IT expenses and legacy system costs
Unlike traditional products that are manufactured, the most tangible item provided for your insurance product is the paper that the contract is written on. Staying with the manufacturing analogy for a minute, the most expensive piece of “equipment” needed to “manufacture” P&C insurance products are clearly the IT systems involved - and often there are many! Carriers generally have a policy administration system that manages all aspects of quoting, issuing, and adjusting an insurance policy. These policy administration systems may or may not include a billing system (used to issue bills and collect payments), a rating system (used to price the policy) and an underwriting system (used to assess and manage the risks associated with a policy). There is also a claims systems that is used to take a First Notice of Loss, assign and manage the status of claims, capture estimates, update status, and manage payments among other tasks. The claims handling system may or may not be the same system that is used for estimation of a claim’s cost, whether it be an auto physical damage claim, injury claim, or property claim. If a carrier relies on independent agents, there is also integration with an agency management system which can be large and complex. On top of that, there are usually systems to manage litigation, compliance & regulatory issues, complaint resolution, accounting and finance, HR...the list of IT systems goes on and on.
In turn, these systems all generate data that must be extracted, transformed, and loaded into analytical data stores for use by actuaries, data scientists, predictive modelers, underwriters, analysts, product managers and others to gain insights into how the business is performing. This data comes in as structured data (captured in consistent, extractable formats, such as drop down selections and other fielded data entries) and unstructured data (such as photos of exposures and damage as well as free text descriptions and notes). The data must then be processed, stored, and made accessible to all the different business units who need access to it. Carriers also need powerful servers and other hardware in order this massive amount of data. To cite one example, State Farm has over 6,500 terabytes of SAN storage with over 10 times the amount of data housed in the Library of Congress.[28]
The good news is that insurance companies were often early adopters to leveraging computer systems to manage these large, complex data sets. The bad news is that most of these companies still rely on these legacy systems from the 1970s and 1980s. Legacy systems are large, complex and hard to transition away from. They are also expensive to maintain and increasingly rely on outdated technology and programming languages that have not been taught in schools for decades.[29] Often management of these systems is handled by seasoned company employees who are inching close to retirement as well as offshore resources from India and elsewhere that specializes in managing and modifying these systems. Customers may not even realize that their carrier still uses legacy systems as many have built out newer capabilities such as the ability to quote and service policies on their website, only to have the website interfacing with the legacy components working overtime behind the scenes.
Managing all of these systems is expensive, particularly using legacy systems and technology that is well past its “sell by” date. The research firm Celent estimates that by the end of 2017, IT spending on insurance globally totaled $184.8B[30] and another estimate states that carriers spend $3B annually to keep outdated systems functioning.[31] Some newer startup carriers such as Clearcover brag about how they are able to compete against larger, traditional players because they are not weighed down by the costs of maintaining legacy systems.
From a policyholder perspective, they are typically insulated from all of this discussion about legacy systems versus alternatives such as software as a service (SaaS) that leverages cloud computing technology. If carriers transitioned away from legacy systems, they could leverage a platform such as Amazon Web Services (AWS) that is much cheaper and more efficient to perform the same functions. Most customers do not know and likely do not care about such esoteric topics such as legacy systems in insurance, but there is one implication that does matter to them: cost. What percent of the premium are consumers paying to maintain outdated legacy systems as compared with the cost of managing modern ones? The differences in cost are meaningful, yet there is no additional value that policyholders receive from paying higher premium to keep alive old technology - if anything, the opposite is true. What customer would not want to pay lower costs to leverage the latest technology?
Regulation and compliance costs
Regulation, and compliance with those regulations by carriers, are an important part of the insurance ecosystem. Insurance is truly a unique product: hard money is paid up front by consumers to a carrier in return for the promise to pay later if a loss covered by the policy provisions occurs. The entire setup depends on a credible promise by insurers to be there in the future when the policyholder expects them to. While many insurance companies are honest and trustworthy and will in fact be there for their policyholders when a claims is filed, without regulation it would be challenging for consumers to determine which ones in fact are credible and which ones will not. Insurance regulation, like banking and other financial services regulation, provides independent oversight and serves an important purpose to build trust in the system. In turn, this trust creates buy-in on the part of consumers and is a critical component of a healthy insurance ecosystem.
While robust insurance regulation and industry oversight is an important component that makes the whole ecosystem work, the true question is: how much regulation is necessary to credibly perform this function and how much is overkill? Is there a point at which additional regulatory requirements simply adds to the costs borne by policyholders with few benefits in return? How many regulatory bodies impose requirements on insurance carriers and how universal are those requirements? Unlike many other countries, the United States has state-based regulation. This means that carriers that write business nationally must comply with over 50 regulators in order to offer the same products to customers in each state. The National Association of Insurance Commissioners (NAIC) provides an excellent framework to facilitate idea sharing and draft Model Laws that help bring some consistency, but there are still huge variances in state regulatory requirements. On top of state Department of Insurance (DOI) regulators, there are some federal-based regulatory bodies such as the Federal Insurance Office within the U.S. Treasury Department, the Federal Reserve Board, and other entities that govern some portion of a carrier’s activities. If an insurance carrier does business internationally, this adds even more authorities and regulations that must be compiled with.
Setting aside the question of the relative merits of the different regulatory bodies and the regulations themselves, compliance with these requirements comes at a cost. According to data from NAIC compiled by the R Street Institute as part of the 2017 Insurance Regulation Report Card, the 50 states plus Puerto Rico and Washington D.C. spent $1.43B on insurance regulation in 2017. However, the cost paid by insurance carriers - and ultimately policyholders - was much more as shown in the table below.
Category
Amount (in millions)
Premium taxes
$19,240
Regulatory fees and assessments
$2,910
Miscellaneous revenues
$1,120
Fines and penalties
$125
Total
$23,390
Source: R Street Insurance Regulation Report Card (2017).
If you divide the cost of regulation ($1.43B) by the total amount collected from insurance carriers by regulators ($23.39B), only $6.1% of the amount collected by states actually is used for insurance regulation. How these regulatory and associated costs get allocated among policyholders is also an important question. States that have greater regulatory burdens that cost more to comply with should see those costs passed along to policyholders in that state alone, not others. Whether this allocation of regulatory costs perfectly get pas
sed along to only policyholders that will benefit from that particular regulation is debatable.The more complex and onerous the regulatory environment, the more opportunity there is for “regulation cost leakage” to be passed along to the wrong policyholders. The bottom line is that compliance with regulatory requirements adds substantial costs to insurance agencies and carriers, and those costs get passed along to consumers as part of their premium. Consumers do not have the choice to only pay for the regulations that they value; they must pay for all of them.
Detecting and combating fraud
The opportunity for fraud in insurance was mentioned earlier in the chapter when discussing the principle of indemnification and contracts of adhesion where any ambiguity is resolved in favor of the policyholder. While not as large as the other major expenses, insurance fraud is a problem that causes a significant financial drain at the expense of legitimate policyholders. Any fraudulent claims that are not caused and unwittingly paid by the insurance carrier are simply seen as losses in the exact same way that legitimate claims are. In addition to any money from premium that is unintentionally paid out for fraudulent claims, all of the expenses involved in performing reasonable due diligence in detecting and investigating fraud are additional costs that are ultimately borne by policyholders. Between the cost of fraud itself and the expenses involved in combating fraud, a portion of premium paid by policyholders is wasted from the perspective of a legitimate customer. Chapter 5 goes into more depth on the topic of insurance fraud including common sources of fraud, how carriers seek to combat fraud and the associated costs of both.
Legal costs and related fees
One final source of expenses that is worth calling out are the high legal costs that can be driven by how attorneys’ fees are set in a given jurisdiction. Insurance carriers are often litigants in legal cases on a variety of topics, most notably claims disputes. Some plaintiff attorneys have made their careers based on suing insurance carriers over their claims settlement practices. Defending these lawsuits costs a lot of money, both for a carrier’s internal legal team as well as retaining outside insurance defense counsel.
In some jurisdictions, most notably Florida, plaintiff attorneys who successfully sue an insurance carrier also have their fees paid based on a state’s attorney fee statute. In Florida, these one-way attorney fees provide that insurance carriers must pay for the plaintiff’s attorney fees if there is a judgment or a decree in favor of the insured and against the insurer in any amount. The fees work one-way because the reverse is not true: if the insurer wins a complete and total victory, the insured owes nothing towards the attorney fees incurred in defending against the lawsuit.[32] This “lawsuit abuse” issue varies greatly by jurisdiction but the costs can be substantial. One estimate is that lawsuit abuse in Florida is the equivalent of a $3,400 tax on every family according to Mark Wilson, president and CEO of the Florida Chamber.[33] The state-backed insurer of last resort in Florida is Citizens Insurance, and one-way attorney fees are at the heart of the state’s Assignment of Benefits (AOB) crisis which has led loss costs for Citizens to rise from $367 in 2011 to a projected $2,083 in 2017, leading to a projected loss of $100 million for the company after a 30% increase in the number of lawsuits.[34]
Certainly, many insurance lawsuits represent legitimate grievances from policyholders seeking to obtain the full settlement value of their covered claim. Other lawsuits represent a true difference of opinion over some aspect that is in dispute and requires the court system to determine an outcome that both parties will abide by. But do all of them? Even spurious lawsuits that are successfully defended by insurance carriers, and do not result in any plaintiff attorney fees being paid, cost money - money that is ultimately paid through policyholder premiums. Most insurance carriers seek to resolve disputes through mediation or arbitration clauses to help reduce legal costs. However, they remain a large expense that insurance carriers bear today. The benefits to each individual policyholder of these legal costs are unclear. Most will not personally see a benefit or, if one if received, it has limited value to that consumer.
EXPENSE REPORT
Why does insurance cost so much? The primary reason is to pay the financial losses that stem from covered claims. However, as discussed in this chapter there are a number of additional expenses that also drive up the cost of insurance premiums. Some of these expenses are needed, and policyholders benefit from them. Many other expenses that are incurred do not substantially add value to insureds. Unfortunately, policyholders cannot pick and choose which expenses they are willing to pay for and which to avoid. Insurance expenses are a take it or leave it proposition for policyholders; they can only control the expenses they pay by shopping around.
Each insurance carrier has a different expense ratio - the dollar cost of all expenses other than LAE ratioed to premium (revenue). The loss ratio and expense ratio are put together into a combined ratio or the sum of all losses and expenses divided by total premium. Lower numbers are better: if a carrier has a combined ratio less than 100, that means they are making a profit on their operations (what is known as an underwriting profit). A loss ratio over 100 indicates that the carrier is losing money on their operations: the cost of losses combined with their expenses is not fully covered by the premiums they collect. Due to timing differences, premiums are invested until they are needed to pay claims, and this investment income can offset a carrier’s underwriting losses on their insurance operations. (In fact, for longer-tailed lines, such as workers compensation, where the ultimate settlement of claims can take years, this is the norm.)
Insurance companies exist to make money. Given a set of losses and expenses, their actuaries will perform detailed statistical analysis to determine what premium to charge. Over the long run, they typically get it right more often than they get it wrong, and insurance companies continue operating, often for decades. That is the good news. However, as a policyholder you want to pay only as much premium as is needed to cover any future losses you may incur as well as enough expenses to cover all of your needs as a customer.
As a consumer, you can choose which insurance carrier to do business with, and if you are enterprising enough you may even be able to compare the expense ratio of different carriers as part of your overall selection criteria. Some carriers have much lower expense ratios than others. Carriers that have higher expense ratios may provide additional value that is worth paying extra for - or they may not. As a consumer, you can make the decision of which insurance carrier to purchase coverage from, even more than one if you decide not to bundle your products with a single carrier. However, what consumers cannot do is pick and choose which expenses to pay with any of the carriers they choose to do business with.
The high cost of insurance driven in part by high expenses provides a huge market opening for nimble traditional insurers, reinsurers, technology firms, insurtech startups, and/or non-traditional competitors. Using the latest technology such as cloud computing, artificial intelligence and blockchain, process improvements and cost efficiencies can be gained to reduce insurer expenses. Beyond incremental improvements in insurer efficiency, an entire new paradigm could emerge in the future that can provide a similar level of risk transfer (downside protection) that is closer to the true cost of pure, legitimate losses compared to the current insurance ecosystem.
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CHAPTER 4 - IT’S COMPLICATED
SEND LAWYERS, GUNS AND MONEY
In the last chapter, we covered the first fatal flaw of insurance: it’s too darn expensive. If that wasn’t bad enough, insurance is also too darn complicated. First off, is insurance actually a good or a service? Most products fall neatly into one of these two categories - but insurance is harder to classify because it has elements of both. When insurance is a compulsory purchase, either mandated by law or a lender, it is a good; you must have insurance products in order to own something else you really want. For example, consumers need auto insurance to drive that new vehicle off the car dealer’s lot
or homeowners insurance to move into that new home they just got a mortgage for. Do people really contemplate their financial risks and coverage needs at these moments? Or are people just trying to get a quote and issue a policy as fast as possible to check off this box that’s required of them?
On the other hand, a good is generally something tangible. Where is the tangible portion of insurance? The PDF of your auto insurance identification cards? There isn’t much other than some paperwork and billing statements that you can actually hold with your hands. Yet, clearly policyholders are paying for more than papers. So insurance is better classified as a service then and not a good, correct? If you ever experience a loss and file a claim, you are definitely receiving claims service. But the vast majority of people never file a claim during their policy term. What service did they receive?
Some carriers refer to any consultations about coverage options and adjustments that are made as “policy service,” but it’s not as tangible as the handyman that fixes your appliances, the car wash that cleans your vehicle, or the hair stylist that makes you look good (hopefully). Servicing an insurance policy emcompasses a broad range of activities that can be done either in person, over the phone or on a digital platform and includes:
•providing a quote
•binding coverage
•providing proof of insurance and other documents
•providing a myriad of customization options including different limits, coverages, deductibles, contract types, endorsements
•adding or removing drivers, vehicles, and other exposures
•rebasing policies to a new location
•renewing policies
The End of Insurance as We Know It Page 4