Pulling back the curtain to shine light on ‘scary’ insurance phrases

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Reinsurance/ILS, Blockchain, and insurance financials.  Not quite lions, tigers, and bears, but for many who follow insurance the three concepts are as daunting and pose discomfort in understanding. Why then the mention?  Because in an earlier social media post I noted that the three words do not generate a lot of media content traffic, and if there is a related posting, not much response.  A wise connection dropped the key hint to that puzzle- the words need to be discussed in context that makes sense to the reader.  A cool idea, Modern Accelerator .

Patrick Kelahan is a CX, engineering & insurance consultant, working with Insurers, Attorneys & Owners in his day job. He also serves the insurance and Fintech world as the ‘Insurance Elephant’.  Image

Let’s dive into the three concepts with a full recognition that this blog will serve merely as an overview and whetter of appetites causing the readers to want to consume more. Fair warning- even keeping the topics brief- TL:DR may apply.  That’s OK.

Insurance Financials

There is plenty of government oversight for accounting that dovetails with plenty of regulation, we can’t touch on all the respective countries’ agencies and regulators but in essence they all serve the key roles of making uniform 1) how insurers account financially for their business, and 2) how insurers account for how solid they are in being able to serve their policyholders relative to the agreed scope and cost of risk.

It’s an alphabet soup of government orgs or standards: GAAP, FASB, SAP, IRDAI, NYDFS, SEC, IFRS, FCA, FSDC, SUSEP, NAICOM, ICLG, ASIC, APRA, etc. (almost) ad infinitum.

Fundamentally there are three accounting principles (of the many) with which insurers must comply, just in a slightly different manner from most business organizations :

  • Revenue Recognition Principle
  • Matching Principle
  • Historical Cost Principle

Without complicating things too much, insurance companies have financial stability burden to prove continuously- a carrier’s ability to fund the risk costs that it has agreed to.  All those policyholders have an expectation of indemnity or payment if a loss or occurrence to which their policy agrees to cover /pay comes to fruition.

The three principles noted above are part of the key differences between insurance companies and others, primarily because what insureds receive for premiums is a risk agreement that elapses over time.  Receive $1000 for an insurance contract today for twelve months’ cover.  Money in the bank for a promise over time.  So in respect to compliance with the Matching Principle, premiums are deemed  ‘written’ only until an increment of the policy’s time is expired, wherein the portion of the premium that matches the period is booked as ‘earned’.  One month’s policy duration allows 8 ½% of the written premium to become earned, six months’ earns 50%, and so on.

So you can see how a carrier with a ton of cash on hand might not be as liquid as one thinks if there are an according ton of policies on the books whose expiration extends over twelve months or more.  Written and earned- key concepts.

Here’s an example of a P&L statement showing the written and earned premiums, from German insurer, DFV_AG or Deutsche Familienversichurung:

DFV Inc

The sharp eye will note in addition to written and earned premiums there are lines showing the ‘Share of reinsurers’; that will be touched on in the Reinsurance portion of our discussion.

Traditionally the written and earned difference followed a solid calendar pattern due to typical annual expiration of polices.  But what of on demand or ‘gig’ policies?  The covered period may be a few hours or days, so there is little lag between written and earned status.  Knowing a carrier’s business model has become more important than ever since a heavily funded entrant’s cash may be more restricted if it’s a traditional style insurer in comparison with an on-demand player.

Carrying the discussion to the Matching Principle (matching costs to the period in which the costs were incurred) suggests a few important financial factors:

  • Costs of policy acquisition is matched to immediate written policy premiums, e.g., agency/brokerage commissions, marketing, admin office costs, digital format costs, etc., but
  • Costs of policy administration, e.g., adjusting expense, loss costs paid, etc., may be charged to earned premiums in a different incurred cost period.

As for the Historical Cost Principle, regulators want to know concretely what amount a carrier assigns to portfolio assets.  Insurers need to be liquid in their asset portfolio so assets can easily be converted to cash if loss payment volume so demands.  For example, bonds might fluctuate in value over time due to variances in interest rates, but carriers need to maintain a historic cost to keep regulators content for solvency calculations.

Quite a rabbit hole are financials, so the conversation will conclude with THE common comparative measures for P&C carriers-  loss ratio, expense ratio, and combined ratio.  These measures will give the reader a clear idea if earned premiums (revenue) exceed or are exceeded by expenses and loss cost.

So,

loss ratio = claim payments + adjustment expense/earned premiums, expressed as a %

expense ratio = expenses other than adjustment expenses/earned premium. Expressed as a %

combined ratio is a sum of the LR and CR.

Ideally CR is < 100%, meaning earned premiums exceed costs and underwriting activity is profitable.

What must be remembered as carriers are compared- the maturity of a carrier in terms of time in business, how aggressive is growth relative to existing book, the nature of the carrier’s business and how that affects reserves (immediate draw on profits.)  Entrants may have LR that are in the hundreds of %; consider trends or peer comparisons before your lose your mind.

Reinsurance

Reinsurance is insurance for insurance companies.  There, that was easy.

Rei was once an easier financial concept to grab- carriers would sign treaties with reinsurance companies to help protect the primary insurer from loss outcomes that exceeded typical loss expectations.  Primary carriers do not plan (or price) for an entire region to be affected at the same time, but sometimes things happen that require excess over planned loss payments, e.g., wind storms, wildfires, tornadoes, earthquakes, etc.  Primary carriers will purchase reinsurance that for a specific period, and in an amount that is triggered once a carrier’s loss payments for the treaty peril or perils is incurred.  Pretty direct and expected by regulators, and part of claim solvency calculations.

What has occurred over years is that reinsurers have evolved into other types of excess risk partners, covering more than just catastrophe losses, and becoming excess risk options.  If you again review DFV_AG’s income statement and consider the premium and loss cost portion of the carrier’s P&L shared with reinsurers, you’ll understand the firm has ceded premium and costs to backers to help smooth growth and provide backstop to the firm’s ability to pay claims and serve its customers.  This has become a common methodology for startups and existing carriers, allows more product variety for reinsurers and spread of risk.

Another evolution over the past years beyond reinsurance is the advent of Insurance Linked Securities (ILS), capital vehicles that are designed solely as alternative risk financing.  Insurance-linked securities (ILS) are derivative or securities instruments linked to insurance risks; ILS value is influenced by an insured loss event underlying the security.  What’s that?  ILS are capital vehicles that simply are designed to pay on an outcome of a risk, e.g., hurricane, earthquake, etc., sold to investors looking for diversified returns in the capital markets.  A hedge against a risk for insurers, an option for better than normal market returns for the holders.  Often referred to as Cat bonds, these bonds serve an important role in the risk markets, and are an opportunity for holders for income.  Often ILS are sliced and diced into tranches of varying risk bonds to smooth the outcome of a linked event.  Don’t be surprised if ILS become a more accepted means of financing more common, less severity risk within the industry, or in use in unique new risk applications, an example being pursued by Rahul Mathur and colleagues at Backstop Insurance.

Blockchain

So much promise, so much confusion, overreach and failure to launch.  Or maybe Blockchain’s connection with the perceived wild west of value transfer, crypto currency, has colored the insurance world’s relative arm’s length view of the concept.

A quick search of definitions produces many references to bitcoin and other crypto currency (I’ll leave those to my knowledgeable Daily Fintech colleagues), but we simply want a definition that maybe doesn’t sound simple (Wikipedia):

“By design, a blockchain is resistant to modification of the data. It is “an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way”. For use as a distributed ledger, a blockchain is typically managed by a peer-to-peer network collectively adhering to a protocol for inter-node communication and validating new blocks. Once recorded, the data in any given block cannot be altered retroactively without alteration of all subsequent blocks, which requires consensus of the network majority. Although blockchain records are not unalterable, blockchains may be considered secure by design and exemplify a distributed computing system with high Byzantine fault tolerance. “

Open. Distributed. Peer-to-peer. Decentralized. Immutable. Cool for generating crypto, but not so much for the wild data sharing needs of insurance.

So why is Blockchain not taking hold for insurance?  The use case is tough for carriers- unstructured data (of which carriers have a ton) do not play well in a Blockchain (Blkcn) environment, many changing players in an insurance claim, and so on.  Blkcn holds data securely, but doesn’t guarantee cyber security outside the ledger. Blkcn can be more cumbersome for data retrieval across consortia-based ledgers.  Multiple writers to the ledger, multiple efficiency issues to overcome.

But what of uses for reading data once placed in the ledger? Can be very cool. Anthem is a US health insurance provider serving millions of subscribers nationally, the company recently initiated a Blkcn pilot wherein the company is making ledger access an option for the test participants, with patient records stored in the ledger, and individual subscribers given the option to give providers access to health records via use of a QR code that has an expiration date.  Subscribers have the power over their records and access is given for read only permission.  There are many potential benefits to health insurance Blkcn but the options must dovetail with data security.

Another positive scenario for Blkcn application- crop insurance in previously under-served markets.  OKO Insurance provides micro crop insurance policies in Africa, backing by reinsurance but administered in part by distributed ledger, each farmer’s information residing in the ledger, and access provided to underwriting and reinsurance.  And- if payment is made a partnership with digital payment systems to facilitate settlement.  An active Blockchain as a service company, BanQu, is expert at facilitating these frameworks and has a portfolio of projects around the globe where ‘first mile’ and ‘last mile’ data are administered within a ledger for the respective customer and its affiliates/suppliers.  Permissioned but not written by multiple players, QR codes to allow involved sources access to a supply chain.  And the sponsor of the ledger has a clear data record of each step in a supply or value chain.  Speaking with the firm’s business development executive, Brady Bizal, we discussed how a Blkcn ledger such as BanQu provides could serve as an ecosystem initiative for regions, including the details of insurance for a farmer, payment records, link to in country digital payment systems, risk mitigation firms, and as warranted, the transaction/finance data can be accessed by permissioned bankers at the customer’s choice- the magic of QR codes.  It’s an entrée to a trust system that may otherwise not exist.  Opportunity.  Maybe not the original thinking for Blkcn and insurance, but sit for a few minutes and you will think of many similar possibilities for blockchain use in health insurance alone.

Sorry, there is so much that could be written about the three concepts and I’m hopeful the article answered some questions about finances, blockchain and reinsurance/ILS.  It’s certain readers and experts will advise me of missing sections, and that will be the foundation for a next article on the subjects.

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