How insurance providers waste premiums
Let's explore further some relevant cost drivers for P&C insurance:
- Loss-adjustment expenses (compensation process),
- Advertising and publicity costs,
- Commissions of agents and brokers,
- Maintenance of aging mainframe systems,
- Control and enforcement costs,
- The false narrative of consumer fraud,
- Using the judicial system to punish consumers.
Loss adjustment expenses.
There is a fundamental concept of insurance called compensation. An insured
policyholder should be put as close as possible to their pre-loss condition
after a covered loss. The policyholder should be left no better off than
before the loss. (In fact, this will be calculated less any deductible
that might occur, providing some risk-sharing by the insured).
The definition of coverage is as old as insurance itself and a basic idea
seldom challenged. Indemnification is vital in distinguishing insurance
from other financial products such as stocks, bonds, etc.
Another similar term called improvement means an insured can not be made
happier after a protected loss. This not-for-profit" aspect that
separates insurance from speculative financial products is well-intentioned.
Think for a moment that insurance has a profit motive: this explanation
drives two leading insurance; financial hazard and moral hazard. Moral
hazard applies to any scenario where a policyholder has a strong incentive
to lie, cheat, steal, or otherwise manipulate their insurance company
into making a payment for a non-occurring insured loss - virtually a motivation
to commit fraud.
Moral hazard refers to a circumstance where a policyholder lacks a strong
motivation to care for and maintain the insured object properly. Any loss
may be due to the policyholder's negligence. Although both moral hazard
and moral hazard exist, the basic principle of change is intended to help
restrict an insured's incentive to benefit from failure (whether induced
by deliberate harm or opportunistic loss inflation).
However, what good is insurance if you, as the policyholder, are not entirely
compensated for your loss? Suppose the insurance company doesn't pay
to fix or restore what was lost from a protected threat. In that scenario,
the policyholder accepts some downside risk they attempted to pass by
Again, insurance is essentially distinct from financial speculation. Policyholders
should obtain a reasonable payout for their loss. Conceptually, insureds
should not become financially worse after a covered loss (again, less
deductible may apply).
This payout theory and associated definition of change are enshrined in
insurance contract law and regulation. Consequently, insurance companies
are frequently quoted as saying, "We pay what we owe - no more and
no less." So why is reimbursement a problem? Since it comes at a
high cost, as determined by the annual bills of loss adjustment expenditures
incurred. Claims adjusters operate solely for deciding what (if anything)
is a covered loss after a claim is reported.
The related loss adjustment expenses may differ by product and loss type.
Claims professionals are qualified and certified to work (when necessary
by each state). Over my 20 years in insurance, I have had the pleasure
of knowing many claims adjusters. As a community, claims adjusters are
a source of experience and excellent work.
However, the reason we need specially qualified claims practitioners is
primarily due to compensation theory. By comparison, this compares with
the definition of parametric insurance, where the insurer provides a payment
to the insured until an arbitrary threshold is met. For example, when
a fixed independent wind observation sensor reports a rake over, say,
120 miles per hour, a predetermined payout is activated and made, regardless
of the damage incurred.
This strategy's benefits are that payouts are promptly made to the
insured, and loss adjustment expenses are avoided, minimizing coverage
costs. The downside is that the insured can be made financially better
or worse, depending on the actual price to repair the damage.
The payout sum is based on calculations of the amount of damage 120 mph
winds will do to a particular structure or another insured asset, so the
payout's relative adequacy is directly related to the calculation's
Bottom line: alternatives to compensation, such as parametric, will promote
the same risk management processes as lower-cost insurance. Owing to the
sheer scale of the P&C industry in general and particular loss adjustment
expenses (over $65B in 2017), any small change in claim processes calculated
in fractions of the LAE ratio quickly adds to a substantial reduction
Much technological innovation has occurred in the claims space, especially
in AI and machine learning. Digital capabilities also triage claims faster
and evaluate the most effective routing and handling. Perhaps the best-known
example is "AI Jim" from renters insurance startup Lemonade,
which founder Daniel Schreiber revealed by settling a claim in just 3
seconds to set a world record in 2017. The key is to find improved efficiencies
while retaining due diligence to correct the statements.
Advertising and publicity costs
Acquisition costs are a significant driver of expenses in any sector, but
they are crucial in P&C insurance, particularly in the space of personal
lines. Over the years, there has been much discussion on whether or not
personal lines goods like auto and homeowners insurance are commoditized
products. (As you read Bill Wilson's excellent book When Terms Clash,
he argues persuasively that they are not, while most customers and carriers
behave as though they were.)
Sidestepping the debate, U.S. carriers spend billions of dollars annually
seeking to differentiate their brand from their rivals. How much annual
ads pay P&C carriers? Much! It's hard not to run every day on
a single commercial, either on TV, radio, or online. Additionally, in
the last 10-20 years, prices have risen sharply as carriers compete aggressively
to attract customers.
In short, carriers spend large amounts of money on ads to increase brand
awareness and persuade customers to purchase their insurance policies.
Carriers hope customers turn to save money, bundling insurance policies.
How do carriers know they're approaching customers? That's where
marketing comes in.
Carriers use data and analytics to classify target markets following the
segments they aim to attract. Besides advertisement costs, the cost of
collecting third-party data and conducting the analytics required to operate
a sophisticated marketing campaign is also essential. A customer with
a specific carrier already profits from all this advertisement and marketing
expenditure? It's unclear if they benefit in any tangible way.
These expenses are intended to expand and attract new customers. Although
a stable carrier that raises sales and income is better than one that
isn't, it's uncertain that any of this is linked to the actual
claims service or payout ability when a loss occurs. Which essentially
concerns current policyholders. The bottom line: these costs bring little
to no benefit to current carrier customers. Thus, to the degree that they
cause premiums to be higher than otherwise, they are incredibly inefficient.
Commissions of agents and brokers
Agents and brokers, collectively called manufacturers, are the leading
insurance carrier sales force. Commissions reward producers for attracting
and managing new consumers. Commissions differ significantly depending
on whether the agent is independent or exclusive, business line or form
of regulation, and the carrier's compensation structure. Carriers
also pursue competitive advantage by can producers' payments. Carriers
usually pay new and renewal commissions. These commissions are expressed
as the company's written premium percentage.
New business commissions are often higher than renewal commissions to represent
extra costs borne by agents and brokers for promotions, recruiting, and
quoting new customers. Renewal fees are charged as policy renews to offset
the expenses paid by the policy agent or broker.
Expenses incurred by agents and brokers can include: first notice of failure
and help settle a claim and any other guidance, requests for information,
changes to policy terms and conditions, and other policy service work.
Professionals, agents, and brokers are qualified professionals.
Most of the agents and brokers I've met over the years are hard-working
and care for their clients (although most insurance professionals have
tales of agents and brokers doing little work). Starting an organization
is hard. There are many costs involved in attracting new consumers and
increasing companies. Earning enough commissions takes a while to become
a prosperous business. Over time, good agencies receive more money from
renewal commissions due to gross revenues and less new business.
Because most agency costs are due to promotions and acquiring new customers,
agencies may have an opportunity to "auto-pilot" as renewal
commissions become their crucial income source. From a policyholder's
viewpoint, as an agent or broker's customer, do you get a commensurate
return for the portion of your premium dollars devoted to commissions?
This is a highly customized query for each customer. Some policyholders
derive much benefit from the partnership, even well-established. Other
clients may obtain a declining discount from an agent or broker over time
as the renewal process smoothens. Some customers may have received little
to no value once their initial policy is developed. Frankly, much depends
on whether or not a policyholder argues.
An agent or broker will certainly make a living by acting as a powerful
advocate during a client's need after a tragedy or significant loss.
Overall, creating a broad statement about the value obtained compared
to commissions' compensation is hard. The critical insight is that
in new business or renewal, the same commission percentage is paid regardless
of the amount the client perceives.
Clients who get a lot of money from their agent or broker don't pay
more than clients who don't get much weight. The amount of premium
to pay commissions may or may not reflect a fair customer cost. Put another
way, covering these commissions' fees can not offer much, if any,
perceived benefit to clients not participating or relying heavily on their
agent or broker.
IT and legacy system costs
Unlike typical goods manufactured, the most tangible item of your insurance
product is the document written on. The most expensive piece of equipment"
needed to "manufacture" P&C insurance products are the IT
systems involved, and many!
Carriers typically provide a policy management system that handles all
aspects of quoting, authorizing, and changing insurance policy. These
policy management systems may or may not include a billing system (used
to control bills and receive payments), a ranking system (used to pricing
policy), and an underwriting system (used to determine and manage the
risks associated with policy).
A claims system is also used to delegate and monitor claims, capture estimates,
update status, collect payments, and other activities. It may or may not
be the same method used to measure the cost of a claim.
For auto physical harm claims, accident claims, or property claims, different
systems may exist. If a carrier depends on independent agents, integration
may be broad and complex for an agency management system. Besides, there
are typical litigation processes, enforcement & regulatory problems,
complaint resolution, accounting and finance, HR. The IT systems list
goes on and on.
In turn, all of these systems produce data that needs to be collected,
converted, and loaded into analytical data stores for actuaries, data
scientists, predictive modelers, underwriters, analysts, product managers,
and others to gain insight into how the company is doing.
This data enters as structured data (captured inconsistent, extractable
formats such as drop-down choices and other fielded data entries) and
unstructured data (such as exposure and harm pictures as well as free
text explanations and notes). The data must be collected, stored, and
made available to all the various business units that need access. Carriers
will need robust servers and other hardware to consume such extensive data.
To mention one example, State Farm has over 6,500 terabytes of storage
with over ten times the amount of data deposited in Congress Library.
Once called the technology "early adopters," most insurers rely
on these legacy systems from the 1970s and 1980s.
Big, complicated, and hard to replace legacy systems. They are often costly
to maintain and increasingly rely on obsolete technologies and programming
languages that have not been taught in schools for decades. Maintenance
of these systems is mostly done by experienced employees of corporations
heading towards retirement or offshore resources specializing in maintaining
and updating them.
Customers may not know their carrier still uses legacy systems. Many have
built on their websites new capabilities, including quote and service
policies, to have legacy components working overtime behind the scenes.
Managing all these systems is expensive, primarily using legacy systems
and technologies long past their "sell-by" date. Research firm
Celent reports that the insurance industry invested $184.8B globally by
the end of 2017, and another report states carriers pay $3B annually to
keep obsolete programs running.
Some smaller startup carriers like Clearcover brag about how they can compete
against bigger, conventional players because they don't weigh down
the costs of maintaining legacy networks. Usually, policyholders are isolated
from all this debate of legacy systems versus SaaS alternatives, which
leverages cloud computing technology.
If carriers step away from existing systems, they can utilize a platform
like Amazon Web Services (AWS) to perform the same functions more cheaply
and efficiently. Most consumers don't know and probably don't
care about such obscure topics as insurance legacy schemes, but there's
one implication that matters: cost. What percent of customers' premiums
pay to retain obsolete legacy systems? Price discrepancies are meaningful,
but policyholders have no added benefit. If anything, it's the contrary.
Which consumer wouldn't pay lower prices to exploit the new technology?
Costs of enforcement and compliance
Regulation and compliance with these regulations are integral aspects of
the insurance ecosystem. Insurance is indeed a particular product: customers
pay hard money to agree to pay later in an insured loss. The whole setup
depends on insurers' steadfast commitment to being there.
While many insurance providers are trustworthy and will be there for their
policyholders when a claim is made, legislation lets customers decide
who is reputable and not. Insurance regulation, including banking and
other financial services regulation, offers independent supervision, and
creates system trust.
In turn, this confidence generates insurer buy-in and is a vital component
of a stable insurance ecosystem. How much regulation is required to fulfill
this role credibly, and how much is overkill? Unlike several others, the
U.S. has state-based legislation.
This ensures that carriers who write business nationally must comply with
over 50 regulators to sell consumers in each state the same items. The
National Insurance Commissioners Association (NAIC) offers an excellent
framework for exchanging ideas. NAIC also writes model laws that provide
some clarity, but the state regulatory standards also differ considerably.
In addition to the state insurance department (DOI) authorities, several
federal administrative agencies such as the U.S. Federal Insurance Office.
Treasury Department, Federal Reserve Board, and other agencies control
any portion of a carrier's operation. Suppose an insurance carrier
does business globally, increased regulatory uncertainty. Compliance with
these specifications costs.
The 2017 Insurance Regulation Report Card, 50 states plus Puerto Rico and
Washington D.C. Spent $1.43B on premiums in 2017. However, the premiums
charged by insurance carriers - and eventually by policyholders Just 6.1
percent of state-collected taxes and fees are used for insurance control.
How these regulatory and related costs are shared among policyholders
is also significant.
States with more significant regulatory pressures should see enforcement
costs transferred to policyholders in that state alone, not others. However,
the more complicated and challenging the regulatory climate, the more
potential to move "regulation expense leakage" to wrong policyholders.
Consumers don't only have to pay for the laws they value; they all
have to pay.
The false narrative of consumer fraud.
Although less than other significant costs, insurance fraud creates a small
financial drain on policyholders. In addition to any money from the premium
inadvertently paid out for false claims, all expenses incurred in carrying
out proper due diligence in detecting and prosecuting fraud are eventually
borne by policyholders.
Together, they reflect substantial waste from a valid consumer viewpoint.
In other posts, I have discussed the insurance industry fake news narrative
of insurance fraud, including familiar causes of fraud, how carriers attempt
terrify consumers under the guise of combating fraud, and the other related
Insurance carriers love litigation.
High legal costs can be driven by how fees are set in a given jurisdiction
and how much an insurance company wishes to punish its consumers. Insurance
carriers are familiar as litigants in legal and claim disputes. Due to
insurance companies repeatedly abusing consumers, some lawyers made their
careers holding insurance carriers accountable.
Defending these cases costs a lot of money, both for carriers and outside
lawyers' internal legal staff. Some states owe fees to plaintiff lawyers
who successfully sue an insurance carrier. In Florida, these payments
apply if there is a judgment or decree against the insurer in any number.
Costs function one-way as the opposite is not valid. If the insurer wins
the case entirely, the insured owes nothing against the lawsuit's
attorney fees. Many times an insurance carrier will defeat a claim because
they outspend the plaintiff 1000 to 1.
This topic and costs of insurance companies recreationally attacking insureds
through the legal process differs considerably by jurisdiction. According
to Florida Chamber President and CEO Mark Wilson, the insurance company
enjoys punishing consumers through Florida's litigation process. The
money wasted amounts to $3,400 per household that the insurance provider
spends instead of paying valid claims.
Nearly all insurance cases reflect worthy grievances from policyholders
seeking full compensation value on their legitimate insured claim. Other
possibilities are valid disputes that require court decisions. Nevertheless,
insurance carriers like using the legal process to attack their policyholders.
This recreational sport costs a lot of money and will eventually raise
Some legitimate insurance carriers want to settle conflicts through mediation
or arbitration. Legal costs are high, and most disputes are valid. Many
policyholders see little or no benefit from these expenses, and insurance
carriers should have just paid the claims from the start.
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