Economy & Business
The Great Risk Transfer
Over recent decades we have seen an increasing trend of transferring risk from institutions to individuals. There may be good reasons for this, but information asymmetry can make life very difficult for ordinary people to manage the consequences.
By Lee Faulkner
Risk is a natural and unavoidable part of life, and it would be pretty boring if that were not the case. You can choose either to live with a risk or insure against it, but making that choice requires a level of understanding of risk, and a degree of financial literacy, that even those who consider themselves as financially smart are now unable to deal with. Information asymmetry, where the institution knows more than you do, and often plays on that and wants to keep it that way, just adds to the problem.
Over recent years there has been an increasing trend towards transferring risk from institutions - the state, employers, and financial services companies - to individuals - ordinary citizens, employees and consumers. This means that individuals now have to understand and deal with risks they never had to worry about before.
We need to understand how this happened, what the consequences are, and ask ourselves whether we should be slowing or reversing this risk transfer, and/or equipping people to be better able to deal with it.
The causes and effects
There are many reasons why the Great Risk Transfer has happened - technology, medical science, increasing longevity, and changes in financial regulation are the main ones.
Previously, when buying a life insurance policy, people were allocated (“underwritten”) to a fairly small number of homogenous risk groups based on their age, gender, and some aspects of their health and lifestyle, whereas today an insurance company could give you a bespoke price based on your genetic code. A fundamental tenet of insurance - the pooling of risk - could be replaced by the individualisation of underwriting and pricing. Medical science and technology can make that happen, if we allow insurance companies to do it. Having “bad genes” can now make you uninsurable.
Increasing longevity should be a good thing, but it has meant pension schemes and governments removing benefit guarantees and transferring the risk of poverty in old age to the citizen to deal with.
Better regulation has meant our financial institutions are now more robust, and able to deal with the consequences of more unknown future catastrophes, but that has come at a cost - what the bank or insurance company used to cover implicitly they now either exclude or explicitly charge you for. That has led to restricted accessibility to some products for some risk groups.
As risk is increasingly being transferred from the institution to the individual, so do the role and responsibilities of each change. Individuals now have to understand and manage the risks that institutions used to deal with.
There has been a fundamental rebalancing between the state and the individual, from collective responsibility to individuals coping on their own - is that balance right now, and will it be right in the future? Are financial institutions going to hide behind information asymmetry and outsource all risk to their customers, or are they going to help consumers make the best decisions for themselves? Are advisers now properly equipped to give the right advice to their clients, or do they need to be retrained? Should employers be more paternalistic and take on financially educating their workforces as one of their core responsibilities?
There are two main strands to dealing with the effects of the Great Risk Transfer - helping people with their decision-making, and rebalancing the risk.
From the point of view of the average consumer, complexity is the number one barrier to good decision-making; information asymmetry exacerbates it. Even financially savvy people these days find it very difficult to make good decisions about managing risks and achieving the best outcomes for themselves. If we help people manage their risks through good decision-making this could help many people but that requires proper financial advice.
Good, independent financial advice is hard to come by - there are plenty of salespeople around, but commission-only remuneration systems, and volume-based sales incentives, put their true motivations into question. We have to reassess, and urgently, whether these payment practices should be allowed to continue. Financial advice should be affordable and accessible, and should help people wade their way through complexity; it should not be an exercise in tolerating hard-nosed selling.
We must find ways of providing support to people in making complex decisions about their own financial risks independently of all sales pressure. We must also see financial wellbeing and financial education as a right - not a privilege for the rich but a right for everyone.
If we equip people to make good decisions, and help them recognise, and potentially deal with information asymmetry they will have a better chance of coping with the challenges of risk transfer, for example:
- If you know that your genes make getting affordable insurance difficult, then knowing how and where to shop around, and which insurers do and don’t ask certain questions, might help you find what you need;
- Understanding the realities of increasing longevity, and the risks of running out of money in retirement just because you live too long, will help you understand your retirement needs better and ensure you put enough into your pension plan;
- Most people understand the volatility of certain types of investment, but do they understand that in the context of the timeframe they will be investing over? Short-term ups and downs don’t matter when you’re investing for your pension, but they matter a lot if you’re saving to buy a house;
- If you understand the risks of getting sick long-term, or having to deal with end-of-life care costs, then your plans can take into account a wider set of risks for a greater number of scenarios.
All of this requires proper education, and accessible affordable financial advice.
Should we rebalance the risk transfer?
Maybe the Great Risk Transfer has gone too far, and now is the time to put it into reverse? Life seems to be getting more complicated, not simpler. Banks and insurance companies seem to be getting more sophisticated in the ways they hide what’s going on under the guise of slick marketing campaigns, rather than giving us what we need and want at a fair price.
If we’re going to put the risk transfer into reverse by moving the responsibility for some risks back to institutions, then that requires major structural change. That means products, services, advice, and regulatory frameworks. That’s no mean feat, but a few principles can give it a good push.
Firstly, as I alluded to above, employers have a major role to play here - if they don’t want to reabsorb the risks they have passed onto their employees then they must at least educate them about these risks. An average employee cannot make the decision about whether to pay into their pension scheme or invest elsewhere unless someone explains to them the relative risks of each option. Financial education should be done at work and in work time, and advice services should be made available to employees.
Secondly, the regulators of our financial institutions need to move beyond establishing and maintaining solvency, important though they are, and widen the metrics they are measured against. These metrics should cover transparency in sales processes and sales remunerations, simplicity in product design, accessibility guarantees for those who might potentially be denied access, simple standardised literature to enable consumers to compare products, and clear information about how they, themselves, make money.
Finally, the state - our governments are not being honest with us about increasing longevity and the potential for medical advances to improve it more, and the financial consequences of this. They must educate us about the costs and the options and stop abdicating their responsibility to inform by passing the buck and hoping for the best.
Nothing I’ve said in this article is particularly ground-breaking or earth-shattering; what I have tried to point out, though, is how much risk has been transferred from institutions to individuals under our noses without our noticing and certainly without telling us. It’s been happening for a while and we have, perhaps, not realised the extent to which we are now assuming risks we never had to before. Once we realise that, then we need a debate amongst all stakeholders - politicians, regulators, consumer groups and industry groups - about whether the Great Risk Transfer has gone too far, whether the balance is right, and whether it’s time to put it into reverse. If we don’t do this then the consequences for our individual financial security, as well as that of the state, could be disastrous.
Lee Faulkner is a Fellow of the Institute and Faculty of Actuaries, the UK’s actuarial body, and has more than 30 years’ experience in the world of financial services in Asia, Europe and Latin America. He is a Taiwan Gold Card holder and now lives in Taipei.