Breaking into the insurance industry can be intimidating for new entrants, venture capital firms looking to invest in insurance startups, the startups themselves, and even established businesses looking to embed insurance into the goods they sell. One of the most important aspects presented by the insurance industry is the unknown cost of the insurance product itself. When key variables are still unknown during the insurance product development stage, estimating appropriate risk poses a challenge.
For most trades, the cost of the final product is understood before the goods are sold or the services provided. However, in the insurance industry, the cost of the indemnity itself is very much unknown when the product is initially sold. It may be years before an insurance carrier has a good handle on the costs of the underlying insurance product. Additionally, the majority of an insurance product’s expenses, such as commissions, acquisition costs and taxes, are tied directly to the cost of the underlying insurance product.
Actuaries do their best to estimate the frequency, severity, and timing of claims using historical data or other proxies. With so many variables, determining accurate indemnity costs is extremely challenging. Even with a statistically significant set of reliable data anticipated to be predictive of future events, actuarial estimates are exactly that: estimates.
Our insurance product development experts possess decades of experience helping insurance carriers assess risk to protect profitability. Here are some of their insights into why insurance products fail – and how your organization can sidestep costly consequences.
We’ll begin by examining an industry that faces similar cost uncertainty. Specifically, the world of professional gambling.
Like the insurance industry, casinos and sportsbooks make estimates related to the likelihood of Team A beating Team B, or the two teams scoring over or under certain point totals. Accurate estimates mean the money wagered on each side of the bet will approximately even out. Sportsbooks are acting more like market makers, primarily making a profit by matching bettors on opposite sides of the ledger.
However, if their estimates are off – and people placing bets know this – then more dollars will bet on one side versus the other, and the sportsbooks’ likelihood of losing money increases significantly.
Sportsbooks tend to offer many unique and unusual bets for the Super Bowl. Prior to the start of Super Bowl LV in 2021, a sportsbook offered a wager that would pay +750, (i.e. a $100 bet wins $750, plus a return of the original wager) if a fan ran onto the field during the game.
Unfortunately for the sportsbook, there indeed was a man who ran onto the field during the game wearing not much more than a pink leotard.
This streaker, however, had done his homework. He and his friends made a series of bets, totaling around $50,000, that someone would streak the field during the Super Bowl. With the odds on this bet being +750, he was looking at a payday of over $370,000 – all because he knew more about the likelihood of this event than the sportsbooks did1.
This example outlines another challenge presented to insurance carriers: we live in a world of imperfect information. The purchaser of an insurance product may know more about their likelihood of needing to use the coverage than the carrier selling it. In the same way the sportsbook was tricked by this Super Bowl streaker, insurance companies must account for a similar unknown.
Let’s shift to another example: pet insurance. The policyholder pays a premium calculated based on factors such as pet type/breed, pet age, etc., in return for a policy that covers veterinary procedures.
If a dog owner discovers their pet needs a $3,000 surgery, and their insurance policy has a monthly cost of $100, the pet owner could easily save $2,900 and shift that burden to the insurance company. Theoretically, the pet owner could then cancel the policy immediately after the completion of the surgery.
This example shows that historical premiums are not adequate to cover the prior claims. Actuaries reviewing such data may suggest increasing the product’s overall premium level.
However, increasing the premium discourages owners of healthy pets from purchasing coverage, continuing this cycle and eventually leaving only the owners of unhealthy pets as the entirety of the market participants. At some point, the premiums get too high, even for the owners of unhealthy pets, and the product completely fails, causing significant losses to the insurance industry.
Thankfully, there are some ways to address the issue of imperfect information head-on:
Insurance products typically apply limits of coverage (both per claim and in aggregate), contain deductibles, and/or require coinsurance. It is important to clearly define how much the policy will pay an insured for each claim and how much could be paid in total (aggregate) throughout the policy period.
While this won’t define an exact cost of offering insurance, these coverage restrictions give us a better idea as to the expected cost to the provider.
In the pet insurance example, had the policy contained a $2,500 per event limit, with a $100 deductible and a 25% coinsurance, the cost to the insurance company would have been reduced from $3,000 to $1,800 [= ($2,500 limit – $100 deductible) x (1 – 0.25 coinsurance)].
The application of policy limits, deductibles, and coinsurances has the added benefit of encouraging policyholders to shop the market to locate a vet who will perform a similar, but less expensive, surgery. In the example above, the insurer pays $1,800 and the remaining $1,200 is the responsibility of the pet owner.
Say, for example, the owner shops around and finds a vet willing to do the same surgery for $2,000. In this scenario, the insurer will be responsible for $1,425 = [($2,000 procedure – $100 deductible) x (1 – 0.25 coinsurance)]. While the insurance carrier’s costs are reduced by $375, it’s the policyholder who receives most of the benefit, as their costs drop down to $575 vs. $1,200 previously.
A policy prerequisite allows the insurer to establish a condition or series of conditions that must take place before coverage is provided. Policy prerequisites act as an additional form of underwriting and can dissuade customers from purchasing coverage for a specific event they know will take place. Similarly, a coverage trigger allows an insurer to reduce coverage to only certain pre-specified events or otherwise specifically exclude coverage for a pre-determined list of events.
A policy prerequisite for pet insurance could require a diagnosis from a qualified veterinarian to identify the pet’s pre-existing conditions. From there, policy exclusions can list any procedures that would not be covered by the pet insurance policy. This would exclude coverage from the surgery presented above.
An insurance company can also establish a coverage waiting period between the date a policy is purchased and the date coverage is enacted. This waiting period can keep an insured from purchasing a policy immediately before they know a covered event will take place.
In the case of the pet insurance policy, a coverage waiting period could possibly have prevented the insured from buying a policy as soon as they found out surgery on their pet was required.
One final tool in an insurer’s arsenal is to fully earn the policy’s premium, where allowed by statute. This prevents a policyholder from canceling coverage – and, more importantly, receiving a return premium – just after a covered event triggers. This is more common for policies such as warrantees, extended reporting periods on claims-made coverages, special event policies, etc.
In the end, the streaker from Super Bowl LV did not get his winnings as his bets were voided by the sportsbook after he bragged a bit too loudly about his master plan. Although insurance companies need to account for instances where the policyholder knows more about their likelihood of using an insurance policy than the carrier does, insurers do have some tools and strategies to prevent a situation like the sportsbook example above.
Can your insurance products can stay afloat and ward off metaphorical Super Bowl streakers?