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A taste of shared value.

As insurers get better at separating risk "lemons" from "peaches," competition increases, driving down profits. Shared value products are one way insurers can respond.

Insurance firms are beautiful machines that create wealth from risk. While the machines still have years to run, cracks are likely to appear due to disruptive innovations from big data and the internet of things. To continue creating wealth in the face of these disruptions, insurers need to show strategic risk leadership. One way to do this is to strike deals with one of the modern technology platforms that provide detailed, cheap and high-quality information about potential insureds. Another way is for insurers to reconceive the structure of their products.

Strategic risk is concerned with perils that can threaten the competitive rank of the firm; leadership is about coping with change, according to John Kotter, regarded by many as an authority on corporate leadership. Thus, in this case, strategic risk leadership is about how a firm's executives cope with the threat--and opportunity--created by the plummeting cost of information.

Our daily interactions with the internet create a digital exhaust which when snared, analyzed and correlated can reveal our individual desires, how we allocate our wealth to fulfill our desires, and the risks we take to attain our desires. With this information, firms can pitch their products to us in irresistible ways. This knowledge also challenges the way insurance firms do business both with individuals who buy coverage for themselves and individuals who buy coverage on behalf of their organizations.

The Fruit Effect

To visualize the impact from big data and the internet of things, consider individual consumers of auto insurance. Insurers need to differentiate high-risk consumers-"lemons"--from their low-risk counterparts--"peaches"--since both coexist in the insurance market.

Whether an auto insurance applicant is a lemon or a peach depends on how many miles and how fast the consumer drives, when and where the consumer drives, and how much aggression the consumer channels into driving. For the past few decades it has been prohibitively expensive to measure these factors precisely, so insurers have relied on clever shortcuts. They classify potential insureds according to easily observable attributes such as age, and they offer different deductible-premium combinations.

At the end of the day, however, this is an imperfect way of classifying risk. Some lemons manage to pass for peaches, thus the premium for peaches is higher than it would be if only true, low-risk drivers were considered. Lemons that pass for peaches pay a lower premium than if they had been properly classified. Thus, in the current market, low-risk policyholders subsidize high-risk policyholders.

These subsidies break down, however, when specialized algorithms can perfectly identify how sweet a peach or how bitter a lemon each policyholder is, as well as how high a premium the policyholder will accept before balking at coverage. This knowledge allows insurers to perfectly match each consumer with a unique premium--economists call this first-degree price discrimination. This process is especially troublesome for insurance markets.

To explain why, one needs to go back to a 1976 paper by Michael Rothschild and Joseph Stiglitz, a winner of the Nobel Memorial Prize in Economic Sciences. Rothschild and Stiglitz showed that if an insurer can cost-effectively separate policyholders according to risk, the insurer can poach all the lower-risk policyholders from its rivals by offering slightly better terms. The rivals left with only higher-risk policyholders would make a loss unless they increased premiums. As insurers, or modern technology platforms with access to even better data on consumers, peel off the sweeter and sweeter peaches into preferred risk classes, premiums on the remaining policyholders will increase further and further. When the premium increases become steep enough, the sour peaches and all the lemons will stop buying insurance and will demand premium relief from their national politicians and state regulators. The insurance affordability/ availability crisis of 1984 to 1988 should serve as a guide.

Commercial Impact

The impact on insurers selling commercial coverages will be subtle but still profound. Unlike financial markets, where bankers rely on the mechanics of arbitrage to price identical risks the same, in insurance markets underwriters rely on analogy to price similar risks the same. Of course, what risks an underwriter considers similar may not dovetail with how the client views things. Traditionally, it has been through their relationships that underwriters and clients come to agree on which risks are similar enough for pricing. When, however, an algorithm fueled by digital footprints can efficiently pair underwriters and clients according to their perceptions of risk, commercial underwriting becomes a commodity. Claims adjusters will face a similar commoditization as structures, components and fixtures in commercial buildings and machines ping the insurer when they fail. An algorithm can then efficiently tally damages and dispatch repair crews.

Therefore, innovations from big data and the internet of things that reduce the cost of information threaten the ability of insurers to create wealth for investors. Insurers can respond to such threats by reconceiving the structure of their products.

According to Michael Porter, considered the preeminent authority on business strategy, and Mark Kramer, by reconceiving its products, a firm can create "shared value." Such an approach calls on managers to use the objective of maximizing the investors' wealth in deciding how to accommodate, rather than ignore, the multiple demands placed on the firm at the intersection of societal and economic change.

Adoption of a shared value approach to the design of insurance products will encounter resistance--an influential report by the European Commission on shared value creation neglects to mention the need for a firm to generate wealth for its investors. Nevertheless, the economic potential of encouraging shared value thinking in an insurer is solid.

Some insurers have already begun the process of creating shared value products. The most natural examples are from life and health insurers. John Hancock and Oscar give their policyholders financial incentives to improve their health. The fact is that healthier and longer-living policyholders are good news for life and health insurers.

There are also good examples from the property/casualty side of the industry. Munich Re has developed a series of products that reduce uncertainty associated with the long-term success of new, environmentally friendly technologies. These products establish floors in the financial impact that underperformance of the new technology can have for its adopters. Thus, the insurer encourages the adoption of the technology while earning a premium.

Strength in Numbers

To neutralize the threat from big data and the internet of things, however, insurers need to develop shared value products on a massive scale. One way is to reconceive insurance as coverage linked to various indexes. Unlike today's increasingly customized insurance-related indexed products, the shared value indexed products ought to have mass appeal.

Coverage linked to an index on a massive scale is not a novel idea. It originates with Robert Shiller, who has been awarded the Nobel Memorial Prize in Economic Sciences. What is novel here is my assertion that there is currently a confluence of factors that can actually bring shared value indexed products to the mass insurance market. Ironically, the same digital data that threatens insurers' ability to generate wealth for investors also makes feasible the development of an array of indexes.

Insurers already possess strong expertise in constructing indexes and linking coverage to them. Consider, for example, the success of industry loss warranty (ILW) products. At its simplest, an ILW pays off when the Property Claims Service Catastrophe Loss Index exceeds a pre-agreed threshold. The index measures the total economic loss to the insurance industry from specific, high intensity perils. It reduces moral hazard because neither the behavior of the ILW holder nor the behavior of its seller can alter the payout.

The broadness of the index, however, creates basis risk because industry aggregate losses are unlikely to fully map to losses experienced by the warranty's holder. The industry has shown a robust ability to address this basis risk. Since 2002 a quiet transformation is taking place in index construction.

Loss indexes are being granularized down to the geographic area of a county. Such progress in controlling basis risk in ILWs demonstrates the feasibility of constructing even finer indexes, both by area and/or peril.

Imagine a global market where each insurance firm has a copyrighted array of indexes to offer to the public. Individuals and corporations purchase units of the index that most closely matches the peril they wish to hedge against.

Because policyholders know best if they are a peach or a lemon, each will adjust the number of units they purchase according to the size of the loss they are likely to face. Payouts can either be directly related to the index or a ratio of the policyholder's economic loss to the index. The insurer takes on the role of market maker for its indexes and collects royalties when others sell coverage linked to its indexes. Insurers with strong liquidity can even engage in proprietary trades using the indexes of other insurers.

If insurance firms can reconceive their products to spread risk among individuals on a massive scale while controlling moral hazard, then we are all better off. First, individual policyholders benefit from a decline in the cost of coverage, with high-risk policyholders given an incentive to manage their risk so they reduce the units they would need to purchase; those who elect not to do so may find little sympathy.

Second, society benefits because communities can hedge against different families of risk; in these products society can gain a resilient global risk/ disaster recovery system. Third, since insurance currently protects against a relatively small portion of risks, the new vast markets created by these products will generate a heap of wealth to investors. Indeed, these three advantages ought to motivate shared value products in the insurance industry.

Key Points

The Problem: The availability of inexpensive, detailed information on consumers threatens the ability of insurers to create wealth for investors.

The Response: Some insurers are now offering shared value products that encourage consumers to take steps that decrease their risk while allowing insurers to make money.

The Next Step: Insurers need to develop shared value products on a massive scale; one way of doing this is to reconceive insurance as coverage linked to various indexes.

Best's Review contributor Nicos A. Scordis, Ph.D., is a professor in the School of Risk Management, Insurance and Actuarial Science at The Peter J. Tobin College of Business, St. John's University. He can be reached at
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Title Annotation:Strategy
Author:Scordis, Nicos A.
Publication:Best's Review
Date:Dec 1, 2016
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