disclose YSP prior to closing. I have to believe that insurers writing mortgage brokers and lenders professional liability (malpractice) coverage are concerned with this. It wouldn’t take many of these actions to start an avalanche of litigation, especially for those in the most “bubbly” real estate markets of California, Nevada, Florida and New York. I’m certain there are litigators who wouldn’t mind trying.

Of course, where the YSP was disclosed and agreed to by the borrower prior to closing, I have no issue. I wonder just “how many” disclosures occurred prior to closing…

I do have one final question, but it is admittedly rhetorical: How can we objectively review borrowers’ legal counsel’s role here? While the closing documents are in preparation, this information is available. What action(s) did borrower’s counsel undertake to explain YSP to their clients? Yes, I know. This line of questioning is a slippery slope with no answer.

Think this post is over the top?  Check out this link.

I’m not going to try to talk you into it. I’ve heard all the objections and reasons for not buying private disability insurance. None of them any good. If you don’t mind NOT having an income when you’re not able to work, you’re right, you don’t need disability coverage.

If however, having a ready income stream when you can’t work is important to you (heck, maybe it’s even a necessity with that mortgage you have and car payment and let’s not forget the insurance and …), you’d be wise to consider it. Premiums are about 3% of gross income per year.

But this post isn’t about buying disability coverage. It’s about buying it BEFORE you start your own business.

You see, no one thinks about disability insurance before they start their new business. Truth is, it’s next to impossible to get it once you begin self-employment. This is due to the financial underwriting process the company will undertake, where you will have to prove the financial “need” for the coverage by providing copies of your W-2 (or similar documentation) for review.

See the problem already? You won’t be able to prove financial “need” because you probably will not have a salary at opening day- OR you will have a greatly reduced salary at start-up, which will severely limit the amount of coverage you will be able to qualify for.

There’s also the bit about employment history. Disability underwriters want to see 2+ years at a job (or at least job function). You won’t have that at start-up either. It’s not difficult to understand why. Offering a policy to someone in a new business has the very real increased potential for claim written all over it. Not doing well in your new venture? No problem! You’ve got a disability policy that’ll pay!

So, before you leave that cushy job (with group long term disability coverage), budget for a disability policy on yourself while you can qualify for it!

My good friend Phil has always said that a very smart insurer could make a killing by offering “End of the World” coverage. The idea is that people would buy insurance to cover themselves from the peril of Armageddon and the “End of the World”. In case you weren’t aware, insurance policies as a general rule specifically exclude the peril of war (there are some exceptions).  In the event of a claim, people could send in their proofs of loss to a mailbox or post office box for review (and prompt payment, ostensibly).

If any underwriter at Lloyds of London thinks this is a good idea for a new product and can get 100% subscription, call me.

Some subjects just lend themselves to exciting writing: politics, religion and of course, the current media-created sensation du jour, Britney Spears. Let’s face it: writing about insurance is kind of like trying to make paint drying exciting and inspires as much enthusiasm as the thought of watching grass grow.

Well, no argument here. In fact, after spending close to 20 years in my chosen profession, it’s absolutely true that people want to know about their coverage exactly on two occasions: when their premium is due and when it comes time to file a claim. This should not exactly surprise anyone.

The industry is vast and complex and it’s not surprising to get (at least) 2 different answers to any one question asked. Even alleged “experts” disagree on fine points of coverage (ask a victim of Hurricane Katrina if their loss was a result of a flood or wind damage) and in many occasions, the court system is relied upon to tell us what the definition of is is. And so goes the insurance industry’s delicate dance with the legal system. It’s sometimes impossible to imagine one without the other.

Personal financial risk management is not for the timid or weak of heart. The best insurance people find reasonable solutions to the very real risks faced by their clients. When things go well, the work goes mostly unnoticed, due to the intelligent risk management design of an insurance professional.

There is a subtle, yet real difference between the terms customer and client – they are not interchangeable. Essentially, a customer is a Wal-Mart shopper: the active party in a transaction. A client is generally defined as one who is “under the protection of another”. Usage of the term “client” conveys an active professional standard and duty of care, which may be why the term has fallen out of favor.

Over the past decade, insurers have come under increasing pressure to become more a “financial services firm that happens to do insurance” than what most people think of as the traditional financial risk transfer role of insurers. With this subtle transition, and much to my dismay, insurers have been quietly exiting the “client” business.

Of course, the insurers are not solely to blame, as they will stress that they are only reacting to consumer demand. There’s truth to it: One cannot get through an evening without seeing at least one TV commercial with an animated character espousing the ability to quote, bind and print auto insurance policies online within minutes.

The subtext is clear: The burden of being “correct” has shifted to you from the insurer (or its representative) . Regrettably, the choices made will not be known to be adequate until AFTER an incident. Let’s be careful out there!