The Power of Data Mining

Posted on by David Wright

Reading about Emerging Adolescence in the NYT, I was particularly annoyed at this:

People can vote at 18, but in some states they don’t age out of foster care until 21. They can join the military at 18, but they can’t drink until 21. They can drive at 16, but they can’t rent a car until 25 without some hefty surcharges.

Rental companies’ decisions are based on insurance data and so are based on behaviour. The rest of these are political artifacts, long ago dressed up in the ‘logic’ of that age but really resting on ugly political deal-making, warped by public choice failures and surviving thanks to status quo bias.

But our author redeemed himself eventually:

The scientists found the children’s brains were not fully mature until at least 25. “In retrospect I wouldn’t call it shocking, but it was at the time,” Jay Giedd, the director of the study, told me. “The only people who got this right were the car-rental companies.”

This is why the auto industry has the capacity to be the most competitive insurance market of all – standardization of coverage and vast amounts of high quality data.

The Business

Posted on by David Wright

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.

Tort Reform

Posted on by David Wright

90% of insurance press falls into three categories:

1. Puff pieces about some industry grandee or cat product “innovation”

2. Chicken Little Tales about how some legislative catastrophe is just around the corner (climate change is big, as is whining about the lack of US tort reform)

3. SHOCKINGLY boring actuarial stuff.

#2 is the intellectual trap. You think you’re doing a good job because you think you’ve identified a neato risk nobody has priced in.

*smack*

Insurance folks are meant to be paid to assess risk. But risk isn’t something you see and touch, have drink with and that gets punched out by that drug dealer because it touched his girlfriend in the strike zone at a bar late that night in Vegas last year.

No, risk is a helpful intellectual framework in which to think about things that might happen. You might think that this is a profession for people who are good at figuring out what risks are out there.

You, my friend, could not be more wrong.

(Exaggeration for effect alert)

Insurance isn’t about assessing risk. Insurance is about getting on oversubscribed deals, writing more in cyclical upswings, having low expense ratios and conservative bond portfolios and not being played for a sucker by a broker. People who assess risk don’t write anything.

Not that you should have a team of died-in-the-wool morons running your portfolio, mind you, but you could probably get away with it if you had a microscopic expense ratio and laid ¾ of them off in a soft market.

But that’s barbaric. My point is that people that think too much about stuff don’t write any business – imagining ways something could go wrong is easy. I had a prof in U that said MBA programs are about teaching people a hundred million reasons to say no to ideas. Living with risk is the real skill.

So all this whining about Tort Reform by insurance companies is a red herring. The market price will adjust if claims blast off into the sky because of climbing tort expenses.

Otherwise, you’re still making money on it, so why waste your breath?

Inflation and Insurane

Posted on by David Wright

I like this presentation by Bob Hartwig at the III (haven’t finished it yet).

I find his treatment of real vs nominal variables frustrating, though. The CPI measures what people spend on stuff and is ultimately driven by wages, imho.

Wages might drive many insurance prices (rating basis for insurance costs for many companies is their payroll). But, realistically, insurance rates are not set by some theoretical link between the driving variable (wages or whatever) but by claims experience. Any changes from ‘inflation’ are competed away if the claims don’t show up. What drives claims? Well, of course they’re driven by changes in some components in the CPI, among many other things (legislative changes, exogenous shocks, etc). But this year’s claims cost is often driven by the CPI level from when the claim occurred, which may be years in the past. So there’s a lag. Tough to predict.

Bob’s an economist, so he lives and breathes ‘economic’ variables and probably doesn’t often dig into his preconceived notion of what they measure. Inflation is different depending on what you’re doing. I imagine the correlation between changes in the driving variable for an insurance policy (wages or whatever) and the actual claims cost changes is much smaller than one would think. I’d bet real money it’s less than 0.5 in the short/medium term (1-5 years).

Why Insurance Exists

Posted on by David Wright

Brooks has a good one today (just read the bold stuff):

Over the past decades, we’ve come to depend on an ever-expanding array of intricate high-tech systems. These hardware and software systems are the guts of financial markets, energy exploration, space exploration, air travel, defense programs and modern production plants.

These systems, which allow us to live as well as we do, are too complex for any single person to understand. Yet every day, individuals are asked to monitor the health of these networks, weigh the risks of a system failure and take appropriate measures to reduce those risks.

If there is one thing we’ve learned, it is that humans are not great at measuring and responding to risk when placed in situations too complicated to understand.

I heard a story recently about a group of insurance executives meeting with BP’s risk manager in the 90s. She reiterated a common refrain: we don’t need insurance because we have a huge balance sheet.

Indeed.

And yet, insurance still has something to offer:

1. Individuals often overstate risk tolerance, especially with respect to organizations. I think that this is a combination of Robin Hanson’s Near vs Far bias and agency cost. People rely too much on silly capital models and not enough on anticipating the response of those individuals who (collectively) actually pay the costs (shareholders, stakeholders, etc) of risk when it goes pear shaped.

2. A market based appraisal of what the risk is worth. Sure, insurance underwriters may not understand it perfectly, but at least get a second opinion. You might miss something and the costs of that are, obviously, huge.

In spite of the fact that most risk is fundamentally incomprehensible, the insurance industry is actually quite stable. It continues to baffle me, to be honest, but I can’t argue with success.

I still don’t know what to make of all this

Posted on by David Wright

Felix comments on El-Erian’s summary of the PIMCO global economic outlook.

Whenever I feel overwhelmed by the big picture, I retreat to my analytical roots in the insurance world.

Inflation can be dealt with fairly easily because prudent insurers will have sufficiently implemented ALM and so maturities should match payouts and so inflation will only hurt on the liability side of very long (insurance) tail lines of business. No systemic threat there.

Sovereign defaults will be tricky for insurers in those countries likely to default, but those insurers don’t matter because those economies don’t matter in a global sense.

I’d be surprised if knock-on effects of bank insolvencies for those heavily exposed to defaulting countries moved anyone’s needle.

Stagnant growth? Meh. It matters for this thing called “economic growth” but that’s mostly about opportunity cost. If my living standard doesn’t keep skyrocketing (in the historical sense), I will hardly notice. Real growth in the stock of insurable assets will slow, but insurers make their money from their leveraged bond portfolios, anyway.

Rise of the BRICs? Meh. My view is that those countries aren’t stable enough legally and don’t yet have a big and valuable enough stock of assets to protect to support globally important insurance industries.

State capitalism and bailouts? Now we’re getting somewhere. My view is that Uncle Sam prevented/delayed an insurance calamity over the last couple years. Bailouts kept the skeletons in the closet, which people would undoubtedly have wanted to claim for (thinking mostly professional liability here). A more severe recession would have triggered a load more property “oops” claims than we saw, though we did see an uptick.

More bailouts could prolong the soft market.