Game Theory and Insurtech

Although insurtech will surely disrupt the industry, a key question is seldom asked: How can, and will, incumbents respond?

One of the hottest topics in insurance industry forums, the news and many prognosticators/speakers' commentary is that there could be a threat to the insurance industry because of insurtech — that the insurance industry will be revolutionized and that incumbents should be in defense mode to retain their business. That threat carries some credibility, but there is some issue with many of the forecasts out there. I think the thought process is somewhat flawed, for two reasons:
  1. Rarely is anyone putting a time-frame on their predictions. Anyone can predict something with no time-frame and, hence, have no accountability if they are wrong. This is like the fortune teller stating, “You will die in the future.” Although that fortune is accurate, you might feel ripped off if you paid for it.
  2. The predictions seem to be coming from a vacuum and don’t include thoughts on game theory. Some predictions rarely account for or think about incumbents; the incumbent insurer advantage and reaction; and how long the insurtech investor can realistically wait for outcomes/results.
Let’s focus on No. 2. Game Theory Game theory is the branch of mathematics concerned with the analysis of strategies for dealing with competitive situations where the outcome of a participant’s choice of action depends critically on the actions of other participants. Game theory has been applied to war, business and biology. But this art/science isn’t discussed when predictions about the industry are presented. A basic thought is, if insurtech is going to threaten incumbent insurers, how do we think the incumbents will react? Incumbent Insurer Options Incumbents have a few options regarding insurtech:
  • Imitate — recapture market position once insurtech has revealed that an approach works. Each company can develop new technologies to improve operating efficiencies, source risk quicker, understand exposures better, etc.
  • Wait Longer– for the success of an approach to be revealed. If customers don’t react to a new technology or the advantage is not apparent in results, no resources were wasted. If you’ve read Good to Great in insurance or “Good to Great,” the book, think about the flywheel or the Walgreens example. The ability to wait is greater for incumbents in insurances, as insurance markets are not a winner-takes-all.
See also: Complexity Theory Offers Insights (Part 1)   Incumbent Advantage Incumbents have a huge advantage; they have customers, capital, track record for sourcing risk, systems, platforms, regulatory framework aligned, etc. Newcomers have to take riskier strategies to move into the ranks of the incumbents. If incumbent insurers use simple game theory strategies, they have a lot of benefit. A defensive position by incumbent insurers can affect timing, forecasted results, market share, etc., ultimately delaying insurtech investors from seeing the gains or traction they were hoping for or predicted at the time of the investment. This delay could change exit strategies for investors. Venture Capitalist business model Many of the funds coming into the insurtech space are from venture capital firms. An investment from a venture capitalist typically is a form of equity financing — the VC investor supplies funding in exchange for taking an equity position in the company. According to Harvard Business Review, “Venture money is not long-term money. The idea is to invest in a company’s balance sheet and infrastructure until it reaches a sufficient size and credibility so that it can be sold to a corporation or so that the institutional public-equity markets can step in and provide liquidity. In essence, the venture capitalist buys a stake in an entrepreneur’s idea, nurtures it for a short period of time and then exits with the help of an investment banker.” The investors in VC funds expect a return of between 25% and 35% per year over the lifetime of the investment. This is because of the nature of the risk. For every deal that doesn’t go as planned, VC firms need those with great hockey-stick-returns to meet this expectation from investors. Insurtech investors/Market Cap Other questions would be around the market multiple given to an insurance company versus a technology company. Are those companies that are positioning themselves as the “future of insurance companies” taking a prudent approach in trying to unseat incumbents? Is it better to be a servicing company over a disruption startup? Given the timing and investor strategy, would insurtech companies be better off positioning themselves as technology services companies for the insurance industry versus insurance companies with great technology? At least it’s safer for the investor at the time of sale… If an investor is looking for an exit strategy, would it prefer a multiple of earnings similar to an insurance company or a publicly traded tech company? Capital Into Insurtech Despite the influx of capital into insurtech recently, funding to this sector may be flattening in 2017. (There are a few articles written about this at Insurance thought Leadership and others.) Based on funding patterns, it appears at least $2-3 billion a year is now going into “Series B” and “Series D” funding — meaning into existing companies that have been around for at least a couple of years. Margin Compression Who is better suited for margin compression to be removed from the system? If you look at Uber, transportation services companies were loaded with debt (NYC medallions cost around $1 million) and insulated by a regulatory framework that supported that debt. In addition, the downward pressure on the cost of a ride to the airport was immediate and seen in real time by both the consumer and the seller. So, transportation was ripe for disruption driven by consumer demand With insurance companies, the pressure will take time to shake out. Because the cost of goods sold (or losses) is unknown at the time of sale, the ability to decrease costs is somewhat limited to expense savings. Again, advantage incumbent — at least until you can prove that technology works and has passed savings to the customer through enhanced loss-cost prediction and risk selection. With incumbent insurers sitting on mountains of cash/bond portfolios as insulation to the margin compression, some companies can achieve low single digit ROEs just on their investment portfolio alone, even before underwriting results. So, who is better suited for the decrease in margin? Where should investors be putting their capital for the long term? See also: Einstein’s Theory on Work Comp Outcomes   Thoughts Incumbents are going to react and defend their positions and acquire teams or technology that have proven to help (lower expenses, acquire customers, etc.). VC investors are going to push for exit strategies or sales to incumbent insurers over the next five to six years and will look for new investment opportunities. This article isn't intended to make incumbents feel warm and cozy about the state of the market. There definitely will be some disruptions of certain sectors of the industry. However, if you're looking to compare the disruption of Uber to the insurance industry, I believe it will be an uphill battle to disrupt insurance in a similar fashion. (Thanks, McCann-Ferguson). But anything is possible. Don’t get complacent and disregard the consumer. The insurance industry is in need of a technology shakeup — and one would benefit the customer, the insurers, the insurance incumbent investors and many of the insurtech founders/VC firms.

Warren Franklin

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Warren Franklin

Warren Franklin is a co-founder and editor of InsuranceShark. He is a retired insurance industry veteran, who spent his career working at large publicly traded insurance and reinsurance companies.

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