Notes on Insurance

Insurance is dull at first glance to most people. But over the last few weeks, especially after reading Mihir Desai’s The Wisdom of Finance, I’ve come to appreciate its beauty. There’s the story of how cavemen invented a clever risk-sharing mechanism. Say you have six cavemen living in six different caves, and every once in a while, a predator like a tiger or bear would go into one of their caves while they were out foraging or hunting or whatever it is that cavemen do, and completely destroy all their possessions. After this had happened a few times, a smart caveman suggested splitting up their valuables among the six caves when they went on extended hunting trips. That way, they all lose a little bit rather than just one of them at random being completely ruined. Such pooling of risk is the fundamental concept of insurance.

Offering Insurance

Anyone offering insurance products has to perform the following functions:

• Marketing to acquire customers
• Underwriting (setting premiums, assessing risk of potential customer)
• Handling claims from customers, processing and paying them
• Investment of accumulated premiums
• Reinsurance to insure yourself against systematic risks

In practice, a single company rarely carries out all of the functions internally. Instead, multiple companies work together on this. The exception is a vertically integrated player like GEICO.

Types of Companies in the Insurance Industry

Carriers are at the top of pyramid (companies like AIG). The ultimate determinant of whether a carrier is profitable is a combination of the combined ratio ((claims paid + operating expenses) / premiums written; > 100% is a loss, < 100% is a profit), and investment returns. Carriers cede some underwriting authority to MGAs (managing general agents), but MGAs still have quite a bit of freedom in who they sell their policies to.

Agents don’t take underwriting risks, they simply get paid commissions (a fraction of the premiums) for every customer they sign up. There’s a difference between a broker and an agent: brokers work for the insured (the customer) vs. agents who work for the insurer (if exclusively with one carrier, then they are called captive agents). Interestingly, brokers still get paid by the insurer, even though they work for the insured.

Credit for the image above goes to Kyle Nakatsuji who wrote a great article describing in detail the various players.

Not included in the diagram, reinsurers are the insurance companies for insurance companies. At this level of abstraction, you can imagine pooling the risk of an earthquake insurer with director’s liability insurer (two things with very low correlation), or pooling risk across national borders, etc. If there are aliens out there who felt as vulnerable as we do about our planet, we probably should pool the risk of an asteroid collision with them so that if one of our planets gets hit with an asteroid, the other can pay for the rebuilding, rather than one of us going extinct. The basic financial structure of a reinsurance deal is that the insurance company pays premiums, and beyond a certain amount of claims, the re-insurer pay all remaining claims owed by the insurer.

InsurTech

InsurTech is the future of insurance, and it’s interesting to see where on the chart various companies fall.

I switched from State Farm to Lemonade for my renter’s insurance. The fact that I didn’t have to call up an agent, or have to deal with all that paper mail, etc. for something as standard and basic as renter’s insurance was a strong reason to switch (but to be honest, an even more compelling reason was that Lemonade had lower premiums). Lemonade is a carrier, rather than an MGA so they have full control over their policies. Jetty is similar to Lemonade, but on the other hand, they are an insurance agency so they receive commissions and do not take on any underwriting risk.

Insurance search engines like Coverhound, PolicyGenius, etc. perform a very similar role to traditional brokers (in fact, they are often licensed as brokers), they work for the insured, and help you find the best insurance for you, and in turn, they get a commission out of each lead or each policy that gets written.

One thing that’s particularly interesting about the insurance industry is the incredibly high customer acquisition cost:

Direct insurers — those that sell policies directly to consumers through the mail, the Internet or telephone solicitations — had an average “acquisition cost” of $487 per policy in 2014, while captive insurers — those relying heavily on exclusive agents — spent an average of $792, according to research from William Blair & Co.

And this is one of the reasons why lead generators, agents and brokers are able to make a living out of just selling policies for commissions. The Internet obviously disrupts traditional customer acquisition in significant ways. Lemonade has done a tremendous job with marketing and re-targeting on Facebook (that’s how they got me!). However, commercial property insurance is still likely done locally, where the insurance agent in your neighborhood that you’ve known for a decade is king. Embroker is trying to disrupt that.

Embroker is a more hands-on broker for businesses, but still utilizes quite a bit of technology. They have great case studies on how they are helping businesses. Brokers benefit from better customer service, because their goal is to be advocates for the customer. Large companies often have an internal risk management team that is responsible for both reducing risk of loss, and also buying the right kinds of insurance. Embroker works as both a broker/risk manager for smaller companies that don’t have their own in-house teams.

Like every other industry, there are also big opportunities in improving the IT infrastructure of insurance which companies like Socotra are trying to do.

The Exciting Future

Insurance could actually be simple, cheap and useful, rather than something everyone reluctantly purchases:

To illustrate the power of a mobile-first platform, imagine a personal auto insurance mobile app that uses the smartphone camera in policy issuance, authorizes payments via a payment API, processes driving behavior via the phone’s GPS, accelerometer and a connection to the insured vehicle in order to influence or incentivize safe driving behavior, notifies the carrier of a driving signature indicative of an accident, and integrates third-party software into their own app that allows for emergency response and rapid payment of claims.

The world is changing faster than ever as well, and insurance will have to adapt to cover new risks as well as integrate newly available data:

• Self-driving cars (this is going to completely disrupt the auto-insurance industry)
• Drone insurance
• Cyber security / identity theft / digital property
• IoT (Internet Of Things) enables the collection of a lot more data which can be used to improve the underwriting (companies already give you discounts on renter’s insurance if you have a fire alarm)

Resources

• Thoughts on Insurance by Aaron Harris
• So Your Startup Wants to Sell Insurance by Kyle Nakatsuji
• Insurance Fundamentals series by Albert Wenger
• The Next Billion-Dollar Insurer by Jay Farber
• Insurance: Concepts & Coverage: Property, Liability, Life, Health and Risk Management by Marshall Wilson Reavis III