How does insurance work anyway? Do you need to care?
Insurance, to be fair for most, is incredibly dull. But it is one of the things that makes the Western world go round.
We all buy insurance, either directly or indirectly. If you drive a car, own a home, work in an office. All of these things require insurance. Whether we like it or not or whether we think it is fair or not.
Insurance in layman’s terms works like this — you pay a premium every month or year and in case of an unexpected event or damage to your property, your losses are covered by the insurance company. Seems like a reasonable thing to do — paying premiums monthly or yearly rather than having a large bill in your hand to deal with in case something goes wrong.
This idea is definitely a great mean for profits for the participants in the insurance industry — catastrophic events that wipe out the whole insurance capital backing the policies are extremely unlikely, hence insurance companies are doing relatively well.
Who comes up with the insurance products and prices?
There’s various risk assessment going on in insurance that I frankly will not start boring you with. But at a glance it works like this:
There are various areas of risk assessment.
Actuaries determine the likelihood of risk and exposure. They calculate the costs that come with a disastrous event or claim and create projections based on that. They are essentially calculating how much money the insurance company needs to collect for policies in the bank if things go south. Making sure this amount is enough to pay out claims and also stay in profit.
Underwriters. The info provided by actuaries helps shape underwriting. This is the insurance jargon for signing and accepting liability under an insurance policy. Underwriters accept the insurance premium in return of a guarantee to cover the risk. The term comes from the Lloyd’s of London insurance market. Bankers took a fee for literally writing their name under the risk they were willing to accept.
What is it that hinders innovation?
Like in any industry, large corporations tend to move rather slowly. Sometimes not because they don’t want to. Changes take time because there are various levels of approval, many departments ideas need to go through. Many people that need to agree on things. The more opinions, the longer it takes.
Now to draw a parallel to the previous thought, even something as decentralised as bitcoin is having difficulty coming to a consensus when it comes to important decisions on development. Referring to last year’s hard fork situation. Too many opinions, hinder decision making. I am not talking bitcoin down in any way, this is just how it panned out.
I am also not comparing insurance companies to bitcoin in any way, just pointing out that when there are a lot of decision makers , simple things will take a lot of time. For example, the giant Deutsche Bank upgraded their ancient IT systems only in 2016. Why did it take so long? Because cost analysis up to that point suggested that change will be more hassle/cost than moving to something more efficient.
So if we wonder why there is a lack of modern insurance products in the market. For example why AirBnB hosts cannot insure their property or why cryptocurrency wallets don’t have an option for insuring the assets against hacking. It is not because the insurance companies don’t care. It just takes them time.
Where does the money come from to pay your insurance claims?
In simple terms it works somewhat like this:
Insurance companies need to hold an extra % of gross written premiums (total of policies sold) as capital. For example if $1M worth of policies are to be sold, around $300k needs to be kept in liquid assets. This is in case the claims needed to pay out are higher than the amount collected from selling policies.
The reality is the pricing and risk assessment have been designed in a way that all claims will be paid out from policies sold and there will also be a little bit left over for profits. In addition to that the capital and profits are normally invested further into stocks, bonds, currencies. Making the profits even higher.
Can this be done differently? Regarding the capital requirements — no. This is a legal requirement. In the EU insurers and reinsurers need to adhere to the Solvency II regulations.
Where does the capital come from?
But how do they make money?
Leverage used in insurance is the deferred liabilities ratio to shareholder equity. Also more universally called the debt to equity ratio. What is leverage? Official definition is this: The use of borrowed capital for (an investment), expecting the profits made to be greater than the interest payable.
This makes sure that in case of catastrophic loss all claims can be paid out. However as these instances are rare, this money is reinvested, making profits. On the other hand if the risk assessment and pricing is wrong, this capital can be eaten up rather fast to pay out claims. Leverage is a high risk & high return instrument, no different in insurance.
Similarly how banks make money off your deposits by lending out money they don’t really have.
Are you bored yet? There’s more.
There will also be profit from what is left over from all premiums collected and claims paid out.
Even though there is a requirement to keep the insurance capital safe (see Solvency II above), this will be reinvested to make more money.
In addition to this insurers don’t pay out all the money they collect straight away. Insurance company will collect premiums, invest that money, and then pay out claims when needed. Usually happening at a later date. This is called the insurance float.
The insurance float is what has created a lot of wealth for Warren Buffet for example.
Essentially making more money from money. Amazing how finance works, right?
What could be different?
We cannot get past the regulations in place in the insurance industry. And frankly, perhaps shouldn’t. However, what can be done is bringing some more competition and diluting the power from a handful of big players.
Insurance industry’s goal is of course to make money. And because regulation is on the side of insurance companies there’s very little way for anyone else to get in. They are comfortable, changes take time in large corporations and they don’t necessarily have to innovate as fast as the market would want them to.
So what can be done differently? Give insurance brokers the power.
Why you may ask? In Europe insurance brokers sell over 50% of the market. They know what they are doing and they know the customer well.
What they need to be able to sell their bespoke products is someone with a license and insurance capital (the money making pile of cash mentioned above). They can do this with insurance companies however the process is long. Usually taking about 2–3 years.
Black Insurance gives insurance professionals a way to get the capital and underwriting to start selling their own insurance products.
Why is this better?
- Time to market will be 10x lower compared to today’s insurance companies.
- Admin costs over 2x lower compared to insurance companies
- Retail investor can also invest into insurance capital
Do customers need to care about this?
Absolutely not. We deal with what goes on inside of insurance. Customer gets better products at a better price. Aside from that, it is business as usual.
No one should be spending time on thinking about their insurance cover. It should just work.
Black is going to fix it.