Tag Archives: Friendsurance

Pimping the Peers (Part 2)

In the last post on this topic, I highlighted how new technologies, broadly under the fintech tag, had the potential to disrupt the banking sector, primarily by means of automating processes rather than any major reinventing of business models (although I did end that post with a bit of a rant about innovation and human behaviour). Blockchain is the hot topic that seems to be cropping up everywhere (I’ll leave that for another time). This post is about insurance and new technology, or in the jargon, insurtech.

The traditional business model in the insurance industry is not reacting well to a world of low or negative interest rates. For the life insurance sector, the duration mismatch between their liabilities and their assets is having a perverse impact as interest rates have fallen. Savings returns for aging populations have been sacrificed in Central Bank’s attempt to stimulate economic growth.

In addition, the traditional distribution channel for selling life insurer’s products, and the old adage is that these products are sold rather than bought, has relied too heavily on aging tied agents whose focus is on the wealthy client that can generate more fees than the middle class. The industry is generally at a loss on how to sell products in a low interest world to the mass market and to the new tech savvy generation. As a result, the industry and others are throwing money at a rash of new start-ups in insurance, as the exhibit on some of the current hyped firms focusing on life insurance below illustrates.

click to enlargelife-insurance-big-data

As the exhibit illustrates, the focus of these new start-ups is weighted towards technologies around product development, distribution, and underwriting. Some will likely succeed in trying to differentiate further the existing clientele of life insurers (e.g. real time health data). Many will be gobbled up or disappear. Differing attitudes between those aged under 34 and the older generation towards online distribution channels can be clearly seen in the survey results in the exhibit below.

click to enlargeattitudes-to-life-insurance-distribution-channels

With longevity and low interest rates the dominant challenges for life insurers today, automation of processes will assist in cutting expenses in the provision of products (mainly to the existing customer base) but will not likely meaningfully address the twin elephants in the room.  Citigroup reckons that in 20 of the largest OECD countries the unfunded government liability for pensions is around $78 trillion which compares to approximately $50 trillion in GDP for all OECD countries in 2015. I look forward to conversing with a robo-advisor in the near future on what products it recommends for that problem!

Insurance itself is hundreds of years old and although the wonderfully namely bottomry (the earliest form of marine hull insurance) or ancient burial societies are early examples, non-life insurance really took off with mass markets after the great fire of London in 1666.

The most hyped example of insurtech in the non-life sector is the impact of technologies on the motor business like drive-less cars and car telematics. This paper from Swiss Re shows that the impact over the next 20 years of such advances on motor premia could be dramatic.

Much of the focus from insurtech innovation is on reducing expenses, an item that the industry is not light on. The graph below shows examples of the level of acquisition and overhead expenses in the non-life sector across different jurisdictions.

click to enlargenonlife-expense-ratios

A recent report from Aon Benfield went further and looked at expenses across the value chain in the US P&C insurance sector, as below. Aon Benfield estimated overall expenses make up approximately half of gross risk premium, much of which represents juicy disruption targets for new technology in the insurtech world.

click to enlargeexpenses-across-the-value-chain

Insurance itself is based upon the law of large numbers and serves a socially useful function in reducing economic volatility by transferring risks from businesses and consumers. In 1906, Alfred Manes defined insurance as “an economic institution resting on the principle of mutuality, established for the purpose of supplying a fund, the need for which arises from a chance occurrence whose probability can be estimated”.

One of the issues identified with the current non-life insurance sector is the so-called protection gap. This is in effect where insurers’ risk management practises have got incredibly adapt at identifying and excluding those risks most likely to result in a claim. Although good for profits, it does bring the social usefulness of the transference of only the pristine risks into question (for everybody else). The graph below from Swiss Re illustrates the point by showing economic and insured losses from natural catastrophe events as a % of GDP.

click to enlargeinsurance-protection-gap-uninsured-vrs-insured-losses

It’s in the context of low investment returns and competitive underwriting markets (in themselves being driven by low risk premia across asset classes) that a new technology driven approach to the mutual insurance model is being used to attack expense and protection gap issues.

Mutuals represent the original business model for many insurers (back to burial schemes and the great fire of 1666) and still represent approximately a third of the sector in the US and Europe today. Peer to peer insurers are what some are calling the new technology driven mutuals. In fact, most of the successful P2P models to date, firms like Guevara, Friendsurance, and Inspeer are really intermediaries who pool consumers together for group discounts or self-financing of high deductibles.

Lemonade, which launched in New York this week, is a peer to peer platform which issues its own insurance policies and seeks to address the protection gap issue by offering broader coverage. The firm has been heavily reinsured by some big names in insurance like Berkshire Hathaway and Lloyd’s. It offers a fee based model, whereby the policyholders pay claims through mutualisation (assumingly by pools determined by pre-defined criteria). Daniel Schreiber, CEO and co-founder of Lemonade says that the firm will be ”the only insurer that doesn’t make money by denying claims”. Dan Ariely, a big deal in the world of Behavioral Economics, has been named as Chief Behavioral Officer, presumably in an effort to assist in constructing pools of well behaved policyholders.

The graphic below tries to illustrate how the business model is evolving (or should that be repeating?). Technology offers policyholders the opportunity to join with others to pool risk, hitherto a process that was confined to associations amongst professional groups or groups bound by location. Whether technology offers the same opportunity to underwrite risks profitably (or at least not at a loss) but with a larger reach remains to be seen.

click to enlargeinsurance-business-models

It does occur to me that it may be successful in addressing areas of dislocation in the industry, such as shortfalls in coverage for flood insurance, where a common risk and mitigant can be identified and addressed in the terms of the respective pool taking the risks on.

For specialty re/insurers, we have already seen a bifurcation between the capital providers/risk takers and the risk portfolio managers in the ILS arena. Newer technology driven mutual based insurers also offer the industry a separation of the management of risk pools and the risk capital provided to underwrite them. I wish them well in their attempts at updating this most ancient of businesses and I repeat what I said in part 1 of this post – don’t let the sweet scent of shiny new technology distract you from the smell of the risk…..

Lessons from Lloyds

There is little doubt that the financial services industry is currently facing many challenges and undergoing a generational change. The US economist Thomas Philippon opined that the finance industry over-expansion in the US means that it’s share of GDP is about 2 percentage points higher than it needs to be although he has also estimated that the unit cost of intermediation hasn’t changed significantly in recent years, despite advances in technology and the regulatory assaults upon the industry following the financial crisis.

The insurance sector has its own share of issues. Ongoing low interest rates and inflation, broader low risk premia across the capital markets, rapid technology changes such as big data and the onset of real time underwriting are just the obvious items. The Economist had an article in March that highlighted the prospective impact of data monitoring and technology on the underwriting of motor and health risks. This is another interesting post on a number of the new peer to peer business models such as Friendsurance, Bought by Many, and Guevara who are trying to disrupt the insurance sector. There can be little doubt that the insurance industry, just like other financial sectors, will be impacted by such secular trends.

However, this post is primarily focused on the short to medium term outlook for the specialty insurance and reinsurance sector. I have been asked a few of times by readers to outline what I think the next few years may look like for this sector. My views of the current market were nicely articulated by Alex Maloney, the Group CEO of Lancashire, who commented in their recent quarterly results statement as follows:

“The year to date has seen a flurry of activity on the M&A front within the industry, much of this, in my view, is driven by the need to rationalise and refocus oversized and over stretched businesses. We also continue to see a bout of initiatives and innovations in the market, the sustainability and longer term viability of which are questionable. These are symptoms of where we are in the cycle. We have seen these types of trends before and in all likelihood, will see them again.”

Lloyds of London has had a colourful past and many of its historical issues are specific to it and reflective of its own eccentric ways. However, as a proxy for the global specialty sector, particularly over the past 20 years, it provides some interesting context on the trends we find ourselves in today. Using data from Lloyds with some added flavour from my experiences, the graphic below shows the dramatic history of the market since 1950.

click to enlargeLloyds Historical Results 1950 to 2015

The impact of Hurricane Betsy in 1965 upon Lloyds illustrated a number of the fault-lines in the structure of Lloyds with the subsequent Cromer report warning on the future danger of unequal treatment between insiders (aka working Names) and “dumb” capital providers (aka all other Names). The rapid influx of such ill informed capital in the late 1970s and the 1980s laid the seeds of the market’s near destruction largely due to the tsunami of US liability claims resulting from asbestos and pollution exposures in the 1980s. These losses were exacerbated by the way Lloyds closed underwriting years to future capital providers through vastly underpriced reinsurance to close transactions and the practice of the incestuous placement of excess of loss retrocession for catastrophe losses within the market, otherwise known as the London Market Excess of Loss (LMX) spiral. There is a clever article by Joy Schwartzman from 2008 on the similarity between the LMX spiral and the financial risk transformational illusions that featured heavily in the financial crisis. Indeed, the losses from the sloppy “occurrence” liability insurance policy wordings and the tragedy of unheeded asbestos risks continued to escalate well into the 1990s, as the exhibit below from a 2013 Towers Watson update illustrates.

click to enlargeTowers Watson Asbestos Claims US P&C Insurers

What happened in Lloyds after the market settlement with Names and the creation of the “bad bank” Equitas for the 1992 and prior losses is where the lessons of Lloyds are most applicable to the market today. The graphic below shows the geographical and business split of Lloyds over the past 20 years, showing that although the underlying risk and geographical mix has changed it remains a diversified global business.

click to enlargeLloyds of London Historical Geographical & Sector Split

Released from the burden of the past after the creation of Equitas, the market quickly went on what can only be described as an orgy of indiscipline. The pricing competition was brutal in the last half of the 1990s with terms and conditions dramatically widened. Rating indices published by the market, as below, at the time show the extent of the rate decreases although the now abandoned underwriting indices published at the same time spectacularly failed to show the impact of the loosening of T&Cs.

click to enlargeLloyds of London Rating Indices 1992 to 1999

As Lloyds moved from their historical three year accounting basis in the 2000s it’s difficult to compare historical ratios from the 1990s. Notwithstanding this, I did made an attempt to reconcile combined ratios from the 1990s in the exhibit below which clearly illustrates the impact market conditions had on underwriting results.

click to enlargeLloyds of London historical combined ratio breakdown

The Franchise Board established in 2003, under the leadership of the forthright and highly effective Rolf Tolle, was created to enforce market discipline in Lloyds after the disastrous 1990s. The combined ratios from recent years illustrate the impact it has had on results although the hard market after 9/11 provided much of the impetus. The real test of the Franchise Board will be outcome of the current soft market. The rating indices published by Amlin, as below, show where rates are currently compared to the rates in 2002 (which were pushed up to a level following 2001 to recover most of the 1990s fall-off). Rating indices published by Lancashire also confirm rate decreases of 20%+ since 2012 in lines like US property catastrophe, energy and aviation.

click to enlargeLloyds of London Rating Indices 2002 to 2015

The macro-economic environment and benign claims inflation over the past several years has clearly helped loss ratios. A breakdown of the recent reserve releases, as below, show that reinsurance and property remain important sources of releases (the reinsurance releases are also heavily dependent on property lines).

click to enlargeLloyds of London Reserve Release Breakdown 2004 to 2014

Better discipline and risk management have clearly played their part in the 10 year average ROE of 15% (covering 2005 to 2014 with the 2005 and 2011 catastrophe years included). The increasing overhead expenses are an issue for Lloyds, recently causing Ed Noonan of Validus to comment:

“We think that Lloyd’s remains an outstanding market for specialty business and their thrust towards international diversification is spot on from a strategic perspective. However, the costs associated with Lloyd’s and the excessive regulation in the UK are becoming significant issues, as is the amount of management and Board time spent on compliance well beyond what’s necessary to ensure a solvent and properly functioning market. Ultimately, this smothering regulatory blanket will drive business out of Lloyd’s and further the trend of placement in local markets.”

So what does all of this tell us about the next few years? Pricing and relaxed terms and conditions will inevitably have an impact, reserve releases will dry up particularly from reinsurance and property, investment returns may improve and claim inflation may increase but neither materially so, firms will focus on expense reduction whilst dealing with more intrusive regulation, and the recent run of low catastrophic losses will not last. ROEs of low double digits or high single digits does not, in my view, compensate for these risks. Longer term the market faces structural changes, in the interim it faces a struggle to deliver a sensible risk adjusted return.