Insurance is a Commodity: A Continuing Series

Posted on by David Wright

I was reminded today of how many insurance companies actually make a profit: Premium Financing.

The idea is that an insurer accepts some credit risk from the policyholder by not getting all the money up front but charges some insane interest rate on the loan (like, credit card interest insane).

The published rates are therefore cheap, generating much less money than would actually be needed to run the company. Insurance regulators can cheerfully pat themselves on the back, though, because rates are low.

Customers are obviously fine because, like with mobile phone plans, the deal appeals to their huge discount rates.

The trick, of course, is that because this is the only profit these companies ever make, they have to shield it from everyone, particularly reinsurers. Imagine a Joint Venture where the costs are split 50/50 but the revenue is split 60/40. Big problem.

And because most of the companies that work this way are small (for some reason), they are heavily reliant on reinsurance. So they desperately need this service (reinsurance), but simply cannot afford to pay full price for it.

These clients are the biggest pain in the ass. Honestly.

Organizations as Leaders

Posted on by David Wright

In syndicated financial transactions, having larger, higher-status companies on a placement makes a genuine difference in completing it. Generally, a company’s status is closely linked to its longevity and (re)insurers feel this even more keenly. For organizations whose purpose is to absorb economic shocks, the highest achievement is to persist.

Incidentally, I am constantly intrigued by the anthropomorphism. Corporate law aside, companies aren’t persons. It makes as little sense to refer to a conscious entity called “Sony” or “AIG” as it does to say “China” devalues its currency or “America” wages war. Individuals make decisions, not organizations.

Anyway, I get why there are leaders and followers. In the reinsurance world*, where syndicated placements are common, the only accepted competitive advantage is a company’s record of sourcing and selecting risks to assume. Not too hard to copy that, is it. And so you have a relatively homogeneous market with terms usually set by the company longest in the tooth.

The logic here reminds me of an idea I really struggled to understand for a while. I’ll try explaining it with an example from the link.

The number of things we use our eyes for is very large. If all we ever did was look down a pipe, we could get by with lots of configurations: one eye, fifty eyes, etc. But because there are so many tasks for our eyes, there’s really only one solution that works optimally for everything: two eyes.

Systems that need to adapt to many environments tend to converge to an optimal solution. Homogeneity is a sign of progress!

There’s a competing idea that celebrates diversity. This is the theme of Scott Page’s *The Difference*, which taught me two things that I already knew, but always need reminding of: first, diverse problem solving heuristics in cooperation are superior to homogenous ones.  Second, that real solid ‘scientific’ proof of a social phenomenon is a stupendously (stupidly?) rigorous affair.

So, diversity or uniformity? I’m not sure which is right, really, and maybe both are. Diverse heuristics get you to the answer faster, no doubt, but once the optimal answer is discovered, the diversity isn’t very useful anymore. Well, until the environment changes, that is.

Some things always work. Until they don’t.

*Insurers tend to compete with different distribution models; reinsurers, for the most part, don’t.

Now We’re Talkin’!

Posted on by David Wright

Finally, some real innovation!

A new online system from the Chubb Group of Insurance Companies… allows drug and medical device developers to quickly secure required insurance documentation for clinical trials around the globe.

“If a clinical trial is delayed because a certificate of insurance is not available, inaccurate or incomplete, it also shortens the timeframe during which a life sciences company enjoys patent exclusivity,” added Goudsmit

Now THAT’s something of value to the world. Like, literally measurable economic benefit.

Even if some of us are skeptical of IP.

Well done, Chubb!

Um, Which Way is Downstream?

Posted on by David Wright

My boss sometimes laments that we’re in a declining industry and, to be honest, the statistics do show the absolute level of employment in Reinsurance on a steady downward trend.

That doesn’t mean the industry is declining, though. Quite the opposite: it grows with the economy.  Insurance is a business that passes the ‘grandmother test’ because “there will always be insurance”.

So what’s happening?

Here’s Paul Krugman, commenting on an old article of his:

[I argued that] information technology would end up reducing, not increasing, the demand for highly educated workers, because a lot of what highly educated workers do could actually be replaced by sophisticated information processing

And again, citing the work of Autor:

[they] argued that the crucial difference in terms of possible replacement of humans by machines was one of routine versus non-routine, rather than white-collar versus blue-collar

So, to the degree that the insurance business is a collection of routine processes, folks get replaced by flops and the balance slowly moves from labour to capital.

I’m rather obsessed by this macro trend, as a quick flick through this blog would plainly show.

But it’s bigger than insurance, of course. And ain’t no recent thing.

I like to think of economic progress as the decline of the share of our income spent on food, water, shelter and other ‘necessities’. As they get cheaper, we get richer.

Here’s Arnold Kling:

As the cost of food and durable goods falls, what are you going to do? You only consume more health care services if you think you are sick and that the doctor can do something for you. So you either consume more education or more leisure.

These trends matter. The strongest businesses don’t fight the current, they ride the crest.

So, at the margin I expect three types of businesses to grow in the near term. The first is the medical industry (easy).

The second supply things people do in for leisure and/or education. The Silicon Valley social media types are all over this, along with self-help gurus and tv producers.

The third business joins the chorus crushing the costs out of the the rest of life’s pursuits. Think commodity producers (insurance!) and the news media. Over time, their quantities supplied grow with the (world) economy, but their share must fall.

To my boss, then, I say: “watch your margins, insurers grow by adding capital in innovative ways”.

If he’s still worried, I say: “write a book and go on CNBC: become a media darling and guru”.

Still upset? Go to med school.

“Some Day I’m Going to Start My Own Company” – Douchebag

Posted on by David Wright

Perhaps surprisingly, there is a vibrant startup community in the insurance world. In any sales-driven industry, those who can start a business that locks in a distribution channel get rich.

In insurance, these businesses are called Managing General agents (MGAs). They are to insurers what hedge funds are to pension managers.

Anyway, the part about successful MGA owners making big money isn’t lost on many. Predictably, there’s a multitude of frustrated middle managers harboring a deep desire to put their shingle out and strike it rich.

Easier said than done, of course, but it can serve to salve a beaten down ego for a while.

Obviously, I eagerly count myself among these despondent douchebags.

Interestingly, most MGAs are only barely viable. They typically identify some market micro-segment with only enough scale to make a little money; the rest is hopes and dreams stuff that never comes true (but proven by hockey stick growth targets!). Economists would say price equals marginal cost here, and go to bed happy with the state of the world.

At scale, the insurance market is a commodity business, but at the local level it’s a relationship business. Different skills.

Those with the best view of the big picture are the corporate types and they just aren’t entrepreneur material. Too secure, too much to lose. They overthink and do things like write blogs about entrepreneurs while having started nothing at all in their lives.

The local shark is often a champion salesman but runs out of gas when he runs out of hours in the day to sell. No scale.

When lightning strikes and you get the natural entrepreneur with a solid grasp of the whole thing?

That dude gets rich.

Why Does Berkshire Hathaway Hold Any Debt At All?

Posted on by David Wright

You could be forgiven for not noticing with pages of self congratulatory pagentry like this:

Unquestionably, some people have become very rich through the use of borrowed money. However, that’s also been a way to get very poor…

But leverage is addictive. Once having profited from its wonders, very few people retreat to more conservative practices. And as we all learned in third grade – and some relearned in 2008 – any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero. History tells us that leverage all too often produces  zeroes, even when it is employed by very smart people…

On the facing page you can read a letter sent in 1939 by Ernest to his youngest son, my Uncle Fred. Similar letters went to his other four children. I still have the letter sent to my Aunt Alice, which I found – along with $1,000 of cash – when, as executor of her estate, I opened her safe deposit box in 1970. Ernest never went to business school – he never in fact finished high school – but he understood the importance of liquidity as a condition for assured survival. At Berkshire, we have taken his $1,000 solution a bit further and have pledged that we will hold at least $10 billion of cash…

Flip over a few pages. Now, what do you see on the balance sheet?

Cash and cash equivalents:

(2010) $ 34,767

(2009) $ 28,223

yep, that looks right. But wait a sec, what’s THIS?!

Notes payable and other borrowings:

(2010) 14,477

(2009) 13,769

Growing every year. Why oh why?

Here’s David Merkel:

What I am saying is that once the discipline against debt is breached, it becomes easy to justify more debt.  I think we are seeing that now, and Buffett is compromising his principles.

Hey, Greenberg eschewed debt for two decades, and then piled it on for two decades.  Is Buffett doing the same thing?  Personally, I think he is, though I don’t think he has thought it through.  Warren, if you are reading me, pull back on the debt.  It killed Hank.

Douchebag Alert!

Posted on by David Wright

Man do I hate this post. Let me count the ways:

Basic Math:

I’d say I correctly broke down how a dollar  of insurance premium gets distributed, but I made two errors. I stand by the main cost being claims and brokerage. I glossed over the breakdown of the rest, though. There’s profits (5%), Reinsurance (5-10%) and internal expenses (5-15%).

Different Reality:

The internal expense portion is massively dominated by one function: regulation. In the US, there are fifty regulators a nationwide carrier needs to cozy up to. FIFTY. Insurers are NOT just pools of capital. They are money + regulation passing machines. That function is pretty resilient to ‘streamlining’.

No Balls:

So why did I decide that the smallest share of premium is the one to automate? The fat is in the brokerage because they have the power over the business.

Facile Business Fantasy (I really hate this part):

‘Silicon Valley’? WTF are they going to do for you? Social networking or cloud computing? You going to improve our process by outsourcing it? The key problem here is that if someone else has an idea that’s great for insurers, they should just start an insurance company. All you’d bring to the table is regulatory expertise and work flow systems. Not very impressive is it?

All the money is in the distribution network. Forget insurance. Find a way to take out the broker and let the insurers play with the regulators.

This is why I was worried about writing more. I start slinging stuff out the door and only later realize it’s shit.