Zach Finn, Butler University
3 February 2020Analysis

Becoming an insurance company may be easier than partnering with one

I’ve been thinking a lot about technology lately: what has changed; what is changing; and how much faster and farther it could all go. Artificial intelligence (AI), telematics, blockchain-enabled smart contracts, big data and numerous other marvels seem poised to disrupt many of the ways we currently work, communicate, do business and even how we analyse and transfer risk.

Is it just me, or does this larger theme of massive opportunity resulting from massive disruption sound a lot like the late 1990s and early 2000s? For those too young to remember, there was a buzz in the air about new technology. It seemed obvious that technology was going to transform everything, even if it was not clear how.

“Risktech, and the ability to use new technology to better measure, manage and/or monetise risk, will eliminate the need to buy as much, and as many types of insurance.”

Investopedia defines the aftermath of this period’s irrational exuberance as the popping of an “internet bubble”. That bubble resulted from massive overinvestment in “the new, poorly understood commercial opportunity presented by the World Wide Web,” according to Clay Halton, associate editor of Investopedia.

“It would take 15 years for the NASDAQ to regain its 2001 peak,” he writes. Twenty years later the economy is still finding the right balance between online and bricks and mortar, as well as between privacy and profit.

With the benefit of hindsight, there was much to be exuberant about. Netflix was founded on August 29, 1997. Seeing Joe Pesci de-aged and back in action in the Irishman might have been worth the bust alone. Netflix is also a great example of how I, personally, misjudged the implications of the era.

I thought Netflix was invented to put video stores out of business, and to bring us more movies, faster. I did not foresee them analysing and monetising our content choices to become an originator of newer, better, content.

In January 2000 I would have told you the internet was invented to bring me data, possibly for sale. In January 2020 I would say the internet was invented to turn me into data that is most definitely for sale.

We are once again at a point in history where new technology seems to be foreshadowing both massive opportunity and massive disruption. Intangible assets now represent more than 80 percent of the value of the S&P 500, according to intellectual property (IP) merchant bank Ocean Tomo’s 2019 Annual Study of Intangible Asset Market Value (IAMV). New forms of IP enable and require a new generation of commercial insurance and alternative risk financing products. This merging of technology and the transfer of risk is currently referred to as insurtech.

New sector

Insurtech is a fast-growing area of investment, although still in its early stages. As investment bank JMP Securities’ whitepaper InsurTech 40 indicates: “There are roughly 1,500 insurtech companies in operation globally, having attracted roughly $28 billion of investment.”

Firms such as JMP see this investment opportunity in the context of the overall global insurance market, which itself represents $5.2 trillion in premiums, although insurance companies are currently the most active insurtech investors.

They are keen to invest in emerging technology to access new clients, sell new products and incorporate new sources of information and data for underwriting and risk management.

If you asked an insurance company in January 2020, it would probably have said insurtech was invented to bring consumers and businesses newer, better and more insurance products. What if it was wrong? Just as sending DVDs in the mail was a red herring as a business model, with streaming waiting to make it redundant, maybe insurtech is a red herring too.

What I’ll name ‘risktech’ is the true opportunity. It is about empowering consumers and businesses to buy less insurance, not more. There is a common theme to insurtech investment, whether it is in distribution, underwriting, claims, or enabling functions such as software and analytics: it is overrepresented in the personal lines submarket and underrepresented in the commercial and specialty lines submarkets.

After reading predications from insurance brokers and investment banks such as JMP Securities, I came away with several unique insights. A false perception exists that commodity-like (personal) lines of insurance are riper for innovation, resulting in significant underinvestment in commercial and specialty submarkets.

That’s too bad when you consider that firms such as JMP Securities put the US commercial lines market at $320 billion in premiums, or 48 percent of the overall US property and casualty (P&C) market. In September 2019, Andrea Wells at Insurance Journal touted that “Today’s E&S Market Is an ‘Overwhelming’ Success”. Insurance Journal is excited because excess and surplus (E&S) lines represent 10 percent of commercial P&C premiums and have grown by 11.2 percent over the last several years.

The notion that personal lines of insurance have a lower bar to innovation could not be further from the truth. Regulators are primarily focused on individual consumers, not commercial insurance buyers, meaning, in fact, that commercial lines are more open to innovation from a regulatory standpoint.

“Freedom of rate” and “freedom of form” in the E&S markets provide significant latitude to price and insure new and/or unique risks, while garnering large efficiencies from new technologies.

However, industry whitepapers on the insurtech and investment landscape, such as McKinsey’s “Digital insurance in 2018: Driving real impact with digital and analytics”, reveal a legacy industry largely focused on defending against innovation from other incumbents.

One passage from McKinsey’s report reads:

“As the number of commercial insurtechs grows, their influence will take different forms. Some insurtechs will partner with incumbents to provide innovative new products and services, and others will be acquired and integrated into incumbents.

“The majority of commercial insurtechs (63 percent) are focused on enabling the insurance value chain and partnering with incumbents. Only a small number of insurtechs (9 percent) are attempting to fully disrupt the insurance market.

“These companies don’t currently pose a serious threat to incumbents, but in the coming years they might be able to make inroads in certain segments or niches and take market share.”

The captives space

Where is the mention of insurtechs partnering with insureds directly, or their captives?

Here is a fun fact about risk managers: we don’t like insurance. Good risk managers know how to broker, underwrite, price, loss control and adjust our risks as well as, or better than, any insurance provider. When we have really predictable, challenging or unique risks we don’t buy insurance, we make it ourselves.

There seems to be a sense of hubris that only insurance companies understand how to operate a risk pool and that any insurtech foolish enough to go it alone is dead in the water. This logic ignores risktech and captives. Beyond statutory and contractual requirements, many commercial lines of insurance are purchased simply because the insured does not have the means to understand its risk well enough to be fully comfortable retaining it.

This blind spot is further revealed in McKinsey’s whitepaper:

“Despite significant digital advances, commercial lines still rely heavily on human judgement—particularly in underwriting. This manual model not only increases operating costs but also limits the ability of incumbents to provide superior customer service (such as risk prevention and loss control) for a select few customers, specifically those with large accounts or where change in risk behaviour would have considerable impact.

“Insurtechs, however, can help scale and expand services, using digital to enable greater interactivity and enhance human judgement with technology. In doing so, companies can extend their services beyond the largest accounts while significantly improving performance and efficiency.”

There is a problem with this thinking. Once technology and interactivity reach the point at which they drive changes in risk behaviour, they will also have reached the point of disintermediating insurers as a necessary component in achieving this outcome.

A former co-worker is now the risk manager for a large manufacturer. He has a department of six people who manage the entire risk management function for a global Fortune 100 company, including a $2 billion captive insurance company. This firm’s ability to go from self-insuring its own product liability risks to selling insurance to its suppliers and/or customers is a much lower bar than any insurer seems to appreciate or understand.

Consider a firm such as US automotive and energy company Tesla. It would seem that rather than engage in lawsuits with customers as to whether the driver, vehicle or autonomous driving system caused an auto accident, Tesla seems content to be on the road to becoming an insurance company.

It is a brilliant strategy: when the auto manufacturer is the insurer, it no longer matters whether it is product or auto liability. As vehicles become increasingly autonomous there will come a point at which insurance becomes a seamless part of the transaction with Tesla, rather than something purchased separately from Liberty Mutual. Tesla can underwrite the risk better and doesn’t need to spend 8 percent of every premium dollar on Liberty Mutual’s LiMu Emu and Doug advertising campaign.

When a firm such as Tesla, Uber, Google or Amazon can use a captive to sell third party insurance products to drivers, suppliers and e-sellers, there will be implications for the legacy insurance market. It will create new, more efficient, competition for those personal and commercial lines’ risks.

Additionally, using at least 30 percent of the capacity in a captive to sell insurance to third parties allows a firm to sell itself other first party lines of insurance for which there may not be adequate capacity in the market.

Consider Google selling itself massive towers of first party IP, cyber, (contingent) business interruption and other lines of insurance via tax deductible captive premiums. Remember that 80 percent of the value of the S&P 500 now comprises intangible assets for which there are not adequate insurance products or capacity in the market.

Google is unlikely to ever buy a billion dollars of IP insurance from a third party insurer. But it might sell itself that coverage via a captive. It might even use blockchain-enabled insurance-linked securities to bypass reinsurance brokers and reinsurers altogether, to monetise and spread some of this new risk directly to investors on Wall Street.

It is therefore not just a matter of critical underinvestment in commercial and E&S submarkets on the part of insurtechs or the legacy insurance industry. It is the industry’s collective failure to understand the power of captive insurance companies and their ability to be used by original equipment manufacturers (OEMs), e-commerce firms, co-ops and industry associations to facilitate fewer insurance purchases, create new third party insurers and, ultimately, allow entry into admitted markets.

The same technology that allows for better underwriting and claim management allows for better risk retention and self-administration. Just as technology can transform insurance, it can also be used to transform risk management. Risktech, and the ability to use new technology to better measure, manage and/or monetise risk, will eliminate the need to buy as much, and as many types of insurance.

If you are an insurtech, the most recent National Association of Insurance Commissioners data from 2018 indicates you have a market cap of 5,965 US insurance companies in which to sell your new whiz-bang technology. On the other hand, if you can partner with insureds directly to better manage and retain their risk, 2017 Economic Census data released by the US Census in 2019 indicate you have 7.6 million employers to work with.

The sheer size of the opportunity alone will lead risktech investment to overtake insurtech investment. Risktech will enable increased corporate retentions across multiple lines of insurance and new alternative risk transfer structures. The likes of Google, Amazon, Uber and Tesla will become hybrid insurance companies.

In 2017, undergraduate risk management, insurance and actuarial science students at Indiana’s Butler University created the world’s first student-developed, and student-run, captive insurance company. Our students completed their own captive feasibility study and oversaw the formation of an international captive.

Butler students proved that captives are much more accessible than any insurer or insurtech imagined. If you can draw an insurance company around the classroom with students, you have to wonder how much you really need a legacy insurer to bring your AI, telematics, blockchain-enabled smart contracts, big data and numerous other marvels to market.

Zach Finn is clinical professor and director of the Davey Risk Management and Insurance Program at Butler University. He can be contacted at: