Can DeFi Disrupt The Insurance Industry? Part 2
How Insurance Products are Priced
In Part 1, You learned some of the basics of DeFi and Insurance.
To really understand if DeFi can overtake the insurance industry, you should know a bit about what goes into pricing an insurance product. Then you can understand why DeFi’s opportunity really exists. Lets deep dive into the various components that go into pricing an insurance product.
Quick Summary
Describe the items that go into setting the price on an insurance product
What are some opportunities for DeFi in insurance
What are some challenges for DeFi in insurance
How do Insurance Premiums Get Set?
There is a long pricing process to set premiums on an insurance product.
The price is set based on models that are built and run by actuaries. These models can be as simple as a single deterministic scenario all the way to stochastic-on-stochastic scenarios with embedded hedging adjustments. The model complexity depends on the complexity of the product, skill of the team, and the regulatory requirements,
The models need assumptions projecting expenses, policyholder behaviors, asset markets, and the population, making the purchase.
Additionally, there will be some profit target for the company to achieve.
Finally, the the model is run to find the premiums needed to hit the pricing targets.
There are typically teams of actuaries and analysts / data scientists who spend all their time refining the assumptions. There are teams that build and maintain the models, and then teams that design products and run the models.
Decomposition of Insurance Product Price
Revenues
The revenue to the insurance company is the premiums collected and any interest earned by the company for investing the premium in the market.
Commission
Most insurance is still sold through an agent. These agents will typically get 20-100%+ of the first years premium plus some much smaller trail commission for multi-year products.
Expenses
Expenses can be broken up into different categories:
Overhead
Acquiring customer
Maintenance cost of servicing the customer (mailing statements, processing payments, tracking account information, etc)
Claim Payouts
When a claim event happens there is a payout made. For auto insurance, a claim would be a car accident. For life insurance, the claim would be a death. For an annuity the claim would be a payment.
Reserves
Reserves are the money insurance companies need to hold to pay off future claims. There is a timing difference between when you pay your premiums and when the claims come in. Typically, you pay premiums upfront and the claim happens later. Therefore, an insurance company needs to take a portion of each premium and hold it in reserve for a future claim.
For example, if you pay your car insurance annually at the beginning of the year, that isn't money the insurance company can go and spend on dividends to shareholders. They need to hold a portion of it in order to pay off the accident claims as they come in.
Reserves take up a lot of time & energy at a company. This is where credentialed actuaries need to calculate reserves and sign-off on the adequacy of reserves.
Each type of product has its own reserve formula depending on the characteristics of the product. Additionally, a large public insurance company typically needs to keep 3 sets of books.
Generally Accepted Accounting Principles (GAAP) accounting is required by SEC for public companies. There are specific reserve calculations under GAAP
Statutory Accounting Principles (STAT) is unique to insurance companies. This accounting framework is conservative and the goal is to try to ensure adequate reserves are held at the company
Adjusted GAAP is typically used by the insurance company to smooth out earnings by removing one-time impacts, mark-to-market volatility, or seasonality. This is the number is usually talked about on the earnings calls instead of a true GAAP.
Annually insurance companies need to review all of their assumptions and this typically leads to large adjustments to reserves and volatility.
Hedge accounting can lead to mismatch on the GAAP statement leading to perceived volatility.
Insurance isn't the only industry to provide adjusted GAAP, and by doing so it makes it easier for analsts
Required Capital
Lastly, there is additional risk capital an insurance company needs to hold. In the US, this is RBC and in EU it is Solvency II. This is a secondary layer of assets that needs to be held in addition to reserves. Holding below a minimum threshold typically requires regulators to step in. The required capital is based on risks of the underlying company.
In the States, a large driver of an insurers debt rating is the amount of capital held over the minimum thresholds. For example, holding 350% of your threshold is the target for a AA-rated company.
Many insurance companies have internal capital calculations to further bolster their balance sheet. The company may run adverse scenarios and find additional capital over the regulatory required capital.
Profit Margin
Insurance companies need to take some profit margin for their own bottom line. Each product will have some target profit and the prices charged will be adjusted to hit that profit (or other strategic goal for the product).
Opportunity in Inefficiencies
The breakdown of where your premium goes is fairly consistent across insurance products. Obviously some products are more risky for an insurer and need more profit margin. Or the administration of the product is more complex requiring higher expenses. But as a general rule of thumb, the below ranges are sufficient:
How do you read the above?
For every $100 of premium, you would expect $10 to $20 of it to be paid out in commission to the agents. Between the reserves & capital the insurer holds, they will likely earn $5 to $10 for every $100 of premium paid by customer.
All the numbers are estimated based on present valuing (PV) the full projection (ie- if you have a 50-year life product or a 1-year auto contract, the results of PVing the full projection should be in the above ranges).
What is the opportunity for DeFi? Here is a little teaser for part 3…Commissions, overhead, maintenance, and acquisition costs make up a good 20-40% expense that the insurance company needs to pay out and pass on to the customer. Taxes need to be accounted for adding another potential 20% expense.
Location, Underwriting, Long-Dated Liabilities
State Product Filing
Each state has its own state regulators that make up the national association of insurance commissioners (NAIC). Many states have banded together to try to follow the same regulations and work together to help streamline the process. However, many states still have their own specific rules. Any insurance product sold in a state to a resident of the state needs to be approved by the state IC.
Any changes to the product needs to be refiled with the state. Many times states will come back with questions and issues with the filing that need the insurance company to respond to.
Underwriting
There is typically some form of underwriting done on insurance policies. For instance, when you buy life insurance the underwriting generally involves taking blood and getting medical records. When you go for home owners assurance the company may require an appraisal of your house and property or do an online look up.
The purpose of underwriting is to better classify the customer into risk classes. The better an insurance company can define the customer, the better pricing they can give you. However, there is a cost to do underwriting and this leads to higher expenses.
If you don't do any underwriting, you can save money on the expenses but it will lead to higher benefit costs (more claims made). This is the anti-selection problem all insurers face.
Anti-Selection happens due to customer having better information on their risk than the insurer and acting in their own best interest.
For example, imagine 2 companies selling insurance in a world with 2 types of risk-level for people, 50% are Good & 50% are Bad:
Good risks will have $50 a year of claims on average
Bad risks will have $500 a year of claims on average
Company A underwrites into 2 classes while company B doesn’t underwrite and everyone gets same rates
Company A can offer 2 different prices on their product. Maybe good risks pay $75 a year and bad risks $600 a year.
Company B says the average claim is $275 (50% * $50 + 50% * $500) so it charges everyone $350.
Anti-selection says that all the good risks will go to company A and pay $75 a year rather than $350. Consequently, all the bad risk will go to to company B and pay $350 a year instead of $600 a year at A.
Next policy renewal, company B needs to up its price (it isn’t charging enough for all the bad risks). This leads into a negative flywheel as
only the worst risks will continue to pay the higher prices which leads to
more claims for insurer, which leads to
more price increases, which leads to more of the remaining better risks leaving and worst risks continuing to pay….on and on
Long-Dated Liability
Some insurance products have very long-dated liabilities. For instance life insurance products can be 100 year liabilities on the insurance companies balance sheet.
Even on the P&C side, there are insurance like medical malpractice. You have heard of a surgeon sewing a surgical tool into a patient that the patient finds out about 10 years later. Then the patient sues and its in court. Therefore, these claims can also take 10s of years to pay out.
The long-dated nature of many types of insurance is going to be very important in part 3, but for now I will just leave it as people are entrusting the insurance company to be around 10, 20, 100 years from now to be able to pay the claim.
There are a lot of breadcrumbs in the above for part 3. Those of you who are astute probably can already see both the opportunity in more efficient costs of DeFi as well as the challenges with the regulation, anti-selection, and potential time frames.