[Note: This item comes from friend Judi Clark. DLH]
Thoughts on Insurance
By Aaron Harris
Jun 29 2017
Two years ago, I printed up Chubb’s 10k and started reading.1 I’d become interested in the insurance industry through a number of conversations with my father-in-law, who is a commercial broker. While I’d thought a bit about health insurance before that, it was mostly in the context of my own access to it, and the never-ending debate around Obamacare.
As I read Chubb’s financials, industry reports, Warren Buffet’s letters, and various blogs I came to realize that the insurance industry was both far more complex and rife with opportunity than I’d assumed. While I’ve always been attracted to fractured and regulated markets, nothing quite mimics insurance in its scope, nuance, and size. I wasn’t the only person thinking about this, as the number of recent insurance tech companies indicates.
Here are a few core problems built into the structure of insurance today.2
Insurance is fundamentally a data problem. Insurance carriers set their rates based on actuarial models designed to predict the likelihood of future events. Without access to oracular powers, these models rely on the best available data when they are built and as they are updated.
This data is necessarily incomplete. It only becomes more incomplete as time goes on and more events pile up in a very large and unordered world. For instance, a home insurer would be able to better predict the likelihood of fire if it knew the details of every overloaded power strip in every home in its portfolio. It does not.
The issues faced by carriers with data extends to the setup of carrier/broker relationships. These relationships necessarily involve lots of paper because there are few simple systems that easily integrate the two sides. This means that information about customers is often relayed poorly, misunderstood, or simply ignored.
Trying to figure out all of the different players in the industry is difficult at best.
When it comes to the distribution side, I can’t do it any better than Kyle did here: https://medium.com/@kylenakatsuji/so-your-startup-wants-to-sell-insurance-a0167581f7b1.
However, there are even more players involved behind the scenes which are important to understand if you want to uncover opportunities:
Reinsurer – There are companies that purchase insurance risk from carriers. They are critical to the system because insurers will often find that they are overexposed to a given risk (like that presented by hurricanes in the Gulf Coast) and will need to offload some of that risk. Reinsurers traditionally purchase risk from carriers and from other reinsurers. Reinsurers have also begun expanding the types of risk that they will purchase and the stage at which they’ll do it, sometimes acting nearly identically to carriers.
ILS buyers – ILS are Insurance Linked Securities. The most of famous of these are CAT (catastrophe) bonds. These are created by insurers and reinsurers who wish to syndicate risk beyond the insurance world. This is done by creating a bond which pays an interest rate and defaults in the case of particular event. The market for these is currently fairly small, and the bonds are generally purchased by hedge funds. This market will likely expand over time as capital continues to look for yield.
Fronting carriers – These are carriers that form partnerships with other entities, like MGAs (Managing General Agent, defined in Kyle’s post above), wherein the MGA writes risk using the regulatory framework of the fronting carrier, and then immediately sells the risk to a third party. This structure allows entities that could not otherwise sell insurance – whether through business choice, lack of regulatory capital, or lack of expertise necessary to form a carrier – do so as long as the fronting carrier agrees.
Fronting carriers are not capitalized in the same way that large carriers are, as they don’t hold risk on their own books. They generally collect a fee – for the use of the regulatory framework – from the entity finding and pricing risk.