Status Quo

The Financial Services sector is facing an unprecedented level of innovation. Business models are constantly challenged: from banking to payments, and capital markets to lending and saving, culminating in the term FinTech. Numerous challenger brands were established, which forced incumbents to rethink their offerings, to the benefit of consumers.

The insurance sector, however, has successfully avoided deep transformation and seems to be largely driven by corporate needs (capital requirements, pressure on investment yields, large loss events, etc.), rather than the desire to improve the customer proposition.

In the General Insurance space, customers are frustrated with high premiums and cumbersome processes, while insurers are suspicious of overstated or fraudulent claims. It is a vicious cycle.

Thinking about the mechanics behind an insurance contract, the conflict of interest is clear: one additional claim paid reduces the (underwriting) profit of the insurer. Equally, a delayed payment allows the insurer to generate another day, week, or month of investment income. Customers are rarely regarded as a key stakeholder on par with shareholders. Premiums charged during a period are the maximum revenue that an insurer can generate for providing cover for the risk of loss. It is therefore inevitable to manage the underlying parts closely.

To date, claims are still predicted on the basis of proprietary knowledge (though with ever-increasing accuracy) and margins are added on top: risk buffer, operating expenses, and profit. Profit margins are largely dictated by shareholders’ demands while costs continue to increase. Between 2005 and 2015, commissions and expenses grew annually by 1.5% and 0.8% for motor and property insurance, respectively.¹

Settling claims appears to be the only part of the equation that is not fixed. The fewer claims that are settled, the higher the profits for the insurer. The willingness of an insurer to settle claims has become an increasingly heated discussion. The mantra of an insurer being bound to act within the agreed terms and conditions, and as such a legally binding contract, is a poor one from a customer’s perspective.

It is a business model designed to cause friction and results in conflict of interest. It will require a tremendous effort to move back to a time where protection for an uncertain outcome was regarded as a service to society.

Signs of Change

Today, the product offering in the life insurance sector is already shifting, moving away from underwriting to fee-based income. This shift is being driven by external factors such as increasing asset management activities. A company formerly known as The Standard Life Assurance Company claims to be “building a world-class investment company” – and with around 92% of their total income being fee-based in 2015, they may rightfully claim so.²

However, one might argue that the shift from traditional guarantee-based to unit-linked products, where the customer bears the investment risk, predominately helps the insurer, not the customer.

Turning to the dynamics in the General Insurance space, significant change to the centuries-old operating model has yet to come. The focus tends to be on improving operational efficiency with general insurers increasingly looking for collaboration with InsurTech startups to enhance their traditional service.

If a business model has not changed materially over the course of several centuries, it either means that the best model was chosen outright or that the sector in question has so far successfully avoided transformation. If the latter is the prevailing situation, one should expect to see alternative models emerge that might better cater for customers’ specific needs – it’s just a matter of time.

To date, we have seen attempts to enhance the traditional model through solutions commonly referred to as peer-to-peer insurance. Most of these firms recognize the inherent conflict of interest between customer and insurer, and have developed their own solutions to this problem, such as returning excess premiums to customers or donating them to charity.

One might argue, however, that the answer to the industry’s problems cannot be derived from a deviation of the existing actuarial model. At the end of the day, if premiums are paid back in part at the end of the year, it simply means that too much was taken from the customer in the first place.

A New Credit-based Approach

Regulators recognize the need for new approaches and have set up innovation hubs and sandbox initiatives in cities such as Abu Dhabi, London, and Singapore. A changing regulatory landscape acts as the catalyst for change and enables firms to deviate from known paths and allows them to challenge every single component in the value chain.

What is more, one can let go of an operating model that is based on the actuarially predicted level of losses, with the main risk being the underwriting risk. This paves the way for a new avenue: a credit risk-based offering. A credit risk-based model means customers will pay at the end of a period, with the benefit of knowing the exact value of claims settled. Customers can join a group of peers who are like-minded risk takers and are looking to protect similar items. At the end of a period, the group will share the cost of all claims settled equally.

Linking revenues to the actual value of claims handled and paid, by adding a fixed fee per claim, aligns with the interest customers. The firm generates revenue when acting in the best interest of customers: settling their claims. The monthly payments that customers make in this new model will vary, as they are directly correlated to the number of claims. However, customers will be protected from an extreme circumstance through an aggregate Excess of Loss agreement provided by re/insurance partners.

From a customer perspective, they receive two benefits during the onboarding process: the maximum price they will ever have to pay in the period, and the much lower average price they can expect to pay.

Requesting payment at the end of the month based on the true cost of claims will result in a direct correlation between a group of customers and their payments. This fixes a common issue in today’s insurance landscape: accountability. The fewer claims that occur in a month, the less the affinity group will have to pay. A group’s behaviour directly correlates to their payments. It is therefore essential to group customers into similar risk pools. Risk education and prevention will play a crucial role in this proposition to help reduce negative experiences before they even occur.

True, a cost-plus model introduces credit risk where there is little at the moment. The real question is which can be managed better, underwriting or credit risk. With the deep expertise from credit card and lending space, managing the latter should be feasible.

Credit-based models are the new reality and will come to market soon. One example of a company using this type of model is my venture, UK-based company LAKA³ – our goal is to support the development of a new world.