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Todd Hart on Managing Hedge Funds, Reinsurers and Insurers

Todd Hart (mp3youtube) has had the following jobs: political campaigner, investment banker, hedge fund trader, hedge fund portfolio manager, private equity investor, reinsurance company CEO, insurance company CEO and stay at home dad. I’ve seen Todd in action in all kinds of capacities from the lofty heights of deal finance to the gnarliest systems issues in personal lines insurance and I’ve always admired his level-headed attitude in what otherwise might be very difficult situations.

You can be smart and hard working, and Todd is both those things, but to me he is more of a model for *how* to be smart and hard working. In the interview I want you to listen for evidence in the more universal qualities that set Todd apart: curiosity, optimism and a fundamental decency especially towards people that work for him and with him.

One of the things I really wanted to ask Todd was whether management is different in hedge funds, reinsurers or insurers. It is not:

TH: It’s not just capital. You think about your resources. You’re doing resource allocation period. Whether it’s time, it’s people. Attention. Money. A lot of what you’re doing as a manager of anything is you’re allocating. What do you think the most probably outcome and most beneficial use of those resources.

So yeah I guess there is a universality across those things. If you’re running a fund, your biggest resource you have, besides time, which is always your biggest resource. Capital is a huge one. But it’s no different than if you’re running a reinsurance broker, how are you going to spend your time and whatever precious resources you have and not spend and increase your margins.

DW:  How about Risk Management capital allocation and those kinds of functions, those kinds of domains of expertise. Any thoughts on contrasting those between the capital markets and the insurance/reinsurance world?

TH: It’s all basically the same principles. Measure. Keep it simple and measure. I’m sure there are folks who are doing very sophisticated jobs you know when we were putting together our own tools it’s really simple stuff, what are your PMLs what are your limits.

DW: What’s the worst that can happen.

TH: What’s the worst that can happen. I think one of the big differences between the insurance and reinsurance world is the sum of limits you write relative to your capital. You do not want to be publishing that.

DW: a definition of Leverage.

TH: but then if you turn that around equate it to you know you own the Equity slug in a CDO it’s not dramatically different just a question of what capital do you have ahead of you. So we had a lot of conversations around you know what is your limit and that’s why reinsurance works pretty well for a fund because they want to know what the absolute downside is. I do too, and everybody should. For an insurance that’s really the amount of capital you have provided but the leverage is pretty dramatic. It’s actually quite dramatic at a reinsurer as well but in insurance it’s just off the charts.

Todd on systems:

DW: is there a example to come to mind where you know like I made this mistake and then this was the outcome and now I would make a decision later. I don’t know how specific you want to get.

TH: I think as an executive you know we made mistakes around not being firm enough on staying in that customization and configuration zone.

DW: What’s the temptation to leave it. Why do you not? Because everybody probably realizes that on some level right?

TH:What seems to be the interaction that I saw and I would push back on if I saw it again is that ‘we’ve always done a business flow this way we’ve always done it this way and I want the system to mirror our business flow right’. In some circumstances I saw, with a modification of business flow which would have made no material difference you don’t have to redo everything. Part of that is that a system implementation is as much a cultural issue as anything else.

When I walked in to the company we’re in the process of transitioning one system to another and I thought it was not going well and a lot of.. I think I was probably more sensitive to making sure the business Parts the business users were happy and then the technology people were making them happy and so when we went to the second question around technology and I think that lingered through where is I probably should have pushed back a lot harder on the business folks say look, the technology can’t do that and it would be too expensive to create that way.

It’s all about a balancing act. A lot of lessons to learn but you don’t learn these things until you actually make mistakes.

DW: this reminds me of high school football. So my coach.. he was alright, our team was not that good. One of the things he said, which was good, was he said to design the playbook around the team you have as opposed to take the team and force them onto some plays they can’t execute. You have limited talent.

I think what’s interesting about this is that sometimes truths are universal and sometimes they’re not. In this case they’re not because in this case of a system that you actually do want try to redesign the team around it. Swapping a play out in a football playbook is cheap. Changing a system is not. And maybe if there’s a weakness in insurance executives or any executives is that they don’t understand the cost of system changes and so they underestimate them.

TH: Yeah, I think that’s universal.

Folks, there is so much more. I haven’t even given you any quotes on management! Todd is probably the best manager of people I’ve ever witnessed in addition to being one of the best negotiators and strategic thinkers in insurance. And in the show we hear about his strategic thinking and management style but also why American Airlines called him to see if he was ok, what it was like failing in a hedge fund, what a good business opportunity looks like.

You will learn from Todd Hart!

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If you’re an actuary you, like me, probably dread the professionalism continuing education requirement. I think the best time to satisfy this in podcast time. While on your commute, while walking your dog, mowing the lawn. Head over to notunprofessional.com where, for the price of a CAS webinar you can get content dedicated to continuing education for actuaries. Especially professionalism CE.

Why Systems Are So Hard to Build

My guest this week is Bill Jenkins (youtube, mp3). Bill is a technology specialist in the insurance industry. I like to joke that the customer satisfaction rate for insurer systems is 0. But does that need to be the case? I’ve finally had the chance to ask these questions of an out and out expert. Bill has headed up internal technology projects at insurers, he’s run the technology at brokers. He’s been a consultant. A Board member. An industry standards advocate. If there is a puzzle in insurance technology, Bill has probably thought about it and here he is today to help us all better understand why we struggle with technology in insurance.

First, the classic question. Why so many systems? This one always puzzled me. It’s not just about acquisitions. It’s because it’s actually easier that way! Such a satisfying answer (for me) since it aligns with the idea of hidden and underappreciated costs as being the main reason why some problems persist in the world.

BJ: some carriers have multiple and duplicate systems so I worked for a large/ medium sized carrier and we had a eight billing systems.

DW: why, acquisitions?

BJ: Partly Acquisitions partly because it’s one system than address one problem with the other system did so they decided that they needed that this additional functionality that the old system didn’t provide. We just want another one. We had three Bop systems. I was listening to a talk that the chief technical officer at the Hartford was giving and he said every year that goes through the examination and review to determine if they should replace all their legacy systems they had over 330 system. I said to replace all these are they that they projected out would be in 50 years or so and the cost would been astronomical. So all they did was just add systems.

Bill on how project management can achieve great things:

BJ: we also use the project management discipline that we called black hat white hat. Black hat was a hired gun. A project manager who comes in and his or her and only charge was to make sure that the specifications for the system were done and was going to be followed for the requirements of the system and that the time frame that was said would be adhered to. The white hat was an internal project manager who basically made sure the right people were on a project to do the work and also did all the reporting to the Senior Management and navigated the political Waters.

BJ: We built the entire system in 9 months.

DW: Wow, so these things can be done.

BJ: let me tell you the antithesis. Next time around we went with an internal project manager, kept the same skunkworks: 22 months…

DW: So what’s the difference?

BJ: Project Management

DW: So what makes a good project manager?

BJ: well first of all the problem with an internal project manager, and I argue this all the time even when I sit on boards and people are having project problems, a project manager for internal may know all the project management disciplines but they pretty much don’t have the personal characteristics to do the work. You have to be a pitbull.

DW: Put the black hat on

BJ: Put the black hat on.. and you go native too quickly so therefore your scope creep becomes scope leap and you’re fitting more and more into the project and doomed to failure.

And we cover so much more, including how legacy systems are defined by what data they capture and how the information technology industry is perhaps 150 years behind other infrastructure industries. We have a long way to go but things can (will!) be dramatically better!

By the way Bill recommends a book In Search of Excellence, which will hit my reading list soon.

Thanks to Bill for his time. And thanks for listening!

Are you an actuary? Someone you know? Check out the Not Unprofessional Project, content dedicated to Continuing Education Credits for Actuaries, especially Professionalism credits. CE On Your Commute!

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Product Development from Kenya with Barbara Chabbaga

Hi Everyone,

I lived in Hong Kong for a semester in college. The thing that struck me most about that experience actually how familiar life was there. Succeeding in life takes the same qualities everywhere: honesty, hard work, relationships, fun. For whatever reason, learning these lessons in really foreign environments lends another layer of meaning. Or maybe just makes them more memorable.

That universality shines through in today’s interview with Barbara Chabbaga (youtube, mp3), who lives and works in the insurance business in Kenya. How about this for a lesson we can use anywhere in the world: Get the @#$@ out of the building:

How we do it now at AB consultants we call it a bottom up approach. We would never sit in a boardroom and say this is a really good idea.. the kind of product we’d design. I look back at my previous life of working in the corporate world is very tempting you know to sit in a marketing meeting or a product design meeting and say I really really think that if we did this kind of products would work.

What we do now.. we’d probably commission a study, so if it’s with farmers not bring them to our office, go to the field, go to the tier states or go to the informal settlements here in Nairobi. And to be very honest, David, I actually did that for the first time after I left CIC.

But of course not is all the same in Kenya:

…it was a shooting attack, right, shooting, grenades and just shooting anybody in their sight it didn’t matter whether you’re a child. They shot a children’s convention, a cooking class for children, and they shot the children it was horrible and so I was stuck in this little filing room and I was very lucky because it was very hidden. And there were about 30 of us and we hid there for about 8 hours.

…It went on and on and on and you hear the grenade. And you hear the grenade is rolling on the floor because when you roll a pen on top of a table it makes a similar sound and I never knew that until after that ordeal. And a pen rolling on a table, it terrifies me.  And I sat there in this dark room and I think I’ll probably die today and that we knew that for sure they’re going to find us, that’s what we thought, you know, they’ll find us. and I prayed.. please spare my life and I’ll live my life to its fullest.

After I made a couple decisions and one of them was I was going to leave my job at CIC.

There is so much more to the conversation, including the changes she made to her life after surviving that attack, where the Swahili word for insurance comes from, how many actuaries there are in Kenya (guess!) and how the most successful banker in Kenya made his fortune.

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Insurance is Not Sold with John Shettle

Recently I’ve gotten to know today’s guest, John Shettle (youtube,mp3), and all along I’ve been trying to figure out how to just hook up the cables and suck as much information out of him as I could. But how do you ask someone: hey can I just pepper you with the most challenging questions I can think of in insurance for an hour or so.. you know, for fun?

I’ll tell you how.. you start a podcast and pretend “it’s all for the audience”.

John Shettle is awesome. He’s currently an operating partner at Stonepoint Capital and grew up at a family-run MGA, running brokerage and underwriting divisions before taking that company public. The breadth and depth of John’s experience is extraordinary. As another highly successful insurance executive put it to me recently, you can never have enough time with John. I’m honored to have the chance to bottle a bit of him up for us all.

Here is the story of him firing a cherished employee for selling insurance on price:

JS: when I was running an Insurance Brokerage, it had a very very what I thought of was a low retention rate and it was an area that certainly needed to improve on… and so when I reorganized the sales function one of the things that I really emphasized was we’re not going to sell on price and when the client comes in and asks for, ah, says you shopping and he wants to get a quote we don’t respond by getting him the quote we begin to go into a process of Engagement and I also said that to the Salesforce that: “we’re all kind of salary plus commission based, if I catch any one of you just selling price and getting quotes you’re going to be instantly fired.”

And to that extent one day a young gentleman named Eric who I love to death like a son I would keep my office right in the in the area of the office where we had all of our sales reps and I would put myself in the loop when I have time to take sales calls and I overheard him on the phone: “sure mr smith, let me go and get you three or four quotes and I’ll call you back in about an hour” and it broke my heart and I fired him on spot in front of the whole sales organization.

David Wright: No kidding. What should he have said?…

John then gives one of the most lucid lectures I’ve ever heard on how to sell. He’s a master. It’s phenomenal.

But that’s not all! John also explains quite clearly how insurers get it wrong, too:

all the myriad examples of when companies got it wrong… it really comes down always to the combination of 3 things.

One is the underwriter didn’t understand the risk.

Secondly, the underwriter mispriced the risk.. sometimes that happens on purpose.

And third is what I would call sloppy underwriting so when you know you should get certain information and you don’t get it. Where the broker says yeah I know but look it’s the same as last year nobody else is asking for a renewal app why are you asking for it, right, if you want all this stuff I’m just going to go take it somewhere else. What I’ve found is that underwriting disasters happen when two of those three things happen.

And of course there is so much more, including that description of how to sell, a deep dive into the difference between specialty and standard lines and John’s first sales experience (because it’s always good to hear how even the legends start out as doe-eyed newbies like the rest of us).

JS: I remember being scared to death

DW: yeah

JS: 25 years old.. to a retail customer a policy for $110 and it was like a nothing policy and I just remember

DW: were you kind of surprised that he bought it?

JS: yeah and I remember walking on air the rest of the day. And just the adrenaline rush of selling something and having it accepted by somebody you never met was actually pretty cool

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Our Spirit Guide

My guest today is Rick Lindsey (mp3, youtube), who has attracted some attention in the insurance market because his company, Prime Insurance Company, is willing to take on the toughest risks in the toughest lines of business, particularly commercial automobile insurance which is going through a wrenching dislocation right now. Very, very few insurers are making money there. Prime is making a fortune.

Why? How? Then I heard that Rick is from Utah, pilots is own helicopter all over the country and I instantly knew I needed to get to know this remarkable contrarian. I was not disappointed. Rick has built an amazing organization with an amazing culture.

Rick Lindsey: Every other business you’re not asking someone else to tell you what the product is worth… what we do is use common sense. First thing I ask you let’s see what you have.. show me the claims.

Every year we ask them: how did we do on your claims. Because that’s all I care about. I want my insured to tell me you guys were great. You talked to us about the claims, you kept us informed about them and we agreed with the result. With what you did.

What I hear from everybody else is..

what happened on your loss run?

I don’t know.

Well did you know they paid it?

No, I didn’t even know they paid it.. first thing I know it’s on my loss run.

Well why’d they pay it?

I don’t know. I wish they wouldn’t have. they shouldn’t have paid it.

As a company we need to have a relationship with our insured… they feel scared and uncomfortable and their insurance company doesn’t communicate with them. You should be contacting them the minute you have a claim.

I am not going to punish you for reporting claims. I will cancel you for not reporting a claim because then I can’t do my job.

And of course we learn that Rick isn’t just interested in distressed business. That’s just the easiest entry point for his to build a relationship with a client:

If I charge somebody who can’t get insurance anywhere else an extreme price and think I’m going to keep getting that if they perform for me? I’m an idiot.

Perhaps the most fundamental human quality is trust and the thing that great underwriters are great at is figuring out who is worthy of that trust and nurturing it. Rick Lindsey is to me the embodiment of the humanity in insurance. His insurance isn’t about technology and data transfer and machine learning. Rick understands a few really big ideas better than the rest of us and has the force of personality to show us the way. I’m calling him our spirit guide. Listen to hear why…

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Gabe Glynn on Iowa, Manufacturing and Sending People Home from Work

Today’s guest is Gabe Glynn (youtubemp3), co-founder and CEO of MakuSafe and host of the Advanced Manufacturing Podcast. Gabe’s company is a technology startup designing wearable sensors to dramatically improve workplace safety in manufacturing. Here is Gabe on the mission of MakuSafe:

Gabe Glynn: one of the heartbreaking statistics we came across was more than a thousand people a day die in work accidents on this planet so that means since I started this company more than half a million people have not gone home to their families at the end of the day and we believe that with data like this we’re going to be able to send more people home from work and that’s our driving factor.

Gabe is an excellent example of someone with a product that is awesome for insurance but really has very little to do with insurance itself.

David Wright: I like to think about Innovation and insurance as there actually is no such a thing as Innovation in insurance, there is only Innovation in risk management. People in the insurance industry I think get distracted little bit by what they do every day which is insurance and they forget that the social value of what we’re doing is is insulating people from risk and the only way to really affect insurance is to affect the risk

Gabe Glynn: yeah to your point when we started this journey it wasn’t about insurance for us it was about how do we how do we make sure that the environment these people are working in is it is a safe and productive as it can possibly be.

We cover a lot of ground in our conversation, including the culture of manufacturing, why unemployment is so low in Iowa and, of course, how to spot shoplifter.

Here is Gabe’s podcast homepage and MakuSafe’s homepage. Big thanks to Gabe for his time and use of his podcast equipment for our recording! Thanks for listening.

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Bryan Caplan on the Case Against Education

This show’s guest is Bryan Caplan (youtubemp3), Professor of Economics at George Mason University whose latest book is *The Case Against Education: Why the Education System is a Waste of Time and Money*. In this book Bryan makes the point that if we judged education based on how much, as adults, we use what we learned in school, we’d have to admit it’s a shocking waste of time and resources:

David Wright: I remember the first time it occurred to me. I was in third grade gazing out the window and I figured this whole racket was basically just free babysitting for my parents, ah, was I right?

Bryan Caplan: For young kids it’s definitely that, but there’s definitely a lot more going on. Schools definitely teach skills, most obviously literacy and numeracy. But then a big thing that’s going on is that you’re jumping through hoops trying to impress future employers.

Now employers don’t know what you’re actually doing in third grade but since the whole system is so cumulative and sequential.. basically in third grade you’re getting ready for forth grade and fourth grade for fifth grade and so on. And then Junior High and middle school you’re getting ready for high school and high school then is preparing you for college. So very often what you’re learning you’re going to use in a subsequent class. It is used for gatekeeping. But then it’s finally, when you get a job, that’s when the stuff you learn you can safely forget.

Instead, education is about signalling qualities you need to succeed in the workplace. That means more education doesn’t really benefit society!

Bryan Caplan: So the problem is this: when you go and get a better degree this selfishly raises your earnings because you look better but it does not enrich society in the same way. If everyone were to go and get a college degree this would not mean that everyone is good in the same way. This would mean you now need additional degrees in order to convince employers of your awesomeness and we can see very clear empirical evidence of this that over time there’s been massive credential inflation this means if for one and the same job you now need a lot more education to be considered worthy of employment.But if the whole society gets more credentials this doesn’t make the whole society better instead this means that employers will say what’s so great about a high school diploma, almost everyone’s got one now so now you’ve got to get more… as a result there’s this rat race…

So what kind of a world does Bryan want? One with a lot less education spending:

Bryan Caplan: I call it educational austerity. If very wide access to education has caused fruitless credential inflation then reducing access will cause fruitful credential deflation and basically go back to a world where you can get a good job out of high school right so this is the main thing that I push. I talked about a lot of different ways you can cut spending there’s so many different possibilities. I’ve got a blog post on 47 ways to cut spending right so I’m agnostic but there’s just not much research on what’s the optimal way to cut education spending. It’s just not a big topic as you might guess.

And of course we talk about actuaries…

David Wright: Why don’t more people go into vocational jobs?… By training I’m an actuary and that is in some ways I vocational job because I (only) have a bachelor’s degree but it’s it seems to me quite an interesting sector because there’s no other there’s no other profession I think that would be a comparable to actuary where you don’t have to get a graduate degree and so that school system doesn’t hold the keys to the Actuarial profession.

… so I think vocations are great and I think that they’re underrated go by our society why do you think that might be?

Bryan Caplan: Basically there is a pile of government money in favor of the status quo and the status quo is a modest modification of the system from Oxford and Cambridge, right, so basically modern colleges have the fingerprints of early [inaudible] was basically there to train the elite for Law and Medicine and the Ministry…

and one of the main things that education signals is sheer conformity.

I have to admit I remain uncomfortable with the length to which Bryan follows the logic but this book is much more convincing than you’d expect.

We much more than the above, including Bryan’s very interesting idea of the Ideological Turing Test, that just because education is signalling doesn’t mean it doesn’t work and the impact of educational signalling on the civil rights movement!

At The Coal Face of Insurance Analytics

Ladies and Gentlemen, welcome to the coal face of insurance analytics.

Today’s guest is Jim Weiss, the director of analytic solutions for ISO. ISO houses perhaps the richest insurance data repository on the planet and among Jim’s responsibilities is building models that don’t use it! I joke.. Actually, Jim is exploring new frontiers of modeling for insurance purposes. This episode works very well in conjunction with the Cathy O’Neil episode which of course I recommend you listen to right away!

Right out of the gates Jim discusses his view on whether big data in insurance is overrated or underrated:

Jim Weiss: I think if you were gonna write a history of big data in insurance ending today, I would probably have to say that maybe big data in insurance is a little bit overrated. If you look at our industry in recent years, I think it’s kind of a graveyward of big data and analytics type projects that went overbudget overdeadline. I think there were a lot of factors contributing to that, but they can largely be characterized as maybe we’re not doing these projects very well but moreover we’re not picking these projects very well.

Jim on proxies:

Jim Weiss: I feel it’s very difficult to identify something to predict risk behavior that isn’t a proxy unless you’re doing individual risk rating. Unless you’re using something like prior claims to predict future claims, what variable isn’t proxy-ing for something? [From there we talk about my own history as a teenage driver (not great)!]

Jim on how good we are at what we do:

Jim Weiss: Myself and a colleague did a study of some rate level reviews that had been conducted in our industry over the past several years to see how many of them reversed themselves over one or two years.

David Wright: change signs.

Jim Weiss: Not even change signs, substantially reverse themselves. So you have a plus five rate percent rate indication. You notify your agents, you put it in your systems, you sent out hte policy holder notices. you tell the regulators you do eerything you ahve to do. you spenda ll that money, time and effort. then one or two years later. boom, negative five. Completely reversed…

Luckily in the study we did, the majority of the time at the time the rate level indications didn’t reverse themselves within one or two years. It did happen a little bit more often than perhaps I would think.

DW: why do you think that would have happened.

JW: because, Yogi Berra has an expression that making predictions is hard, especially about he future. Ther are so manythings you don’t know at the time you make the analysis.

Finally, in my favorite part of a conversation full of big insightful moments, we discuss whether and how to use complex modeling (and what on earth is modeling for?!):

Jim Weiss: I think, to some degree, applying the smell test to the types of variables you’re looking at, ‘is there some basis in reality’, can be a healthy thing, but I don’t htink it should be preclusive of exploring more complex approaches where prudent. But I’m not sure pricing is necessarily the prudent place for it. It may be but there are a lot of use cases for big data and analytics and sophisticated techniques in our industry which far transcend pricing.

and later..

Jim Weiss: the mix of complicated problem and complicated solution is a particularly problematic one… if you don’t really understand why exactly the approach you’re taking does solve that problem then how do you know it’s not a coincidence.

David Wright: I’m wondering what the objective is of modeling. So one characterization of the objective of modeling is to get an answer you can use. So I get a rate, or I get a loss estimate. I wonder if the real objective is to develop an understanding of the problem. Which is a human consumable… So the output isn’t the answer the output is the story.

This conversation was jam packed with fantastic stuff and the time we spent together flew by. Thanks to Jim for his time and the opportunity to learn! Subscribe in iTunes, stitcher, or by rss feed.

 

The Pestilence of US News

Every morning I get US News delivered to my door. It’s the only dead tree newspaper I’ve ever subscribed to in my life. Lest you begin to think this is some kind of endorsement, know that I never signed up for it, I don’t pay for it and I tried a couple of times to cancel the thing. It’s a pestilence.

When I say delivered to my door, I actually mean chucked out of a moving car onto the bottom of my driveway. This means that every day if I don’t pick the thing up and throw it out it will accumulate, rain or shine. When it snows we inevitably miss picking up a few and after the melt find a few soaked lumps of pulp we then  scrape into a garbage can.

But US News doesn’t care. They’re selling ads. It’s better thought of as an advertisement flier than a newspaper even though every day they publish news stories. And my routine has settled into a grim coexistence with this pest on my driveway. Each morning on my way to work I pick it up and at least get to muse at what headline they decided to put above the fold. It’s a kind of meta-curiosity for me: what is the world focused on today? Then, without even the courtesy of unfolding the thing, I casually toss it into the train station garbage as I jog to my 632am ride into town.

Today I opened it.

US News obviously noticed my haughty indifference and mutated to deliver its payload (advertisements) to its destination (my driveway) more efficiently. You know what doesn’t matter to US News, anymore? The news. Check out the front page:

img_20180205_0626264.jpg
US News Front Page Advertisement

I realize this kind of publicity is what they wanted but they can only abandon their journalistic integrity once (assuming this is the first time). Hope it paid well!

Disruption in Insurance: Harder than it Looks

I wrote the following long form essay for an industry publication. Enjoy!

Disruption in Insurance: Harder than it Looks

I think it was AirBnB that did it best. And I suppose Uber. These two companies introduced a new way of conducting very old businesses, transforming the experience where most would never think transformation was possible. Taxis in particular are horribly contaminated by regulation and special interest politicking. If they are vulnerable, isn’t insurance? Isn’t everyone?

I am a reinsurance broker and one of the things we do is link startup insurance businesses with the capital and partnerships they need to execute. After a while of doing this, you notice even dissimilar ideas fail for similar reasons, which I’ll get into below. As a salesman I am of course an optimist so think of this essay as a list of critiques you, as an entrepreneur, need to overcome to leave your dent in the insurance universe. I hope you do!

I used the word disruption up there and it (the word) is everywhere these days. However, if you were Clay Christensen, the Harvard Professor who coined the term “disruptive innovation” in a 1996 HBR article and subsequent book, you’d probably be frustrated. The term has become massively popular, of course, but widely misunderstood to mean something like ‘tech startups win!’, which isn’t what he was going for. For one, all businesses use technology and new entrants have always used it better than incumbents. Yet all new entrants aren’t ‘disruptive’. Uber has brought dramatic change but Christensen himself is on record saying he doesn’t think it’s disruptive, in the sense he meant for the word.

Real disruption, as defined by Christensen, is scary. For most companies, being relentlessly focused on the customer is a good thing: know what they want and deliver that with focus, discipline and low prices. Or maybe not! In Christensen’s telling, disruption reveals this strength to also be a deadly weakness.

He defines disruption as entering a market from an overlooked customer base, of which he says there are two kinds: low-end footholds and new-market footholds. Low-end footholds start with “less demanding customers” in that they consume much simpler, lower quality products than the mainstream market. The disruptor then progresses up to higher quality customers. In new-market footholds, the disruptor tackles non-consumption first by cultivating customers who had never used the product, then moves into an incumbent’s turf later. In both cases, the end game is offering the final group of customers an equivalent product to the incumbent’s but at a dramatically lower price.

Startups are trying to do this all the time and they are failing all the time. I picture an incumbent smugly chuckling to himself as a constant buzz of startups tap against the window over and again until they drop. What do they fail? Maybe the incumbent thinks discipline of execution and focus on the customer keep it from wasting time on these fancy pants tech ideas. The poison in that chalice is that a company can get in the habit of dismissing everything new and assuming an old ‘bad’ idea can’t ever become good. Venture capitalist Marc Andreessen likes to roll out the old dotcom bubble whipping post, Pets.com, and note that Chewy.com, an almost identical business, was recently sold for 3.3bn. Timing is more important than creativity and timing cannot be planned.

In insurance, the best example of real disruption comes from developing countries in the form of microinsurance. Check this out from the Microinsur website:

We have introduced new forms of protection for emerging customers, including micro-health, political violence, crop and mobile insurance all over the world. In each case, we didn’t start by designing a product in a board room – we visited our customers in markets and villages to understand how they cope with the variety of risks in their lives. The result of this client-centric approach is a new suite of solutions, and the opening of a new market for insurance.

This hits both of Christensen’s entry points: new and low end! In listening to Microsinsur’s founder Richard Leftly’s insnerds.com interview, it’s clear he is aware of this, talking about the power of delivering insurance solutions at phenomenally low overhead costs. A good idea, then. How about timing?

Microinsurance only becomes disruptive if it moves upmarket and the challenge there is regulatory: most insurance buying is forced. Compulsory purchasing makes customers stupid, especially at the low end of the market where the smartest bargain hunters live. Regulators set the rules for what customers can buy and don’t want change. And they have good reason! New products make it hard to tell when someone is underpricing to win, later to collapse in a mess the regulator needs to clean up.

Are regulators ready to try something different? I don’t see it but it’s common for insiders to miss signals of coming revolution. That’s the problem with timing, you need to try (and probably fail!) in order to answer the question: why now?

Enter Disintermediation

I think that when people say disruption they really mean disintermediation. Disintermediation is probably the number one ‘swing for the fences’ strategy for any business. Everyone deals with intermediaries and endures their transaction costs for the benefit of accessing a market. Disintermediation removes the transaction costs but also removes the market! Let’s take three examples:

  1. Cutting out brokers (going direct to consumer or agents)
  2. Cutting out insurers (Automated underwriting)
  3. Cutting out everyone (peer to peer insurance)

Each has been around for decades but none has taken off, really. Here are some ideas for why.

*Cutting out Brokers*

Example: direct insurers and reinsurers

Your broker protects you from getting screwed. Screwed means buying something when an identical product could be had for less. Brokers protect by forcing insurers into the ring to fight for your business. Now, insurance is also complex, requiring some expertise to ensure coverages and terms really are identical before you compare prices. Such expertise means brokers cost good money! Is it worth it?

Let’s come at this a different way by asking “do brokers cause more competition or does more competition cause brokers to appear?” I say the latter: brokers are a symptom of competition, not a cause. And competition is not constant, which means the strength of the broker also rises and falls. That, in turn, means there are two ways to legitimately cut out a broker: 1) remove the need for competition; 2) get insurers to compete without a broker.

Removing competition is not as crazy as it sounds. Consider my business, reinsurance: over the last 30 years the market has had several big negative surprises, causing incumbents to question their understanding of certain businesses, opening up room for several waves of startup reinsurers with distinct appetites. No question those were competition-enhancing episodes.

In between those episodes we’ve witness the reverse: appetites converging as the claims environment settled down. This means carriers consolidate to save on costs since they find it harder to secure an underwriting advantage against others’ identical view of risk. We call this a soft market.

Fewer differentiated options in the market makes a direct relationship more appealing. That said, a complete unification of strategy among reinsurers in volatile business will probably never happen. And even then brokers will always have deeper relationships with the marketplace than a reinsurance buyer and that means better deals. A disempowered broker is still the best place to keep from getting screwed.

In direct insurance things are a bit different, particularly in non-catastrophe-exposed personal lines where products are homogenous and margins are thin. There, new entrants are unable to replicate the data of the incumbents and so bear enormous risk of unknowingly underpricing their business.

Critical mass of is not a new problem in insurance. A hundred years ago the market solved it by banding together to create rating bureaus, centralizing the analysis and often prescribing rates themselves. It was an era much more comfortable with collusion and monopoly than today. That solution is showing its age in many lines: the data needed to put together a state of the art personal lines rating plan has exploded and is growing still. ISO, the heir of the rating bureaus, isn’t keeping up. So market participants have two options: strengthen ISO or be huge. They chose the latter.

The real technological development is that direct carriers are passing on discarded customer leads to competitors, in effect creating bilateral marketplaces. GEICO pioneered a version of this by generating a customer, stripping out the auto and partnering with other carriers (mostly large) to sell the other products. The additional cost of passing a lead to another carrier’s system is zero so why not have a world where large direct carriers are all linked up and whichever portal you enter generates an extra fee for that carrier? That would be a market without a broker but can carriers really stop themselves from manipulating the prices somehow or denying access to the market until your reject a higher priced policy first?

As always, cutting out the broker begs the question: how do you know you’ve got the best deal?

*Cutting out Insurers*

Example: catastrophe hedge funds cutting out insurers and reinsurers and going direct.

Insurance deals in risk. Risk isn’t real, really, like buildings or dishwashers or iPhones are real. Risk is a bad outcome we can’t see coming. Since we can’t see it we can’t avoid it.

That’s nice, says the insurer’s accountant, but that doesn’t help me fill out this tax return. How much money are you making and if you tell me none of it is real again you’re going to jail? Well insurers start with revenue for taking the risk (premium) but no claims payments for a while. What should the accountants do with that? Well, before insurers there were two options, a legal one and an illegal one. The legal option is to declare all the policy limits as obligations and put them on your balance sheet. But we can’t just pay today for every bad outcome that might happen tomorrow, there are too many possibilities!  So enter the illegal one –  to just pretend our way to an answer.

Boy the second one sounds way better. But we still have risk! Now the risk is that the insurer really is insolvent and we don’t know it yet. Who takes this risk? Nobody wants it, least of all policyholders who need their claims paid. So the state takes the risk and puts it into a box called a guarantee fund. They charge for that little trick, of course, demanding money and regulation.

Insurer disintermediation is a really about cutting out the regulator but then someone else has to take the insolvency risk. A workaround exists: using a ‘front’, being a business that takes no risk and only supplies regulatory services. All the other functions: underwriting, finance, claims processing and claims risk are all administered by a variety of agencies, consultants and reinsurers.

Fronting companies are really small, financially speaking, because the premium all goes to pay the agents and consultants and reinsurers. There remains this tiny little probability of the reinsurers, agencies and consultants going out of business or not honoring their various promises. They call it tail risk. But the front is riskless, so who takes that?

Great question! In the (non-fronting) wild, the insurer takes it and keeps a few risk absorbers against bad outcomes: premium, capital and the guaranty fund. The thin front doesn’t keep the premium base, being the first and biggest of those absorbers. As a consequence, modern fronts tend to be incredibly selective of what they accept and/or push as much of this as possible onto the other counterparties.

But as soon as you need to quantify the insurance limits exposed you’re back to the pre-insurance era of accounting, declaring all the limits and capitalizing them on your balance sheet. It really doesn’t work:

There are something like 29 million small business in the US. Each has a GL policy for, say, $1m limit and pays probably something like $1,000 for it. In theory, then, there is 29 trillion in GL limit outstanding for 29 billion in premium. That’s a 1000x disparity.

That’s why insurers aren’t asked to hold collateral against all that limit exposed. But the scope for something going wrong is huge and finding a way to absorb tail risks is the challenge in disintermediating insurers. Policyholders with valid claims aren’t going to get a haircut. Shareholders are tiny compared to the limits exposed. To disintermediate the insurance company you need to answer: who gets the tail risk?

*Cutting out Everyone*

Example: reciprocals, pools, captives, lemonade.

Here’s a cartoon example of how insurance works: we pay premium to an insurer who pays it right back to us as claims. Well, they also sit on it for a few years and keep about a third of it to fund the system: brokers, underwriters, finance departments, taxes. A third?! For giving us back our own premium? Yes.

To an economist, literally everyone in the industry, not just brokers but insurers, reinsurers, adjusters, etc, are intermediaries: they aren’t ‘doing anything’, just shuffling money around, keeping some for their trouble.

Exciting opportunity alert! Let’s cut them all out, go peer to peer and pocket the savings. Not a new idea, I’m afraid. Legend has it that the first insurance companies had exactly such a structure: merchants pooling their losses from sunken ships. So literally every other feature we see of the insurance industry was deliberately invented: brokers, underwriters, finance departments, actuaries…

Let’s defend all our jobs by first stepping back a bit. Insurers protect us from random chance (God) and moral hazard (other customers!).

Protecting us from God is about getting enough volume. House fires are too volatile to pool among 10 or 15 friends. And bigger pools are hard to coordinate so you have to pay someone to help with that. Enter the insurance company processing department and perhaps reinsurance for extreme cases.

I’d argue every other feature of our business exists to protect our premium dollars from moral hazard (ie our fellow customers). Think of the merchant in our primordial insurance pool who lies about his ship sinking and pockets the cash. An insurer is really just a pool of money that each insured has a claim to. Is it so surprising some will greedily eye that cash when they think nobody is watching? Defending the pool against wrongful claimants is what the industry does.

But what about customer service! Lemonade in particular uses the idea of insurers’ poor service as its key promotional message. Even granting that customer service is poor, root problem isn’t that insurers are evil, it’s that customers lie! Even forgetting simple fraud, how about the insured that doesn’t repair his sprinkler system because he has an insurance policy? Moral hazard is incredibly tricky (expensive) to identify. Even then, the higher expense of oversight yields massively larger benefits in reducing the cost of invalid or avoidable claims. This makes insurance cheaper! The chance that you need the customer service is pretty low. The chance that you want those hundreds of dollars of premium back in your pocket is pretty high.

So you can think of the insurance market as having found a balance between low premiums, which customers like, and suspicious and skeptical customer service, which customers don’t like. Cut all that out and you have to answer: how do I protect customers from each other?

So It Can’t Happen?

Now, of course Uber and AirBnB, in particular, looked completely stupid at first. Lots of very serious people had lots of really good reasons for why they would fail. And look at them now! The problem is that those serious people, wrong on those two counts, are normally right. Startups capture the imagination exactly because they’re so outrageous and unlikely. In a mostly market economy like ours, the world is complicated and dramatic changes are very rare. Want to make the highest probability prediction for next year? Start with “more of the same ahead”.

The answers you need to the questions above need to be better than the answers the industry already has:

  • “How do you know you’ve got the best deal?” I test the market with a broker
  • “Who gets the tail risk?” Insurance shareholders and guarantee funds
  • “How do I protect customers from each other?” underwriting and claims management
  • “if disruption, why now?”

The answer to the last is to usually point out any number of the cutting edge technologies of the day and scoff at how slow incumbents are to adopt them. I agree there is opportunity there.

But even startups launched by insiders underestimate the reason insurance is different: you don’t know your costs up front. Without a track record of success regulators, rating agencies and reinsurers will slam the door shut. Building that track record takes time. And during that time incumbents catch up and startups often assimilate, are acquired or blow up.

What’s a startup to do? I say don’t fight against the basics of insurance, use them to your advantage instead. There are times new entrants are allowed in. We call them hard markets and they can work as laboratories of insurance innovation. Incumbents lose faith in their understanding of the risk and deliberately retreat. The system is begging for someone who can be more nimble and solve the market problem.

As I write this perhaps the Caribbean is a good choice, decimated by Irma and Maria? These are challenging situations because along with whatever technology a new entrant wants to bring to the market they need to solve a pricing problem for the risks. But the entrant has a pricing problem no matter when they enter. At least they’re on even ground with everyone else in a hard market!

”This article was first published in the Journal Of Reinsurance, a publication of the IRUA – www.irua.org – and is reproduced with permission.”