Uncalculated Risks

IIPPE in Brief Issue No. 12

by Vicki Zhang

The recent financial crisis has re-opened discussions among economists regarding the epistemology and validity of orthodox economic theories being taught in universities. Consequently, some economics departments, after many decades of focusing on mathematical drilling, started to reintroduce pluralistic economic theories – largely in the form of courses on economic history and thought. However, the same intellectual inquiries have not occurred in specialized undergraduate finance programmes. As someone who teaches undergraduate insurance finance, I have been especially concerned about the long-held assumption about specialized finance programmes, by educators and students alike, that such programmes are only responsible for cultivating financial “technicians”, who do not need to concern themselves with broader social issues.

Recently, with the help of Jeffery Ewener, a political writer, I completed a book that among other things, examined the role of financial “technicians” in the insurance industry – financial engineers, modellers, actuaries. Our point of departure is the ongoing paradigm shift in insurance regulations, from a “rules-based” system where public regulators largely called the shots, to a “principles-based” one where frontline financial technicians have become the de facto regulators. In its origins, this paradigm shift grew out of the changes that occurred in the financial world in the 1960s and 1970s, when insurers were confronted with unprecedented challenges to the very survival of their business and, in response, frantically restructured their products, investment strategies and even their corporate ownership to meet the new conditions. In this process, public regulators became overwhelmed with the complexity and fast-changing product “innovation”, and find themselves in a perpetual cat-and-mouth chase where they had constantly to modify the existing regulations to rein in the new and often hybrid products from the industry. Moreover, insurance regulators were increasingly drawn from the private sector itself, as only those with “hands-on” technical experiences were deemed credible and capable of regulating the industry. As a result, regulators and industry professionals often share the same education, neoclassical perspective, and professional experience and, therefore, agree as well as on the nature of the problems facing the industry, and the narrow range of possible, or acceptable, solutions.

The principles-based regulation, or PBR, became popular against this backdrop. It is a regulatory approach that trusts the private insurers to do the right thing and explain themselves afterwards. Market consistency, the test of the “prudent man”, internal risk management and transparent reporting became the pillars of the new regulatory system. The reliance on companies’ internal models in PBR solidified the private sector’s solution to the recent financial crisis: investing in bigger and faster computer technology, building more complex financial models and exploring new ways for hedging and risk transfer. A foreseeable consequence of this regulatory change is that the industry would be empowered to use complexity further as a shield from close public scrutiny, while regulators suffer from epistemological limitation. It is also not clear how regulators working in the PBR framework may maintain consistency and comparability of model results across entities, prevent gamesmanship introduced by internal models, or have the authority to oversee the third-party solutions frequently utilized by the industry.

This situation – so fraught with economic and social consequence – has evolved in an almost complete absence of public discussion. Social scientists and laypeople find themselves lacking a concrete understanding of the way the industry actually works, or at least one thorough enough to provide the basis for an informed opinion, let alone a fully-fledged critical analysis. On the other side of the chasm, insurance finance students and technical professionals working inside the industry have grown accustomed to simply dismissing what they consider to be ill-informed and irrelevant criticism of the insurance industry.

Therefore, as educators, we have a knowledge chasm to bridge. On one hand, the public needs a clearer description of the recondite financial operations of insurance industry that are now so fundamental to our political economy. On the other, specialized insurance finance programmes within universities should embed the industry-related knowledge within its real-world economic and social context that is the industry’s operational environment, to which it is forced to respond, and upon which it has a considerable and ongoing impact. Our book project and my upcoming associated seminar series are only baby steps towards these ends.

The book: Zhang, V. & Ewener, J. (2014). Uncalculated Risks: The transformation of insurance, the erosion of regulation, and the economic and social consequences. Toronto: Canadian Scholar Press.