Barriers to Insurance Innovation

In exchange for a payment, insurance companies assume risks from policyholders. Because of their ability to aggregate and diversify many risks, insurers can offer this service at a price that is attractive to policyholders. Yet there are risks that insurers refuse to cover, even though the insurer appears to be in at least as favorable a risk-bearing position as is the policyholder. Property insurance contracts, for example, place on policyholders the risk that rebuilding costs will be greater than expected, or that a home will be destroyed by flood or nuclear damage, or that exposure to natural hazards will change over time, or that home equity values will rise or fall. Long-term care insurance commonly makes policyholders, rather than insurers, bear the risk of unexpected industry-wide cost increases or that care will be more expensive than anticipated. Liability insurers exclude coverage for damage caused by pollution. Directors and officers insurers do not cover court-awarded increases in merger consideration even in quintessentially-covered cases where executives breach their fiduciary duties. This lack of risk transfer is surprising, since insurers are likely better situated to bear these and other risks than are their would-be policyholders.

The absence of these desirable risk transfers presents troubling policy implications. This Article identifies these abnormalities and shows where traditional explanations are lacking. I hypothesize that much of the breakdown is due to structural forces that deter innovation in insurance policies. Risks of any meaningful consequence must be reinsured by global reinsurance firms, and reinsurers will have little appetite for novel risks that are difficult to price, especially when, as with any new risk, those risks are tiny relative to reinsurers’ massive portfolios. Moreover, the annual nature of reinsurance contracts means that reinsurers also lack incentives to incubate new coverage that, while small today, may grow significantly in the future.

These deterrents to innovation are problematic both because they produce inefficiently low levels of risk transfer and because they will impede development of new markets and innovative products that rely on insurance to cover their risks. Fortunately, a variety of policy responses that I consider can help correct for these problems.