Disruption in Insurance Industry

Some seven years ago, a few of us were crystal-ball gazing about what lay in the future for the Insurance Industry.

?I predicted something on the lines of - A Google or an Amazon disrupting the industry through a data-driven business model. An all-tech insurer will just need a few smart actuaries and field claims adjustors in its business operations. Everything else will be a self-service mobile/web interaction for the insured and B-2-B EDI interactions for regulators and third parties.

My rationale at the time was that Insurance is an ‘Information Only’ industry, meaning there is no tangible product. The customers buy a promise, a contract to cover certain losses arising from pre-agreed adverse events. So, I figured if tangible products like books can go Borders' way, it was only a matter of time before it happened to the Insurance players.?I was well aware of the technology paradox in Insurance. The reason it has been a perennial IT laggard is also because it has always been its early adopter, which then encumbers it with inflexible legacy systems. This was true in the 50s and 60s when the insurers (along with airlines' GDS systems et al.) were the first to adopt mainframes. And it is true today;?the insurers that twenty years ago implemented Siebel CRM to solve a single view of agents and insureds are now seeing their competitors implement SalesForce as a System of Engagement for their operations teams, providing a single view of agents, policy, and customer interactions history.

Today morning, I thought I would revisit that crystal ball to see if there is a rear-view mirror in there somewhere. Why a Google or an Amazon has not disrupted the Insurance market yet and why do the Lemonades and Roots continue to operate at 150% Combined ratios after 6+ years of trying to disrupt the market? (Credits to Matteo Carbone for the cover image for this article and the analysis of Lemonade and Roots numbers).

?I am beginning to think that the InsureTech entrants are failing to grasp the fundamentals of what makes Insurance complex and just maybe, they are trying to solve problems that do not exist.

?A few examples.

?Case 1- One InsureTech is trying to differentiate how they only use telematics and do not use Credit Score as a rating parameter, implying the Insurance industry’s use of Credit Score as somehow bad or penalizing the insureds.

?Case 2 - Another is claiming it will give back a portion of Premium that was not paid out in Claims.

?To me these come across as marketing gimmicks and make me question if they understand Insurance in the first place.

?For Case 1, consider this. For many years now, in a few Asia Pac markets, you can get a discount on life insurance if you are a vegetarian. So if the US insurance companies introduce diet type as a rating parameter, will they then be discriminating against non-vegetarians or penalizing insureds who are not vegetarian??The Industry, including regulators and actuaries, has spent many years, both from the statistical sciences perspective and legal and ethical aspects, ensuring every rating parameter is a fair discrimination. The Insurance Commissioner in every state ensures it. The way this is enforced is Insurance companies are required to file their rates every time they change a rating parameter or weightage. So, to me, it is misleading to make customers feel that they are being penalized if their credit scores are used as a rating parameter.

?Rate-making is complex, with no simple answers or a magic bullet. Take another example of pay-as-you-go insurance based on the number of miles driven. Odometer mileage has been an accepted rating parameter for a long time now. The more miles you drive, the higher the probability of an accident and the higher the premium you pay. Whether the established insurance players rate based on Odometer mileage or an InsurTech uses telematics for a pay-as-you-go model,?what does not change is the underlying complexity of rating based on mileage. To understand how complicated this can get for an Insurance company, consider this fact. During the 2020 COVID year, while the number of miles driven reduced by 13%, the number of fatalities from accidents increased by 6.8%. Go figure! Is it a matter of adverse selection (meaning that only the most reckless are getting on the road)? How do you adjust your rate-making and your reserving guidelines in light of this? The point is that the law of large numbers is not that simple, and implying to customers that premium calculations using a Credit Score are somehow wrong is kind of a disservice to the Industry.

?Regarding Case 2 of InsurTech giving back a portion of the premium not paid in Claims. It wrongly paints a picture that the Insurance companies are somehow hoarding premiums or not paying enough in claims and, hence, not looking after the insured. Here is why I think that is the wrong message to send.?Insurance companies in the US comply with two sets of regulators. The SEC, whose primary objective is to protect shareholders, and then the State Insurance Commissioners, NAIC, whose objective is to protect the Insureds (not the shareholders). The latter is enforced through statutory accounting practice (SAP). It controls not only what can be counted as an Asset but also ensures enough reserves are maintained to fulfill policyholder obligations. So, for example, a leasehold improvement or equipment that is an asset for SEC filing becomes zero in SAP filing because these cannot meet policyholder obligations. Similarly, while the unearned premium stays as a liability on the balance sheet, the policy acquisition costs, like the commissions, have to be recorded as expenses immediately and cannot be amortized like in the SEC filing. There are stringent rules around treating and maintaining reserves, incurred but not reported (IBNR) losses, and loss-adjusted expenses (LAE). Very few insureds would know that their Insurance company cannot just keep writing new policies. If the New Written Premium (NPW) grows to be more than three times the Policyholder's Surplus, the insurer has no choice but to cede to Reinsurance to stay compliant. While the market will celebrate a 10% increase in revenue for a regular company, for an insurance company, a 10% change in net written premiums will negatively impact the leverage test and will likely result in a rating downgrade.?

?The broader point is that we do not need Insurtech to save the customers from insurance companies. Insurance companies are not hoarding premiums or not giving back what is not paid in claims. The controls and limits around Policyholders' Surplus ensure every premium dollar finds a controlled way back to the Insured. The regulatory mechanisms have evolved over decades, and they ensure that the Insurance companies serve the purposes of the Insureds and, more importantly, the society as a whole. When an automobile driver pays a few thousand dollars to an Insurance company, it is freeing up $30,000 to $40,000 to the broader economy, which would have otherwise been required to keep in their bank to cover accidents.?

?I am not saying there are no opportunities to decrease the expense ratio. If the Insurance industry can operate profitably with loss ratios in the 90% range, it will be the holy grail, but the Insurance Industry does not need the kind of disruption that the InsurTechs are implying. The industry, in my opinion, is doing its job well in serving society and the insured.