Peer-to-Peer (P2P) in the Risk Markets…
In the second of a four-part series of articles around the subject of insurance technology, Ron Ginn focuses on peer-to-peer (P2P).
Read part one: Complexity and resilience in the risk markets — part one
To kick off this segment, let’s first dispel any misunderstandings about what peer-to-peer (P2P) is not. P2P is not mutual insurance. While the mutual insurance model is more of the same spirit as P2P than corp insurance is, mutuals are still operating primarily with the same business methods corp insurance companies use, and the financial service is still an indemnity insurance contract. The same would apply to the fraternals.
P2P isn’t just a behavioural economic twist on insurance to reduce fraud. While there are elements of P2P methods that do invoke (and should employ) behavioural economic principles, employing these principles alone will not qualify a service offering as ‘P2P’.
P2P is “only hype” to get insureds to convert their social network into insurance leads. Like behavioural economics, when done correctly one would expect a P2P service offering to demonstrate a level of virility in excess of existing insurance offerings. That said, as an insurance broker myself, much of our business is generated via client referrals, so traditional insurance already achieves some level of virility, which means that virility alone wouldn’t be a key differentiator for P2P.
P2P is “not actually disruptive, rather it’s only an iteration of innovation” on the financial service that is insurance as we know it today. Many in the industry believe this half-truth. However, if used as a guiding principle, this will prove out to generate a strategic disaster. Currently there are many ways P2P offerings are being deployed in the market that could qualify as only “an iteration” on traditional insurance. However, there are other methods that more fully embody P2P methods that will prove to be quite disruptive to the current balance existing in the risk markets.
OK, so what the hell is P2P then?
In the first segment of this series on complexity, I discussed the three network graphs that have emerged in the risk markets, and which business models embody them.
To dive into this, we first need to boil down and define the activity the risk markets perform for society. Why did the risk markets emerge? Why does society engage with the markets? There are three core societal functions the risk markets preform for society:
- Risk transfer.
- Escrow of funds for a defined purpose.
- Management of reallocation of escrowed funds.
Let’s take a look at each of these functions and the methods deployed to accomplish them.
Risk transfer. One of the core elements required to legally define a contract as an insurance contract is indemnity. Inherent in the term ‘indemnity’ is the idea of risk transfer. Indemnity is defined as, “compensation or payment for losses or damages”, effectively meaning that the risk experienced from a loss event has been transferred from one party to another. (Here’s a definition of the elements of an insurance contract, and here’s a definition of indemnity.)
While insurance is a highly efficient method of accomplishing some portion of total risk transfer, in terms of cost per $1,000 of coverage, an insurance contract is only one of many methods humans use to transfer risk around society, and the insurance method has its limitations. Other formal risk transfer methods include (but are not limited to) product companies offering consumers a warranty on their products, many service companies are bonded creating the same effect as a warranty does for consumers of their service. In the financial markets, we see options and swaps, as well as letters of credit. Formalised charity efforts also amount to risk transfer. In the public sphere, as was demonstrated in 2008, society has formalised methods for transferring risk from systemically important private companies, to the public at large backed by the government’s access to taxation revenue.
Informal methods of risk transfer that can be routinely observed are: families and friends compensating each other for some risk the other has experienced. The same behaviour also emerges within groups and communities that humans naturally form, both with and without the intentional purpose of risk transfer. These methods currently amount to “black market” methods, because they’re not formalised; the economic activity isn’t taxed and it doesn’t contribute to GDP. However, the economic activity does and will always occur.
Escrow of funds. With indemnity insurance and other formalised methods, every insured has paid a premium for the legal right to transfer their risk exposure to another party. Presumably along with many other insured’s premiums for the purpose of accomplishing successful transfer of financial risk from a participant in the group who is unfortunate enough to experience a loss event in the future, to the group as a whole. These premium funds are held in escrow to assure participants in the system, that the system is capable of accomplishing the purpose that compelled the humans to engage with the system. This behaviour can be viewed as an “escrowing of funds, for a defined purpose”.
When observing informal methods, we do not observe this escrow behavioural pattern. Indeed, many family and friends have received news that someone has experienced a loss they don’t have the means to bear. It’s important to note that the person who has experienced the loss event, in many cases, has already engaged with the available formalised methods the risk markets have on offer, but the burden of the risk is in excess of what those methods can cover. With insurance, this uncovered amount of risk can take the form of a deductible, the exclusion of a peril, or a limitation of coverage on a covered peril.
Informal methods of risk transfer naturally emerge to fill these segments of total risk, which formalised methods do not address. Since there are no funds that have been prepaid and escrowed for the purpose of addressing these segments of risk, we observe informal methods of risk transfer employing a post-pay method of achieving coverage. This can be observed in the digital environment on crowdfunding platforms such as GoFundMe, where coverage for a loss event is achieved after the loss event has occurred.
Management of reallocation of escrowed funds. Formalised methods of redistributing escrowed funds, such as insurance methods, employ a legal contract. In black and white, the rules the system will employ to determine for what purpose escrowed funds will and will not be paid out by the system as coverage, and how the dollar amount of that coverage will be calculated. It is this legal contractual methodology that creates the requirement for actuarial work.
Insurance companies employ statistical and actuarial methods to not only ensure that enough money is escrowed to accomplish the purpose for which the society agreed to escrow the funds, but also some additional funds to pay for the costs of the centralised management of the reallocation process, including some additional funds for potential profit for the insurance company.
The degree to which these formalised methods necessitate the burning of escrowed funds is a reduction in the efficiency the system is capable of achieving. Internal process inefficiencies that exist in the companies managing the process effectively add to society’s realised risk from engaging with the insurance system’s methods. Underwriting profit, which is created via actuarial means, essentially amounts to arbitrage that accrues to the insurance system, paid by society.
Currently, informal methods obviously don’t employ legal methods, as no funds have been put into escrow for any specific purpose. The informal methods for redistribution of funds to achieve a transfer of risk unfold as individual peer decisions, directly between the two peers involved. This is an example of budding emergent P2P behaviour.
Let’s get back to the original question. What the hell is P2P?
Whether or not we’re taking about music files via Napster, transportation via Uber, housing via Airbnb, or work via TaskRabbit, the amount of economic activity resulting from those P2P methods blossomed, but only after a platform enabled the formalisation of the behaviour that already existed in the world, albeit informally. In each of these markets, coming out of the industrial age, society had built wonderful centralised organisations to accomplish the fundamental economic activity of the market. In each of these markets, when a P2P platform was built, offering just the right degree of formalisation (but not too much formalisation), to enable (but not inhibit) the connection of individual peers on the platform, the amount of economic activity experienced in society around that economic need grew dramatically to exceed the amount that occurred via the preexisting informal methods. This is fundamentally an expansion of the market’s economic pie.
In the risk markets, we will see the emergence of a P2P platform enhancing the individual’s ability to network together using distributed methods of management, to accomplish the process of reallocation of escrowed funds. With this platform, the three core functions driving society to engage with the risk markets will be accomplished by the individual actors without necessitating a central authority.
New technologies such as distributed ledgers and business methods — which, as it turns out, predate insurance methods by a thousand years, along with a shift in society towards the behaviour patterns that are driving the rise of the sharing economy across many markets — will converge, and the risk markets will see a P2P network come about.
This network will be intentionally designed, to accomplish a positive financial network effect, where the resulting network effect enables the creation of financial leverage, amplifying the amount of risk the individual peers can cover with their own individually escrowed funds. P2P will effectively enable the option of “networked self-insurance” to better cover the gaps in total risk left by already formalised methods.
Insurance methods will not go away. The methods play an important role in how our existing financial system works and is interconnected.
Mitigating risk exposure
It is important to notice what’s not necessary for P2P: indemnity legal contracts, actuarial methods, and a centrally controlled escrow account for processing the reallocation of those escrowed funds. There’s nothing wrong with insurance methods — they work quite well, and systemically serve to mitigate the risk housed on lending banks’ balance sheets, albeit at the borrower’s expense. Lending activity in turn serves a systemically important role of enabling financial leverage for large capital purchases. However, that leverage comes with a risk.
If a bank lends on a mortgage or auto loan and the underlying asset is destroyed, the loan on the bank’s balance sheet will have lost value. Indemnity insurance is likely to remain the only method of mitigating this balance sheet risk exposure that lenders will agree to accept. It wouldn’t surprise me if we see the rise of insurance policies sold to banks on their loan portfolios, much like we see today occurring in the process of securitisation of loan portfolios, and somewhat similar to forced placed property insurance.
In closing, it appears that we are observing in the risk markets, that the ‘insurance industry’ has been behaving in a way that can be described with the saying, “If all you have is a hammer, everything looks like a nail — just insure it”. There are new tools available to the risk markets, along with new behavioural patterns in society that will result in, and we shouldn’t be surprised when, we see new methods — P2P and otherwise — emerge employing these new tools for the benefit of society.
In the next section of this series, I’ll dive into one of those tools: blockchain (aka distributed ledger) technology.