How are the guts of an insurer?
What nobody ever told you…
Ahhh, insurance, that big, old, ugly and unknown industry… Let’s see if we can help our potential customers (yeah, ok, and others…) to understand better this industry and contribute to re-shaping its image!
Insurance is one of the biggest industries worldwide ($5.2 trillion of written premiums in 2018, equivalent of 6.1% of global GDP according to “Swiss Re, sigma, №3/2019”) and one of the oldest (it seems it all started back in the 3rd to 2nd millennia BC with Chinese and Babylonian traders, however modern insurance as we know it today, flourished in the 17th century with the creation of the Lloyd’s market) and yet one of the most unknown and misunderstood sector by consumers. Truth is, it is complex, math-intensive and heavily regulated.
The production facility
Let’s make things easy and go through the basics of how insurance works by comparing it with a more popular industry, for example, manufacturing. Let’s compare them in terms of inputs, production processes and outputs:
The output of an insurance company is nothing else than a contract between the company and the consumer, that is to say, you, the insured, by which the insurer commits to compensate/cover you for whatever protections (accidents, damages, loss, robbery…) you have agreed in your policy. This commitment by the insurer has a price, the premium, and it is the one you must pay for buying insurance.
Essentially, an insurance company is a data-driven organization where, at its core, data is leveraged to calculate the probability of a customer suffering an event that will trigger an agreed compensation. The task of setting a price in insurance jargon is known as underwriting. To put it simple, let’s have a look at the car industry. Some clients might be riskier, for example, they may have higher probabilities of suffering accidents than others or some may be more experienced drivers than the others, so insurance companies will charge higher premiums to those riskier customers. It seems fair, since otherwise good drivers would be penalized!
Insurance is a peculiar production chain where inputs (i.e. data) generally do not cost that much, since the insurers themselves generate more and more data with their own operations. The true significant cost for insurers is, as you can imagine, the compensations paid out to insureds when they suffer an event that triggers a compensation (e.g. a car accident). When these events happen, insureds are usually asked by insurers to submit a claim via a formal process. Let’s see why this claim process constitutes an inherent conflict of interest for insurers.
Claims, the inherent conflict of interest
Every time you claim against the insurer you become a potential cost to them, thus impacting how much profit they make at year-end, and they know it. Insurers will try to avoid, to the extent possible, that payment by either denying the claim or making it “uneasy” for you to file that claim. They will make it hard for you to find a number where you can call, ask for tons of documents, proofs, receipts, delay a response for a few weeks, etc. Insurance companies play with asymmetry of information for their advantage, leaving insureds exhausted and unprotected.
Given that claim cost is not fixed upfront (it is just estimated at the “production facility” by a team of actuaries), insurers try to reduce it as much as possible and refuse as many claims as they can. Claim agents try to minimize impact and they do so by finding exclusions to your case. For those that have ever claimed, I can well imagine you begin to understand now why they generally ask that large amount of questions that beforehand seem irrelevant.
Fraud, a consumer issue
It is not all about bad practices from the insurance industry side. Consumers themselves do sometimes behave in a way that ends up affecting everyone else for the worse. Oftentimes some consumers conscientiously try to strain as much as possible the policy. It doesn’t mean that they want to commit fraud per se, but unwittingly they end up doing something of the kind. Beyond pure profit reasons (as seen above), a significant motive for insurers to design such painful and thorough claim processes derives from high fraud rates. So due to the bad behaviour of a few handful, the rest of customers are nowadays penalized by paying higher premiums and going through painful claim experiences. By claiming only what it is fair (we know is easier said than done), customers will be doing themselves a favour — premiums would be lower for everyone and the claim process itself would probably be much smoother.
Loss ratio, a key metric of the insurance industry
Aggregating the costs incurred by the insurer (the compensations paid out to customers) and dividing it by the total premiums written insurers arrive at the “loss ratio” (other names also used include: claim on premium ratio, incurred claims ratio, ratio of losses to gains, etc.). To put it simply, it is basically the opposite of the gross profit margin (in our previous shoe-maker example, revenue for the shoes sold minus the cost of the raw material and the transformation process).
The Loss Ratio (aka “LR”) is a key metric in the industry. Insurers set targets for this ratio upfront, but since risk is uncertain by nature, those targets are not always met. To be able to price policies in a way that the target LR is achieved, actuaries use statistical models to assess the impact of claims. A relevant example of these models is the frequency-severity model, where first the frequency (i.e. when there will be claims) is modelled, and then, for each individual claim, the expected loss amount (i.e. how much will be the loss associated to the claim) is modelled.
Only for those with a geek component: since nothing at an insurer is deterministic, even the loss ratio follows a distribution. If you google keywords such as “LR model distributions”, “LR prediction models” you’ll find plenty of technical papers explaining how to model and simulate how the loss ratio would look like on a given book of business.
Anyway, LR targets apart, one particularly interesting fact is the different actual loss ratios per product line that you find out there, once the financial year is closed. They can range from nearly 0% to 99%!
As you can see in the chart above, there are some product lines with loss ratios close to 90%. These are generally product lines with higher levels of competition, which most of the times coincides with compulsory products. In a way, value for money here is better for customers. Speciality insurance, on the other hand, tends to be less rivalled, and thus margins for insurers are higher, i.e. lower loss ratios. Moreover, there are product lines with high variability specially all the ones where claims are mostly driven by natural catastrophes. For these type of product lines is normal to have one year of business with loss ratios around 40%, and then the following year have ratios close or even higher than 100% due to a major hurricane, wildfire or earthquake.
Why would an insurer ever underwrite a non-profitable product?
As supermarkets, insurers by their very nature are cashflow positive and accumulate substantial amounts of money. Insurers usually invest this liquid money to gain extra revenues.
For those not familiar with the concept cashflow positive, it simply means that a business collects money today (cash at a supermarket counter) and pay-out after a certain amount of time (pay-out to a grocery supplier can go as up as to 90 days). This simply means that these companies have 90 days of cashflow to “play around” with that money and try to invest it to gain extra profitability.
Within the insurance industry, this practice is very widespread, and it is known as “asset management”. It can become so relevant for an insurer profit line, that there was a time with high interest rates where insurers did not mind underwriting non-profitable products (meaning loss ratios close or above 100% — known as “underwriting negative” products) since they knew that they could gain an extra 15% with the investment of the cash and cash equivalents balances. Gaining that extra margin is much harder now, at least in the western world, but it’s something to have in mind.
Congrats my friend 👏👏👏! You made it to the end 😊! Yep, that was exhausting, we know… We went through the very basics of an insurance company but do be alert for future posts! We’ll be drilling down in some of the key topics that we have outlined here.
