The End of Insurance as We Know It
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Given that insurance is not a product that most consumers wish to purchase, cost is a major consideration. From one perspective, the cost of P&C insurance is in line with comparably priced goods. For instance, profit margins on appliances are typically in the 5-10% range after applying a 20-35% dealer markup over wholesale, which is comparable to the profit margins[19] along with agent commissions[20] and acquisition expenses for insurance.[21] A common way to evaluate the relative expense of insurance is to look at the portion of premium that is devoted to paying claims, referred to as losses, as well as the associated loss adjustment expenses or LAE. LAEs are the expenses directly related to processing, investigating and settling claims. Keep in mind that even claims that result in no payment have loss adjustment expenses. All expenses not related to claims are referred to as underwriting expenses and include all other costs related to running an insurance company. A loss ratio is a common industry metric of the total amount of losses and LAE paid compared to premiums, expressed as a percentage. Based on data from the National Association of Insurance Commissioners (NAIC), here is a breakdown of premiums, losses, expenses and underwriting (operational) profits as of the most recent data from 2016 according to NAIC for select lines:
Line of business
Private passenger auto
Commercial auto
Homeownermultiple peril
Commercial multiple peril
Direct premiums earned (000s)
$209,553,169
$32,243,384
$90,442,791
$39,767,359
Loss ratio
72.0%
69.0%
52.6%
50.7%
LAEs
11.9%
12.8%
8.4%
12.5%
General expense
5.2%
6.6%
4.6%
7.2%
Sales expense
16.2%
19.6%
20.6%
23.8%
Taxes, license and fees
2.1%
2.5%
2.3%
2.3%
Dividends to policy-holders
0.4%
0.1%
0.4%
0.1%
Under-writing profit (loss)
(11.8%)
(10.5%)
11.2%
3.5%
Source: NAIC Report on Profitability by Line by State (2017).
Keep in mind when reading the table above that some lines of business, such as homeowner and commercial multiple peril, are more prone to catastrophe losses and thus wider swings in profitability than other lines. While losses can vary from year to year and also impact loss adjustment expenses, the remaining broad categories of expenses are more stable. General expenses include a host of operational expenses including staffing, IT systems, office space and equipment and more. Sales expenses include advertising and marketing as well as agent and broker commissions, which are the largest source of underwriting expenses for most carriers. Agents and brokers typically earn one set of commissions for acquiring a new policy and another set of commissions for policies that renew.
Based on the information for these four lines of business, note that the loss ratio - the amount of premium dollars actually devoted to paying claims - varies a great deal from product to product. For private passenger and commercial auto, the loss ratios show that roughly 70 cents for every premium dollar is used to cover losses while approximately 40 cents are used for expenses (leading to a loss of roughly 10 cents per premium dollar in 2016). The recent challenges for auto insurance profitability come despite the fact that one survey shows 61% of Americans think car insurance is too expensive.[22] For homeowners and commercial multiple peril, the loss ratios show that roughly 50 cents of every premium dollar is used to pay losses while the remainder is used to cover expenses and provide a profit. The portion of premiums not used to cover losses provide an opportunity to lower costs for carriers, whether reducing loss adjustment expenses or underwriting expenses.
THE COST OF DOING BUSINESS
It is notable that the market for P&C insurance has not resulted in reduced expenses from efficiency gains that consumers might expect, given the technological revolution that has taken place over the past decade. The market for insurance is highly competitive with tens and often hundreds of carriers competing for the same lines of business. Yet expense ratios - the ratio of insurer expenses not related to losses divided by premiums - have remained quite stable as an industry over the past decade[23] with 2017 representing the lowest point at 27.0%. Keep in mind that underwriting expenses themselves are rising during this time along with premiums, rising from $62.1B in 2008 to $75.7B in 2017, a growth of 21.9% over the past decade.
Source: NAIC.
What this trend demonstrates is that P&C insurance as an industry is not becoming more efficient. Expense ratios are not trending downward over time but remaining relatively in line with net earned premium growth, which grew 21.5% over the same time period.
So why does insurance cost so much to provide? On the surface, the costs of providing policies and coverage are not dominated by high fixed costs such as large investments in infrastructure, large transportation costs, complex supply chains, etc. While the largest single expense in the provision of insurance are the losses themselves, as shown above there are still plenty of other expenses that are covered by premiums. These insurance expenses often do not directly add value to customers. Some of the major sources of “hidden” costs to the consumer are labor, IT, production acquisition costs, and compliance & regulation.
EXPENSIVE HABITS
Let’s examine further some of the major cost drivers for P&C insurance:
•Loss adjustment expenses (the process of indemnification)
•Advertising and marketing expenses
•Agent and broker commissions
•Maintenance costs for outdated legacy mainframe systems
•Expenses related to regulation and compliance
•The cost of detecting and combating fraud
•Legal costs and related fees
Loss adjustment expenses
There is a core principle in insurance called indemnification that holds that, after a covered loss, an insured policyholder should be placed back as close as possible to their pre-loss state. Said another way, the policyholder should be left no better off and no worse than they were prior to the loss. (In practice, this would be evaluated less any deductible that may apply which provides for some risk sharing by the insured). There is another, related concept called betterment which holds that an insured should not be made better off after a covered loss. The concept of indemnification is as old as insurance itself and a fundamental principle that is rarely questioned. Indemnification plays a big role in distinguishing insurance from other financial products such as stocks, bonds, etc.
This “not-for-profit” foundational element that distinguishes insurance from speculative financial products is well-intentioned. Consider for a moment if insurance did have a profit motive: Such a motive drives two major concerns in insurance; moral hazard and morale hazard. Moral hazard refers to any situation where a policyholder has a strong incentive to lie, cheat, steal, or otherwise swindle their insurance provider into making a payment for a covered loss that did not actually occur - essentially, an incentive to commit fraud. Morale hazard refers to a situation when a policyholder lacks a strong incentive to properly care for and maintain the item that is being insured, so any loss that occurs may be due in part or whole to negligence by the policyholder. While both moral hazard and morale hazard do exist, the foundational concept of betterment is intended to help limit an insured’s motivation from profiting as a result of loss (whether caused by intentional damage or opportunistic inflation of a covered loss).
On the other hand, what good is having insurance if you as the policyholder are not fully compensated for your loss? If the insuran
ce provider does not fully pay to repair or replace what was lost from a covered peril, the policyholder is assuming some downside risk that they were seeking to transfer by purchasing insurance. Again, the purpose of insurance is fundamentally distinct from financial speculation. Policyholders should receive an amount that fairly compensates them for their loss. Conceptually, insureds should not be made worse off financially after a covered loss (again, less any deductible that may apply). This principle of indemnification and related concept of betterment is enshrined in insurance contract law and regulation. As a result, there is an oft-cited claims motto at insurance carriers that “we pay what we owe - no more and no less.”
So why is indemnification a problem? Because it comes at a significant cost as measured by the billions of dollars of loss adjustment expenses that are incurred annually.[24] Claims adjusters exist for the sole reason of determining what (if anything) is a covered loss after a claim is reported. The associated loss adjustment expenses can vary by the product and type of loss. Claims professionals are trained and licensed (when required by each individual state) for their work. I have had the privilege of knowing many claims adjusters over my 20 years in the insurance industry. As a group, claims adjusters are a fountain of knowledge and excellent at the work that they do. However, the reason we need specially trained claims professionals is in large part due to the principle of indemnification.
By comparison, contrast this with the concept of parametric insurance where a payout is made from the insurer to the insured once an objective threshold is met. For instance, during a hurricane, if a fixed independent wind observation sensor records a gust over, say, 120 miles per hour, a predetermined payout is triggered and made, irrespective of the damage that was actually incurred. The advantages of this approach is that a payout is made in a timely fashion to the insured, and the loss adjustment expenses are avoided, reducing the cost of providing coverage. The disadvantages are that the insured may be made better or worse off financially, depending on the actual cost to repair the damage incurred. The amount of the payout is based on estimates of the amount of damage that 120 mph winds would do to a particular structure or other insured asset, so the relative adequacy of the payout is directly tied to how accurate the estimate is. Bottom line: there are alternatives to indemnification such as parametrics that can facilitate the same type of risk transfer mechanisms as insurance at a lower cost.
Because of the sheer size of the P&C market in general and loss adjustment expenses specifically (over $65B in 2017)[25], any marginal improvement in claims processes measured in fractions off the LAE ratio quickly adds up to meaningful reduction in expenses. A lot of technological innovation has occurred in the claims space, particularly in the use of AI and machine learning as well as digital capabilities to more quickly triage claims and determine the most efficient routing and handling. Perhaps the best known example is “AI Jim” from renters insurtech startup Lemonade which founder Daniel Schreiber announced set a world record in 2017 by settling a claim in a mere 3 seconds.[26] The key is to find increased efficiencies while maintaining the amount of due diligence needed to properly adjust the claims.
Advertising and marketing expenses
Acquisition costs are a major expense driver in any business, but they are especially important in P&C insurance, particularly in the personal lines space. There has been a lot of debate over the years about whether personal lines products such as auto and homeowners insurance are commoditized products or not (if you read Bill Wilson’s excellent book When Words Collide, he argues persuasively that they are not, although most consumers and many carriers act as though they are). Sidestepping that debate, it is clear that carriers spend billions of dollars annually in the United States attempting to clearly distinguish their brand from their competitors.
How much is spent by P&C carriers on advertising annually? A lot! It’s hard not to run across a single ad either on TV, radio or increasingly digital ads in any given day. Additionally, the costs have risen dramatically in the last 10-20 years as carriers compete fiercely to attract consumers. Here are the top amounts spent by P&C insurers on advertising in 2017 based on measured media spending from WPP’s Kanter Media:[27]
In short, there are vast sums of money spent on advertising to raise brand awareness and encourage consumers to quote and buy their insurance products. Carriers are hoping that consumers are switching to save money and are bundling insurance products. How do carriers know they are targeting the right customers? This is where marketing comes in: carriers use data and analytics to identify the target audiences that are in accordance with the segments that the business is seeking to attract. In addition to advertising costs, the cost to acquire third-party data and perform the necessary analytics to run a sophisticated marketing operation is also significant.
How do consumers that are already a policyholder with a particular carrier benefit from all of this spending on advertising and marketing? It’s far from clear that they do benefit in any meaningful way. These expenses are meant to grow the business and attract new customers, and while a healthy carrier that’s increasing revenue and making profits is better than one that is not, it’s unclear that any of this is related to the actual claims service and ability to pay when a loss occurs, which is ultimately what current policyholders care about. The bottom line: these expenses add little to no value for current customers of a given carrier and thus, to the extent that they cause premiums to be higher than they would be otherwise, are highly inefficient.
Agent and broker commissions
Similar to advertising and marketing expenses, agent and broker commissions compensate the most common distribution workforce for their costs in attracting new customers and handling their policies. Commissions vary greatly depending on whether the agent in question is independent or exclusive, line of business, and carrier involved. When a carrier seeks to increase their market share for a particular line, they will often increase the commission paid to agents to attract more customers over a competitor who pays a lower amount. Carriers typically pay both commissions for new and renewal business. These commissions are expressed as a percentage of the written premium of the business. Sometimes, new business commissions are higher than renewal commissions to reflect the additional expenses that agents and brokers incur for marketing, attracting and quoting new customers. Renewal commissions are paid when the policy renews to cover the expenses that are incurred by the agent or broker for servicing the policy. Expenses that agents and brokers incur may include: taking a first notice of loss and helping to resolve a claim as well as any other advice, request for documents, changes to policy terms and conditions or any other policy service work that needs to be performed.
Similar to claims professionals, agents and brokers are licensed professionals. In my experience, similar to claims adjusters, most of the agents and brokers I’ve met over the years are hard-working and genuinely care about their customers (although most insurance professionals have stories of agents and brokers who do not do much work). It is hard to start up an agency: there are a lot of costs involved to attract new clients and grow the business, and it takes a while to earn enough commissions to become a thriving business. Over time, as an agency becomes more established, it can count on more of its revenue coming from renewal commissions as a percent of its overall proceeds and less from new business. Since the majority of costs for an agency are due to marketing and attracting new clients, agencies can have an incentive to go on “auto pilot” in their later years once they are well established and earn a significant amount of renewal commissions.
From a policyholder’s perspective, as the client of an agent or broker, are you getting a commensurate value for the portion of your premium dollars devoted to paying commissions? This is a question that is highly personalized to each client. Some policyholders do receive a lot of value from the relationship, even a well established one that has been ongoing for a number of years. Other clients may receive diminishing value from
an agent or broker over time as the renewal process becomes smoother. Some clients may have received little to no value once their initial policy was established. Frankly, a lot depends on whether a policyholder has claims or not: an agent or broker can certainly earn their keep and more by serving as a strong advocate during a client’s time of need following a disaster or major loss. In general, it is very hard to make a broad statement about the value received relative to the compensation earned through commissions because it is highly individualized based on the agent/broker and client relationship.
The key insight is that the same commission percentage is earned at new business and renewal regardless of the value that the client perceives. Clients who receive a lot of value from their agent or broker do not pay more than clients who do not gain much value. So depending on your perspective, the amount of your premium that goes to paying commissions may or may not represent a reasonable expense to you. Put another way, paying the cost of these commissions may not bring much, if any, perceived value for clients who do not engage with or rely much on their agent or broker.