The End of Insurance as We Know It

by Rob Galbraith

  According to Willis Towers Watson, the main reasons that insurance companies are leveraging CVC are “to create strategic value by developing a direct investment strategy to tap into emerging technologies and capabilities”.[212] The interest in funding investments in insurance innovation by reinsurers over the past few years coincided with:

  •a historically low interest rate environment following the Great Financial Crisis

  •a period of time from 2009-2016 with less catastrophic losses including no major hurricanes making landfall in the United States

  •competitive pressures that have seen returns shrink on traditional reinsurance

  Willis Towers Watson also notes that non-insurance firms have been deploying CVC as well. Of note, they state: “These firms are mostly comprised of large technology or financial companies that see insurance as one of the few remaining sectors that have not yet been revolutionized by emerging technologies.”[213] (emphasis mine). Additionally, a mix of various sources of capital have been funding insurtech accelerators that seek to identify promising startups and provide them with a wide variety of support from funding to office space, access to insurance experts and more.

  It is not straightforward to draw out which sources of capital are flowing in to insurtech from within the insurance industry and outside of it, but regardless the overall growth is impressive. According to data from CB Insights, the number of VC investors in the insurtech space has grown 4x at a CAGR of +30%.

  Source: CB Insights and Willis Towers Watson

  As the profit margins were squeezed in the traditional reinsurance business, reinsurers went looking for alternate sources of return and found it in insurtech startups.[214] Perhaps no company has embodied this transformation more than Munich Re. The digital transformation of Munich Re to an innovation leader and industry disruption has been documented as part of case studies starting with the aftermath of the Great Financial Crisis to today.[215] Munich Re’s focus in the innovation space has gone beyond traditional reinsurance and even primary carriers to focus on innovative new product developments such as a pandemic product.[216] A recent article in Artemis.bm in June 2018 provides some context on Munich Re’s focus areas in the innovation space:[217]

  "What these ventures have in common are the combination of technology, risk management and financial instruments, with the insight from data gathered through sensors and other tech likely to make the management of risk and its underwriting and transfer a far more efficient process, with higher margins as a result.

  That is a key reason for Munich Re’s involvement, as it transitions to a company that can underwrite based on as near as possible real-time data inputs, while building loyalty through the risk management and service provision of the offerings, all with the goal of being the corporations insurer for the long-term.

  Corporations that embrace these types of initiatives are also likely to find themselves buying into them much more deeply than they would to a simple insurance policy alone. It is the overall package that offers them benefits, again helping to create a true customer experience and relationship with their re/insurer, with the obvious benefits for Munich Re."

  INSURANCE INNOVATOR’S DILEMMA

  This focus on sources of investment capital, VC funding and the important role that the traditional incumbents have in driving the growth of insurtech all lead to a fundamental question: how should an insurance carrier innovate? To frame the issue, consider the classic “Innovator’s Dilemma” described by Harvard Business School Professor Clayton Christensen. In the classic business book, Dr. Christensen outlines how traditional companies tend to focus on upselling their product by adding new features and services to increase market penetration and revenue (and ideally raise profit margins). These established companies also focus on the adjacent possible: moving into market segments closely related to those where their core products and services already reside. For example, if you are Apple and dominate the mobile smart phone market with the iPhone, it’s not a stretch to bring the iPad tablet to market. Similar examples in the insurance space abound.

  On the other hard, to truly go beyond incremental improvements and innovate disruptively, new startups often seek to bring products and services to underserved and niche markets. These are market segments that large players usually struggle to address at best and completely ignore at worst. Initially, these niche market opportunities are small and startups must be able to make a breakthrough in terms of their value proposition. This often involves a new technology and/or process that radically reduces expenses so that the “cost floor” that must be exceeded drops to a level that can be hurdled. Over time, if these niche markets are served and become a solid customer base, expansion into other markets can take place.

  Often times startups do not appear to be directly competing with the large, dominant market players because they are chasing smaller niche markets, but if they gain a toehold and are able to grow their business, they may begin to directly compete with established players in core markets. A good example is the difference between a luxury car company such as BMW and a startup like Kia. Originally Kia targeted the low end, price conscious consumer and was not directly competing with the same high end customers that BMW targeted. As Kia gained brand recognition and a customer base, they were able to develop new vehicles that had many of the same features that drivers expected of luxury vehicles at a lower price point. Kia hired the LeBron James to be its spokesperson in 2014 to sell its flagship luxury car, the Kia K900.[218] The idea that LeBron James, arguably the world’s most famous athlete and a multimillionaire athlete and businessman, would drive a Kia led to much social media speculation - which ended when teammate proved that LBJ really does drive a Kia.[219] When Kia first came on the scene, did BMW executives ever think they would end up being a direct competitor?

  To overcome the tendency for traditional carriers to settle for the adjacent possible or incremental improvements to their existing product suite rather than seek radical and disruptive change, carriers have reacted in a number of ways. Here are some of the strategies that have been pursued:

  •Innovate within traditional disciplines such as Product Management, Actuary, Underwriting, Claims, Marketing

  These areas know the business the best and can create valuable incremental innovation, but often times are too beholden to the status quo to bring about radical change

  •Create “skunk works” operations often referred to as “labs”

  These small and loosely structured teams operate a bit more independently of traditional organization hierarchies (think office politics) and help foster tremendous innovation - or squander millions of dollars

  •Form a separate Innovation Unit or team devoted to pushing the envelope

  These more formally dedicated areas can often define current pain points and problem areas in an unbiased fashion since they are designed to challenge the status quo, but they can often chase “bright shiny objects” without bringing about lasting change within business units

  •Create a venture capital arm to review the insurtech space and fund the most promising startups

  Investing in startups who have innovation at the core of their identity rather than attempting to do it all in house can help spur the type of disruptive technology and innovation carriers are seeking, but there can be a conflict between the desire to see a quick profit as an investor and breathe new life into your business operations

  •All of the above

  Some feel the best approach is a blended mix of all of the above, but the investment is sizable and can take away from reinvesting in current operations that can benefit from process improvements and efficiencies

  Bottom line: There is no clear winner and the answer is likely different for each carrier.

  TO ACCELERATE GROWTH, THE KPI IS THE API

  In addition to VC funding, there have been a number of insurtech accelerators that have popped up in the past few years. Accelerators often are funded by a group of firms
interested in seeing startups emerge to serve a particular market segment. Accelerators solicit startups to apply to be part of their programs and hold events where startups can network with VCs, traditional players and other parties to help share technology solutions and make connections that may lead to funding. Accelerators have startups give their “pitch”: a concise description of their technology, the value proposition, and the business model they offer, similar to what is seen on the popular show “Shark Tank”. After startups give their pitches, each pitch is rated across a variety of categories. Startups with the highest ratings get selected to be part of a limited-time development program - generally 12-16 weeks - in which they gain access to expertise and resources to help them develop their offering. Startups also receive some level of basic funding as well as other support such as office space. Many of the most successful insurtech startups today were part of development programs at insurtech accelerators, and they play an important role in the insurtech ecosystem.

  Another critical part of the insurtech ecosystem is the role of application programming interfaces or APIs. APIs provide a mechanism for different systems to talk to one another and interact seamlessly. At the risk of being overly simplistic, APIs turn lines of programming code into Lego bricks that can be stacked on top of each other to make a greater creation than any of the individual building blocks. Companies seeking to be pure technology plays supporting the insurance sectors may not care if their software is supporting the largest traditional players or the newest startup. These firms only care that customers find value in their software and are willing to pay to leverage its capabilities. APIs are also key ways in which agencies, brokers, carriers and other established players can leverage newer technology by simply making an API call and passing information back and forth between their system(s) and the new technology. This process is often easier said than done, but APIs do allow IT departments a way to leverage the innovation created by others without the need to do everything in house from a technology standpoint.

  FOR THE WIN OR FOR THE MONEY?

  For startups, there are a lot of built-in incentives to collaborate or cooperate with traditional players as opposed to outright competing with them. Startups that seek to collaborate by bringing insurtech-enabled solutions to traditional agents, brokers, carriers or other entities can gain a big boost from traditional incumbents. These benefits may include sources of funding, access to important business and technical resources and expertise (whether directly or through accelerators) and potential access to a ready market. If startups are able to navigate the confusing maze that is the world of insurance successfully - and that is by no means easy or guaranteed - their odds of success are greater than the alternative. Success in this case could take many forms, from creating a sustainable small niche business all the way to getting acquired and a big payday for the founders. For traditional insurance players collaborating with startups, a lot is asked in terms of relaxing red tape in order to work alongside a much smaller entity. Gaining acceptance of the new product, services and/or technology is also critical for a successful partnership. Internal politics, poor change management and immovable key stakeholders can ruin an otherwise successful partnership.

  For technology companies building APIs or similar products, they are candidates to be cooperators with traditional players and insurtech startups alike. Companies who build a platform or similar solutions are truly agnostic as to who uses their API: they win either way. They may be able to take advantage of VC funding from traditional industry incumbents as well as VCs outside of the sector. Tech firms will likely attract more favorable valuations as a pure technology play than if they were to fully dive into the insurance market. Technology startups also do not need to concern themselves with many of the thorniest insurance regulation questions such as whether to become a MGA or full stack carrier (although they may be involved in some conversations with regulators to educate them on their tech). The major downside is that tech firms do not possess the industry-specific expertise and run the risk of being “a solution in search of a problem”. Finding the right partners to cooperate with is critical for finding success in the insurance space.

  For those brave insurtech startups seeking to compete with established entities, this is the path of most risk yet most reward. Few have gone down this route as any startup already has a treacherous path to navigate to build a successful business. In particular, investors who commit large amounts of capital are not going to wait around forever to see a return on their investment - they will cut their losses and pursue other opportunities. Yet the insurance market works on a radically different time scale than most VCs accustomed to the tech world are used to. It is common in P&C insurance for pricing and underwriting decisions today to not begin to have an impact until the following year. Often the full benefits of actions are only realized in years 3-5, way more than years 1-2. The combination of pressure from funders as well as speed to market and challenge of competing with entrench parties is daunting. Yet the size of the opportunity is massive and warrants closer examination. For those seeking outsized gains, the enormous size and opportunity of the P&C insurance marketplace, along with its many flaws and openings for disruption, are an attractive prey to slay.

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  PART 4 - PLACING BETS IN THE RISK CASINO: THOUGHTS ON THE ROAD AHEAD

  CHAPTER 22 - CHOOSE YOUR OWN RISKPOOL: THE DECENTRALIZATION OF INSURANCE

  WADING IN

  The changes that are occuring in P&C Insurance open up new possibilities in terms of more flexible products to cover a wider variety of exposures, with more flexible terms at cheaper prices. They can even help prevent losses from occurring in the first place!

  At the core of insurance is the concept of risk pooling, which combines some foundational concepts:

  •Individuals and businesses are generally risk averse and prefer to pay a known, smaller amount of money on a regular basis to avoid the possibility of a large, unforeseen negative financial outcome or “loss” that would be highly disruptive and have major adverse consequences

  •Leveraging the law of large numbers, a fundamental concept in statistics that states the observed average of a phenomena will conform to the theoretical mean given a large number of observations, to spread financial risk

  A corollary to the idea of risk pooling are the concepts of risk segmentation and adverse selection. Within a larger pool, there are smaller pools or groups that has different likelihood and sizes of losses. To illustrate, assume that a larger pool is comprised of two smaller groups: a “preferred” group that has lower likelihood of having claims (losses) that subsidizes a “non-preferred” group that has a higher propensity of claims (losses). A competitor with more refined risk segmentation can “skim the cream” and profitably insure the preferred group at a lower premium, which leaves the non-preferred risks in a group by themselves. Without the preferred group subsidizing the non-preferred segment, the group is not collecting an appropriate amount of premium to cover its losses. This leads to upward pressure on rates for the carrier insuring these remaining risks.

  To illustrate, consider the following scenario where one competitor (Genius Inc.) is able to price based on the orientation of a home while another (Clueless Co.) is unable to do so. The orientation of a home can be an important factor in considering the structure’s propensity for loss: if a side with large windows faces due west where the prevailing winds in that area occur, it is more exposed to loss from high, damaging winds and water intrusion from wind-driven rain. Compare this exposure with a neighboring home where the back of the home, a brick wall with no windows, faces due west and therefore has less exposure to damage from wind events. This is a good example of the type of data that is important for determining loss costs, but hard to capture. How would you ask a homeowner to describe the orientation of their home and what exposure they have to prevailing winds in their neighborhood? With aerial imagery, machine learning, meteorological data and historic claims information, capt
uring this sort of detail is now possible for home insurers today.

  For this hypothetical example, assume Brick House has “true” loss costs of $300 and Glass House has loss costs of $900. Of course, both carriers, Clueless Co. and Genius Inc., do not know these true loss costs and must use actuarial models to derive their best estimate of loss costs for each of these two homes.

  Clueless Co. has no risk segmentation between Brick House, which has a brick wall facing due west, and Glass House which has large exposed windows facing west.

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  2.Since Clueless Co. cannot distinguish between these two risks, which are otherwise identical, they charge both homes a premium of $600.

  3.Genius Inc. recognizes that these two risks perform differently and, using insurtech, segments based on home orientation.

  4.As Clueless Co. does not segment between these two risks, Brick House with the large exposed windows will be attracted to the lower premiums that Genius Inc. offers and leave Clueless Co.

  5.Every time this occurs, Clueless Co. loses a customer that is earning them a profit of $300.

  6.Since Genius Inc. is able to offer a lower premium than Clueless Co. and still earn a profit of $100 on Brick House, they are said to be skimming the cream.