insurance business strategy

Insurers are set up to pay three kinds of expenses:

1. overhead and commissions (under their control);

2. predictable claims (whose risk insurers ‘understand’); and,

3. crazily aggregating black mamba catastrophe claims (bolts from the blue).

Let’s play CEO: which one of these keeps me up at night?

Well, #3 looks pretty scary: that’s where the jacked-up Hollywood-style company killers lie in wait. It’s not just hurricanes, earthquakes and asteroids, either. Corporate scandals (think Enron and all the resulting litigation) and ‘latent’ exposures (Asbestos). Lots of drama, lots of victims and look! There’s Anderson Cooper, brows a-knitted, standing knee-deep in a floodplain shouting at a TV camera.

Meh.

Believe it or not, just knowing that some hairy stuff can happen keeps things in check: lots of capital, expensive insurance for Florida homeowners and constant testing of the market through the reinsurance process.

The softer blood-suckers (Asbestos and Corporate Scandal) resolve through the courts, which drag things out for EVER. This means an insurer, now anticipating lots of claims, can crank up the prices and effectively earn its way out of trouble.

Ok, how about #2? Tread carefully, there’s some action here, but the problem isn’t the cost, it’s the revenue and pricing. An organization needs to willfully brush aside good sense and undercharge for this to be a problem. And as stupid as that sounds, it happens because of…

#1: here’s the killer. No sucker is going to pay a premium for a fancy Louis Vuitton logo on the top of his/her policy, so insurers differentiate on price.

There are two ways of going about this: first, by identifying a poorly served subgroup. This is everyone’s favourite because the ‘winners’ feel smart for identifying a niche and the ‘losers’ feel smart for avoiding a trap. Realistically, this is hardly a scalable and sustainable business model.

The real answer is to pull costs from your process. Think like a manufacturer. Make. It. Cheaper. Then you know you’re in a better financial position at any market price. And the market does weird things.

For instance, imagine you’re a typical underwriter CEO when he finds he’s too expensive.

You’re losing money, but out of ideas. Cut your prices, fiddle the reserves a bit to buy time and hope the market turns!

I imagine these poor suckers like submarine captains who just realize they’ve been spotted on sonar and quickly rig for silent running.

Hundreds of feet beneath the sea, quiet as a mouse, on the brink of death and waiting, desperate for a happy ending…

I hear this all the time and get irritated. Consider these two statements:

1. An investor at a conference: “we think that investors are good at understanding super-catastrophe risk, reinsurers are good at understanding higher frequency risk and insurers best understand high frequency risk”

2. We are looking at this marketplace and just don’t understand the risk.

What does it mean to “understand” risk? I’ll tell you: not a damn thing. If you understood it, it wouldn’t be risky, would it?

Statistics can useful at describing processes without using incorporating any ‘fundamental’ analysis of the drivers of that process.

Coin flipping? Sure, I can get my head around the probabilities in that. Aggregate cost of slip and fall accidents in Montana in 2006 being greater than 2005? Yeah, right!

So we approximate, test, get it wrong and (hopefully) refine. Nobody understands risk any better than anyone else. Those two statements SHOULD read:

1. Investors are happy with returns commensurate with insuring extremely rare events because we don’t ever expect to pay any claims and we (the managers) are happy to get fired if we do. Everything else? I have no idea how their businesses work.

2. We like markets where we think people don’t know what they’re doing and we can convince ourselves that we do. Risk is in the eye of the beholder and we can’t believe that REAL risk exists here. We must be the sucker at the poker table.

Really cool article on how entrepreneurs think, here’s the gist:

Rather than meticulously segment customers according to potential return, they itch to get to market as quickly and cheaply as possible, a principle Sarasvathy calls affordable loss.

And the zinger:

They do not believe in prediction of any kind.

The point is that you’re only focused on something when you’re asked to spend money. This is why prediction markets are so interesting. No amount of fancy pants grad degrees or big scores on I.Q. tests can replace the focusing power of cash on the line.

I work in a business that is obsessed with forecasting the future: no surprise when you sell a product without knowing how much it will cost! The people who are in charge of figuring out the COGS are actuaries, who use all kinds of fancy math for describing (and so forecasting!) processes nobody really understands.

Now, the frustrating thing about actuaries is that they know they’re going to be wrong. And that if they’re wrong in the wrong direction (ie understating the COGS), the company blows up and everyone has to go find a new job. The incentive is pretty strong to overstate the COGS.

Not only is this forecasting, but it’s deeply biased forecasting. To an entrepreneur this kind of thinking is radioactive.

Saw a lifetime achievement award given last night. Good speeches, decent food and a borderline bizarre biographical video of the recipient.

The one thing that really sticks with me is how there are four or five really prominent CEOs that all ‘grew up’ together in the business. Can’t be a coincidence.

So what’s the explanation? Talent? Sure. Social dynamic of peer competition? Probably. But surely those things are common enough.

The thing that I think has to have been truly special is the culture of their common employer. They are the product of their environment. So what is someone to do who finds himself in a mediocre environment? How does a leader create such an environment? Do all leaders want to create such environments?

The leaders of tomorrow are being groomed at an extraordinary organization somewhere. Almost every other organization is busily destroying or limiting its talent. Why? How?

I wanted to write a post that discussed why the insurance business is split into such a bewildering array of classes and sub-classes, each with its own specialized practitioners and each of which sits at a different point on the arts/science continuum.

I realized that I actually can’t write the damn post.

Richard Feynman said that unless something can be described easily to a first-year undergraduate, the teacher, and perhaps the entire profession, doesn’t understand the concept deeply enough.

I love this idea. And I realize that I don’t understand the basics of the fragmentation of insurance classes deeply enough to explain it properly.

So let’s just say this: for some reason, there are lots of insurance classes. For some reason, practitioners don’t tend to cross classes too often. Is it because of relationship networks? Is it because the exposures of this business requires a body of knowledge that is immune to generalization from or into other lines of business?

No idea.