The “Exclusion Monster”

At the moment, the property and casualty insurance industry in Canada has some serious image problems. I think there are at least three reasons for this: the transaction involves no “tangible return”, the public sees insurers taking their money and in return they only receive “a promise”, and I personally think most people have an “intellectual” understanding of insurance but the subconscious reaction to the transaction is “money out, nothing in”, which equals, “we lose”. Furthermore, although any form of delayed gratification elicits a similar response, insurance is harder to grasp because we, the buying public, do not really want to collect “the benefit”.

A less obvious factor is that coverages are often unclear. Buyers of insurance do not really understand the details of policies. When an individual submits a claim, there is a little uncertainty about the extent of coverage and the insured anxiously awaits confirmation from the insurer. Policies are essentially multiple pages of terms and conditions, exclusions, exceptions to exclusions, and so forth. As such, we the public are paying money for vague promises, and there is a perception that insurers will invoke conditions in the “fine print” to deny claims. The public has therefore formed an impression of arbitrariness in the granting or withholding of protection.

Then there is under-appreciation of the nature of “risk”. People do not plan to have accidents. It is true that bad drivers are involved in more accidents than good drivers, but accidents happen to the best of us – this is a basic statistical fact. No matter how careful and competent we are, situations are sometimes governed by circumstances beyond our control. Thus, whether we may be “good drivers” has no influence on medical expenses or the cost of repairing a car.

In addition, insurance is not like a bank account – we do not put money in now and make withdrawals at a later date. Auto premiums of $1,500 per year for 20 years add up to $30,000. This is only about enough to replace the vehicle. Yet insurers promise to reimburse us for medical expenses, income replacement, and all those other costs that can ultimately add up to several million dollars. These are facts that are often overlooked by those insureds currently not facing such a potentially devastating loss.

EXCLUSION QUANDARY

Consumer trust levels are low and the complexity of the product perpetuates mistrust and suspicion. What can be done about it? Even simple personal lines policies are complicated documents. Can we make them more easily understood?

If I were to tackle only one portion of policy wordings, it would be the exclusions. There are a lot of them. There are exemptions to exclusions and conditional adjectives and phrases galore. It seems that these are the root of the problem and the reason the buying public feels so much uncertainty about coverage.

Do we really need exclusions? Can the insurance company just tell insureds, clearly and simply, what they are covered for? Since we as members of productive society spend a lot of money insuring our homes and cars, why is it so difficult for insurers to explain what we as insurance buyers are paying for?

The short answer is that insurance policies have exclusions because insurers offer coverage for every loss possibility, except for items on the exclusions list. The alternative, to clearly list what a policy covers, does not allow for unusual situations. To me, this is the fundamental difference between a “named perils” policy and an “all risks” policy. Named Perils means “listed as a peril means it is covered”. All Risks is the reverse: “not listed as an exclusion means it is covered”.

What are the benefits in comparing “named perils” against “all risks” coverage? Traditional “fire” policies are a good example of “named perils” – if your building burned down, you were covered. If it was washed away in a flood, blown down in a hurricane, pounded by hail, shattered in an earthquake, or vandalized, there was no coverage. The problem with “named perils” arises when other perils intrude on our lives. It matters very little to me whether my house is burned, blown or shaken down. The end result is a sudden lack of shelter from the elements. In a crisis, human nature seems to be to deal with the consequences. The causes are almost irrelevant, once the damage has been done. This is where an “all risks” policy really works.

However, there is one serious complication with “all risks” policies – insurers never meant to cover all possible risks. Some causes of loss are just too problematical. For instance, if “all risks” included arson, it would be easier to burn my house down than to re-sell it. If the country next door declares a state of war and then uses my house for target practice, it is really a political issue. A few simple exclusions would seem to be necessary. The chaos therefore begins.

APPLES & ORANGES

A “few simple exclusions” have grown today to multiple pages of densely-packed clauses that are difficult even for insurance professionals to decipher. Consumers are aware that there are situations where policies do not provide “all risks” coverage, but very few of us as the buying insurance public clearly understand what has been removed or what protection still remains.

To complicate the issue further, it is almost impossible for us to compare different policies. Almost every company has a different version of standard clauses. There is virtually no standardization of coverages from one company to the next, except as mandated by legislation.

This has perhaps led to a new criticism of “vanishing coverage”. There have been recent complaints about “vanishing” coverage, where new and/or tighter exclusions have taken existing coverage away. However, most changes to exclusions that I am aware of are of the “clarifying” type. Legal decisions sometimes reinterpret coverages to include things that were never intended by the underwriter. Of course, the policyholder would not have been charged any premium for the additional coverage, because it was not considered in the underwriting exercise. The exclusion simply maintains the existing coverages.

As a policyholder, I do not have less cover but the world is becoming a more expensive and dangerous place. If I retain this “new risk” component, my personal economic security could be compromised. Although retaining risk is hard to assess, most of us have a good idea what a personal financial disaster looks like. We are therefore uncomfortable with a widening coverage gap.

EXCLUSIONS EXAMINED

Let us look at what makes up an exclusions list. For the sake of this discussion, I am going to divide exclusions into categories, based on some general characteristics. There are various other ways to categorize them, but the idea is to try to narrow down on problem areas by eliminating some of the less troublesome items. The distinctions I am using here are functional – basically, what is the exclusion intended to do?

Intentional acts. The easiest and most obvious exclusions take away intentional acts by the policyholder as a cause of loss. Arson, storage of dangerous materials, and lack of maintenance fall into this category. Acceptable losses have to be “accidental”. This is a concept that most policyholders understand pretty well and agree with.

Social-political causes. “Accidental” does not describe the deliberate actions of governments and other social and political organizations. A declaration of war is not accidental, although some of the consequences may not be intentional. Deliberate flood control efforts by government departments may result in localized inundations. The regular activities of governments can create economic issues for individuals and businesses. There is seldom any acknowledgement by governments of their responsibility to compensate for damages caused by their actions (or inactions). When insurers exclude a social or political peril, there is no secondary mechanism in the insurance policy to “take up the slack”. Policyholders are left on the hook for loss potentials that they can neither asse ss nor prevent. The uncertainty of these arrangements is problematic for both policyholders and insurers. In a large crisis, the political agenda may be to accept no economic responsibility, forcing insurers to provide coverage or leaving us to suffer the losses personally.

Policy-specific exclusions. Some exclusions exist to address specific situations with policyholders. For instance, commercial activity may be excluded in a private residential setting. The pricing of the policy is based on an understanding of the exposures, and exclusions are sometimes added to clarify the extent of those exposures.

CLEAR LINE

Exclusions that deal with intentional acts are the most straightforward. They are usually addressed in Canadian legal system, as fraud, criminal intent, etc. A standard wording should be mandatory. Insurance should not be a protection for criminal activities, and anything other than a “level playing-field” in this area of market practice is probably short-sighted and foolish.

Exclusions that deal with policy-specific instances are at the opposite end of the spectrum, and the diversity seen in these across the market is probably necessary and unavoidable. Particularly as we move from personal to commercial lines, specific cases take on greater significance. These items are difficult to standardize, and probably should not be standardized.

Exclusions with broad social and/or political connections are probably the most poorly handled sections of policy wordings, and it is here I would suggest we look for improvements. I would suggest that terrorism, nuclear, pollution, asbestos, war, flood, toxic mold, and data are issues that affect most or all of us.

As a consumer, I would like to see a clear and explicit line between what is covered and what is not. This allocation of responsibility should be standard and comparable from one insurance policy to another. This does not work if every company customizes the wordings. I would much prefer a clear understanding of the risks that my insurer and my elected representatives are accepting, and ultimately what they are leaving in my hands.

Although there have been standard recommended wordings in circulation for many years, their use is voluntary and implementation is therefore always incomplete.

REGULATORY SOLUTION?

As an industry we have clearly proved that we cannot voluntarily standardize exclusions. Perhaps it is time for the regulators to speak up. An industry-wide consensus is needed and the regulators have the power to unilaterally enforce a measure of standardization. The regulators are probably in the best position to define the limitations of insurance protection and the circumstances where governmental protections should take over. Maybe, in this sense, consumers and the insurance industry need a rewrite of the insurance acts.

The danger, of course, of moving in this direction is that a regulatory solution may be more political than useful. However, this is a danger that most consumers would probably be willing to accept. The alternative is an increasingly inadequate level of policyholder protection.