November 30, 2016
Is It Time to End the Annual Policy?
The insurance industry's continued attachment to the annual policy feels increasingly like a relic from a bygone age of quill and parchment.
Is there anything more emblematic of the largely antediluvian state of the insurance market than the concept of the annual policy?
Admittedly, there is a certain convenience for the customer only having to worry about his or her insurance once a year and for the insurer only having to process the relevant paperwork every 12 months. And for years, of course, insurer returns were almost entirely built off the back of the profits to be gained from investing up-front premiums — as in, not on serving the customer.
But haven’t things moved on?
Certainly, today’s low interest-rate environment (nothing lasts forever, but it is hard to envision what might shift this dynamic in the short- to medium-term) means insurers have to focus far more on correctly pricing risk rather than on yield arbitrage. And our increasingly technically sophisticated and connected world surely raises questions regarding whether market practices essentially inherited from the 17th century are still appropriate.
See also: The Most Effective Insurance Policy
Consider the humble motor policy.
At the risk of gross over-simplification, the market is currently centered on selling an annual policy with pricing essentially dictated by a number of important risk factors (such as the value of the vehicle, driver age, anticipated annual mileage, where the car is kept at night, previous convictions, etc.) But the price you pay reflects little about the environmental factors that really drive risk when you are behind — or not behind — the wheel. While the industry is far more sophisticated than it was 20 years ago, pricing is typically set according to statistical averages for whatever broad risk grouping you happen to fall into — with all the imperfections this implies — to the inevitable detriment of lower-risk drivers within each of those categories.
Today’s technology — of which telematics is a pretty rudimentary example — enables a different approach.
Rather than an annual policy, why not specify a daily standing charge that reflects the true risk to the insurer of the car sitting in your garage, say, where the risk of accident or personal injury or theft is extremely low? Think of it as a standing charge.
However, as soon as you take your car out of the garage, an additional cost would apply — think of the Uber surcharge — but this additional cost would vary depending on the time of day or the driving conditions. Taking the car out in the rain or when it is icy would be more expensive than when the sun is shining. Driving in the middle of the night when there is less traffic is inherently less risky than battling your way through rush hour. Far fewer accidents occur on the motorway per mile driven than on crowded urban streets. And geo-location software could confirm whether you are, in fact, parking your car at home at night as you have claimed or whether you have left it for a few nights at the airport while you fly off to Rome or Miami for the weekend.
This approach starts to suggest some interesting outcomes. First, it allows insurance companies to price far more accurately for the actual risk they face, based not on relatively blunt risk category averages but for each individual driver down to each specific trip. Second, it ensures that drivers pay the true costs of the risk they represent rather than subsidizing their higher-risk fellow drivers. For most drivers, this is likely to result in a lower price because the average is hugely skewed by the tail risk.
Perhaps most interestingly, the approach also enables the driver to better understand the relationship between how and when she drives and the cost of insurance; thus, it potentially acts as a spur for drivers to moderate or modulate their behaviors accordingly, which is where you start to drive some real alignment of interests and benefits for both drivers and insurers.
The good news is that the necessary technology essentially exists today in the mobile device you are probably reading this post on. The various data feeds — weather, time of day, geo-location, etc. — are already there. Even today, my iPhone varies the time at which I need to leave one meeting to make the next depending on traffic and weather.
Of course, as with any radical change to established operating models, there are some important practical issues to be overcome in terms of the customer interface, billing and mechanisms through which customers would physically agree to a surcharge before, during or after a journey, etc. Insurers would need to work through the change in their cash flow profile and may also feel that the complexity of some of the larger risk classes continues to favor an annual cycle. And the impenetrability of pricing in the mobile phone industry, which marches under the banner of increased customer transparency and choice, stands as a stark warning to how the best intentions can lead to utter confusion.
There are some broader potential social concerns, too, around third party tracking of your movements. There are also implications for higher-risk drivers who find themselves priced out of the market where, today, their costs are essentially subsidized by the rest (particularly in circumstances where the constraints of people’s day-to-day lives and jobs may not give them a huge amount of choice regarding the conditions under which they choose to drive), although that particular genie is probably halfway out of the bottle, anyway.
The question, as ever, is whether the inevitable change will come from the incumbents that are weighed down by their legacy positions or from some new entrant that has the freedom of movement but lacks the scale, brand and capital to compete in a meaningful way.
One thing is certain: In a world where one of the world’s largest hotel companies doesn’t own any rooms (Airbnb), one of the world’s largest car hire companies doesn’t own any cars (Uber) and one of the world’s largest retailers doesn’t own any merchandise (Ebay), the insurance industry’s continued attachment to the annual policy feels increasingly like a relic from a bygone age of quill and parchment.