Wednesday, 12 March 2014

Thoughts On The Potential For P2P Insurance

Some interesting discussions these past few weeks about the potential for innovation and 'disruption' in the insurance markets. As ever, there are stark differences between areas that industry players see as ripe for innovation/disruption and the opportunities outsiders see...

A signficant source of this disconnect - and a great source of opportunity for outsiders - is the tendency for established institutions to view the market through the narrow lens of their own existing products and activities, rather than from the customer's standpoint. To really solve a customer's problem, a supplier has to understand the end-to-end activity in which that customer is engaged; and has to consider that it might need to collaborate with other suppliers in the process.

For instance, as a consumer of car insurance, it's important to understand that you don't simply drive you car. You drive it from A to B in the course of some other activity. Is it a one-off journey, or a commute? Does it involve both city streets, motorways and/or rural roads? What time of day is it? Are the road conditions always the same, often wet or sometimes extreme? Why couldn't I switch insurers, policies and/or premiums as these variables change? Could my car be covered by household insurance while parked at home? The answer hardly requires advanced telematics.

Another problem for insurers is their preoccupation with managing short term financial performance within regulatory capital requirements. This favours cost-reduction at the expense of more strategic, long term business development. In fact some insurers may be better off admitting they are simply running-off their existing book. [Update on 26 March: FT coverage of RSA's rights issue underlines this point - it's all about cost-cutting and disposals, to which CEOs have tied some nice incentives].

At any rate, this tells me that insurers will end up reacting to changing demand, rather than reinventing insurance in any substantial way.

The same goes for the insurance industry's attitude to Big Data. While large insurers are quite sophisticated exponents of Big Data, the industry is merely dedicating itself to persuading customers to disclose more and more personal data about themselves for use in marketing extra products, reducing fraud or improving claims-handling.

This ignores the evolution of personal information management services that go in search of products that are right for you personally. Insurers argue that's what happens on price comparison sites already, and the Cheap Energy Club takes that a step further. But we have not yet seen the truly personal 'open data spider' that some of us have been dreaming about. In that machine-readable future, the challenge for insurers won't be to find customers, but to be able to instantly formulate policies in response to customer devices directly peppering their systems with requests for tailored cover.

To be fair, there are also plenty of mistaken assumptions by outsiders about how insurance actually works (or doesn't) today, and which elements of the value/supply chain that are ripe for improvement or disintermediation. For instance, people forget the key role of reinsurers and reinsurance brokers in diffusing the risk of loss across many sources of capital.

So before disrupting today's insurance markets, it's worth pausing briefly to understand the nature of insurance and how the markets operate.

In layman's terms, insurance is a way for you (the 'insured') to transfer to someone else (an 'insurer') the risk of loss, in return for payment (a 'premium'). 

But it's not quite that simple. In legal terms, that 'risk of loss' translates into 'a defined event, the occurrence of which is uncertain and adverse to the interests of the recipient'. The practice of pooling risks also lies at the heart of modern insurance, such that premiums paid for insuring lower risks are used to fund payouts on higher risks. This of course presents a significant moral hazard, and the scandals involving payment protection insurance and so-called 'identity theft' insurance illustrate how the industry has tended to seek out customers who don't actually face a genuine risk that is adverse to their interests and/or would never be able to make a claim (even if they were aware they'd bought the insurance).

Which brings us to the main problem with insurance markets today - they are highly complex and heavily intermediated, often by players who have little or no interest in seeing a genuine risk is insured appropriately.

Modern insurance can be traced to the need to insure property against the risk of fire after the Great Fire of London (and some might say little has changed since then in the way non-retail insurance business is transacted!). The need to spread the exposure to other risks of loss has created markets around certain types of other events, businesses and property. Reinsurance markets have developed to enable insurers to insure themselves against the risks they underwrite. In each of these markets, the distribution, marketing and sale of insurance is heavily intermediated by brokers and others who take their own cut from the gross premium that you pay (the net premium being what the insurer receives in return for underwriting the risk). Insurers also must invest their premiums in order to help fund payouts and ensure they have enough capital to cover their exposures. So there are strong links between global markets for insurance and other financial products, which brings with it hidden costs and fees, the risk of re-concentrating risk in suprising places and exposure to global financial crises...

Rolling all of these issues together, it seems to me that the real purpose of an insurance business is to find people who genuinely face adverse consequences from specific events, the occurrence of which are uncertain, and then to diffuse that risk across as many different sources of capital as possible, as efficiently as possible. 

Some would say that this amounts to concentrating the risk of loss, since those who don't genuinely need insurance would be excluded (but allowed to buy it if they genuinely do just want it for 'peace of mind').  But that only means we should cease pooling risk and find another way to spread it, such as the peer-to-peer marketplace model that is at work in many other industries.

Peer-to-peer insurance would involve the operator of an electronic platform enabling direct insurance contracts between each insured and many investors (whether traditional insurers or not), each of whom would receive a small portion of the overall premium yet only have to pay out small sums in the event of loss. In this way, the risk of loss could be diffused amongst many investors who would only provide insurance as part of a widely diversified portfolio.  In common with the impact of the P2P model in other industries, removing all the middlemen would cut the margin between net and gross premium to a transparent fee for running the platform, leaving the lion's share of the difference with the market participants.

There are some interesting examples that are headed in this direction. Friendsurance, for example, goes part of the way by enabling a crowd of people to fund the excess on each of their insurance policies. I'm also aware of jFloat (yet to launch), which some have suggested is an application of the P2P model. But I understand that it will still involve pooling risk on a kind of mutual basis, whereas I'm talking more about a 'pure' P2P model.

Presumably, this is not what today's insurers, brokers, reinsurers, reinsurance brokers and other established industry participants want to hear. But they too could benefit in the longer term (if they can afford to think that far ahead) by setting up their own platforms or contributing their own capital and expertise.

It's okay, everyone, I'm not holding my breath...

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