Well, that was fast. Remember all those massive, megabillion-dollar data lakes we all kept hearing about over the past few years? With the exception of the U.S. government, we’ll probably never see their likes again. Many of the large organizations that were pursuing those data lakes (not to mention countless smaller ones) have largely changed course. Why? The answer is actually not so surprising, even if this particular outcome is. Many of the CIOs I talk to these days are no longer thinking of their insight systems (analytics tools, data lakes, etc.) as separate from the rest of the business, or the enterprise systems that support them. They’re managing these insights systems more as a portfolio of analytics systems -- a true play for return on investment (ROI). As a result, large investments are broken into smaller, more agile investments. The technology organization may be shepherding 500 analytics projects rather than just five high-profile initiatives -- enabling and supporting 10,000 people, for example, rather than just 100. In that environment, a massive data lake starts to make less sense, even if all those 500 projects tap into it. A data lake is just too resource-intensive. See also: Why Exactly Does Big Data Matter?   Meanwhile, the need to tap into a large volume of data isn’t going away. In lieu of a huge, proprietary data lake, what options are there? This is where CIOs are getting creative, creating a network of smaller, more manageable data lakes, for example, supplementing their data with that provided by other organizations.

Blockchain is a revolutionary technology that could fundamentally change the way business is conducted and result in the restructuring of major industries. At least, that is the view of some prognosticators. Others believe that there are important implications for the technology, but that it will not be truly disruptive. What about insurance? Will blockchain be a major force in the industry, and, if so, when?

New research by SMA sheds some light on these questions. The short answer is that blockchain is likely to play a major role in the reshaping of insurance – but the big implications are two to three years out.

Blockchain has burst onto the scene. Many in insurance are still just becoming aware of its importance and are in learning mode. At this stage, slightly more than half of property/casualty insurers are aware of blockchain and are beginning to understand its implications, while only about 20% of life/annuity insurers surveyed know about the technology. What makes blockchain so powerful is the wide range of potential use cases. As a foundational technology, it becomes an enabler for peer-to-peer insurance, micro-insurance, digital currencies/payments, smart contracts and the exchange of all manner of sensitive documents. None of these require blockchain, but, in every case, blockchain makes the transactions more secure, improves efficiencies and makes new business models more feasible. L&A insurers see the exchange of sensitive documents with prospects and customers as the top potential use case for blockchain in the next few years. P&C insurers are looking to a wider range of use cases with high potential, such as micro-insurance, peer-to-peer insurance and digital payments.

See also: How Will Blockchain Affect Insurance?  

All sectors of the insurance industry increasingly see blockchain as important and potentially transformative. However, the level of investment and projects are still relatively low. About one in eight P&C insurers are developing strategies with blockchain in mind and moving to pilot projects. Only 3% of L&A insurers claim to have any activity regarding blockchain. Several of the global insurance players are participating in blockchain consortiums, investing in startups or implementing live projects with blockchain. Another important consideration is the emergence of more than 20 insurtech firms anchored by blockchain.

Blockchain does show great promise for the insurance industry. There are likely to be more projects, investments, consortiums and production implementations based on blockchain over the next two to three years as the industry gains experience with the new technology. Then it will not be surprising to see a wave of many blockchain-based initiatives ripple across the industry and become a contributing force to industry transformation.

For more information on the insurtech startups, business use cases and insurer blockchain projects, see the new research report Blockchain in Insurance: Insurer Progress and Plans, which is available at this link.

The insurance industry is a $4.6 trillion market worldwide, but it lags when it comes to digitization and providing consumers with great experience and service. We are looking in some depth at the five main challenges that startups are facing. Today, we look at Challenge No. 2. Find Challenge No. 1 here. Challenge No. 2: Providing real innovation that gives a competitive advantage and that provides real value in the long term will be the only way to prosper. Innovation can come by improving the consumer experience in buying and using insurance or offering more relevant insurance at affordable and lower prices. In insurance jargon, this involves optimizing risk protection. Startups can and are focusing mostly on digitizing distribution, especially through a mobile consumer approach. This improves consumer engagement and may quickly generate interest and traffic but ultimately needs to be converted into sales and new customers. See also: Where Will Real Innovation Start? Product innovation involves better and personalized dynamic pricing, which means savings for the consumers and providing targeted and relevant risk protection (coverages). Getting new product into the market with limited data and pricing experience will bring risks. This will, of course, be initially mitigated by low volumes. There is also greater scope for risk prevention. Technology can support consumers by automated monitoring and response, as well as giving real time feedback. In addition, technology provides the opportunity to reduce the claims costs (frequency) impact. Insurance, at the end of the day, is about service - a payment today for a future promise. Having access to the relevant services during an accident or adverse event is crucial for insured consumers. This includes making it easy to report and pay a claim. Having a seamless service will be important for the startups' reputation and operational and innovation capabilities. Startups will need to collaborate and have outsourced arrangements with a range of partners with different mindsets and systems. Takeout Building a robust, full-stack technology platform and end-to-end processes will be critical. Many startups have started, understandably, with the distribution, and few appear to have fully operating platforms that stretch back into the full value chain of insurance operations from selling, distribution, product manufacturing, policy management toward customer servicing and claims management. A full-stack technology platform supports a seamless process for the insured consumers, not only in the buying process but also for policy changes and claims handling. A full-stack technology platform with enhanced data management and analytics at its core will be required in the case of making differentiating, relevant and attractive insurance products and services. The explosion of data must be translated into improving insurance. Data needs to be converted into insurance pricing, more accurate prediction of future claims risk and enhanced and innovative risk prevention services. See also: Innovation — or Just Innovative Thinking?   Excellent service and product differentiation requires full control. Startups will need to be in control of not only marketing, distribution and customer experience but also dynamic data analytics, pricing, product development, policy administration and claims servicing. Even if startups do not provide these activities directly and hand them over to outsourced service providers including traditional insurers, they will need interfaces into other systems that may not be as robust as a new platform. In addition, they will need in-house staff to manage these processes. This will take expertise and time to build out. We are curious about your perspective.

Performing a directors and officers (D&O) insurance audit is a complex exercise that is made more difficult by constantly shifting language, new rulings and claim trends. While much of the policies’ language and terms have remained fairly constant over the years, here are six areas of new or renewed interest that buyers and their brokers will want to pay attention to. See also: The Need to Educate on General Liability   Cyber Exclusions: Because cyber-related litigation has been quiet, there is little case law at the moment testing courts’ interpretations of D&O policies, so it is difficult to determine the adequacy of coverage provided by existing policy language. Generally speaking, D&O policies are not crafted with cyber risks in mind, so many policies may contain problematic language, such as the definition of “wrongful acts.” However, some carriers are going in the opposite direction and are purposefully applying specific cyber-related exclusions to their policies with the intent of pushing the exposures to more appropriate cyber policies. Cyber policies have still not quite adjusted entirely to modern cyber risk, and these exclusions are not yet industry standards, so buyers should — when able — avoid D&O policies that contain cyber exclusions. While most policies are absent of such language, many carriers have included somewhat watered down wording by adding “privacy events and/or invasion of privacy” within the broad bodily injury exclusions. While this language is not as crippling as an explicit cyber exclusion, buyers should still attempt to negotiate its removal. Many professional liability experts also believe broadly worded terrorism exclusions may have the ability to negate coverage for cyber events with the belief that they will be classified as cyber-terrorism. To address the terrorism exclusion, buyers should ask the carriers to “except” (thus, carving back) cyber-related claims. Lastly, while it may be obvious, brokers should advise buyers on the importance of placing separate cyber insurance while also highlighting the intricate coverage differences among them. The same level of attention that is given to grooming D&O coverage should be given to grooming cyber proposals/policies. This includes careful review of policy definitions, terms, conditions, exclusions, etc. Professional Services Exclusion: Along with the contractual exclusion, the professional services exclusion is consistently cited as one of the most sweeping and problematic exclusions for insureds. Broad professional service exclusions typically preclude coverage for claims “for, based upon, arising from or related to” errors, acts and omissions while providing professional services. This exclusion is particularly problematic for service firms because almost any claim can be “related to” their providing of professional services. However, this exclusion is also becoming increasingly problematic for many businesses because so many businesses today provide some level of services (from consulting to technology services). For tech companies, in particular, this exclusion has the potential to preclude coverage for cyber-related claims, as many of the tech services provided may be considered “professional services” by the carrier. When negotiating this exclusion, buyers should ask the carriers to replace the term “for, based upon, arising from or related to,” with, simply, “for.” Such an amendment effectively carves out the errors and omissions exposure the carrier intends to exclude while still preserving coverage for “true” D&O claims. Conduct Exclusion: The conduct exclusions are one of the (if not the) most visited exclusions within D&O policies. While not much has changed in terms of recommendations to D&O buyers, we have noticed a number of carriers that still contain less-than-preferred language. To avoid coverage being denied for unintentional wrongdoing, the conduct should be specifically stated as “deliberate, willful and intentional.” Sufficient severability language should also be included to protect innocent directors. The area where we still see many carriers lacking is in the “ruling language.” For purposes of providing coverage for innocent actors and claims without merit, the carrier should agree to provide defense costs until a final determination is made. More specifically, though, that final “determination” should be in the form of a “final adjudication in the underlying action.” While much of it may seem like a matter of semantics, final rulings/judgments are NOT the same as “final adjudication,” which is required by the courts. In addition, the language should specifically state that that determination be made in the underlying action to prevent the carrier from arguing that wrongdoing found by those outside the courts (such as regulators) nullifies coverage. JOBS Act/Securities Exclusion: Startups and companies looking to raise equity have a new reason to be excited. The JOBS Act provides an avenue for significant growth without all of the time and compliance costs imposed by the strict reporting and disclosure obligations that come with an IPO. And with the new regulation A+, the ceiling has been lifted, allowing a significant capital raise while still remaining private. Those same attractive features, however, also carry some increased risk. The potential for fraud (and accusations of fraud) is considerably higher because of the lack of transparency. Additionally, private companies purchasing D&O may find a somewhat hidden surprise in the broad securities exclusions that almost entirely eliminate coverage for crowdfunding-related claims. While many insurers have been somewhat slow to react, many others responded expeditiously by either adding a separate endorsement or revising their exclusion to carve back coverage for claims that are related to securities and qualify under the JOBS Act. Any companies considering a crowdfunding campaign or raising any equity under crowdfunding regulations should exercise extra diligence when reviewing their D&O insurance to ensure the carrier has appropriately provided coverage for such claims. Without question, this includes smaller companies that may believe they are less prone to crowdfunding claims, which is false. The case against Quest from 2011 demonstrates that these claims can arise over seemingly simple fee disputes. Lastly, organizations should also avoid any carrier-imposed sub-limits for crowdfunding-related claims, paying close attention to the adequacy of such limits when they are unavoidable. Entity vs. Insured Exclusion: The insured vs. insured exclusion is almost as old as D&O itself. To alleviate some of the concerns related to the “I vs I” exclusion, many carriers today have adopted a more modern alternative replacing it with an “entity vs. insured” exclusion. While this substitution is preferred and does seem to solve many of the unintended consequences, it still deserves careful review. The most obvious carve-back that buyers and their brokers should seek is coverage for derivative claims brought on behalf of the organization. Because of their derivative nature, insureds should also negotiate a carve-back for bankruptcy claims brought by trustees and debtors in possession. Additionally, buyers should review the definitions of insured and organization/entity to ensure bankruptcy trustees and debtor-in-possession are also included as insureds. Regulatory Proceedings and Investigations: Coverage for regulatory/administrative proceedings and investigations has always been of interest for buyers but remains difficult to obtain. Informal regulatory proceedings and investigations against the entity itself are the most difficult to insure against. With cyber whistleblower claims beginning, regulators are capitalizing on their success with more “traditional” whistleblower claims, and coverage for government investigations is quickly becoming a topic of renewed interest. Over the past few years, many carriers have begun to provide coverage for informal investigations and regulatory/administrative proceedings against individual directors and officers. Additionally, private companies may be able to obtain coverage for formal investigations and proceedings against the entity itself. It should be noted that, for purposes of reviewing and grooming coverage, administrative/regulatory proceedings and investigations are not synonymous. Some carriers have also been implementing standard coverage for FCPA fines/penalties against individuals. The ability to obtain a policy with such language does not necessarily mean the policy will respond, though. There are a number of additional items that require review, such as claim definitions that require “wrongful act” accusations to trigger the regulatory coverage (which should be avoided). See also: What to Expect on Management Liability  

The origins of life insurance show up at least as long ago as the Middle Ages, when the notion of providing mutual aid emerged in organized structures. People came together via benefit societies for those in need and for the good of all. Similarly, modern-day carriers originated with mutual ownership – a construct that prioritized maintaining an asset pool to cover claims at any time, including ones that might occur decades in the future. A lot has changed. The top 25 life insurance carriers, which control 72% of the market, are largely public companies, so they must serve the demands of shareholders, not just policyholders. State, federal and global regulatory authorities watch over insurers’ moves with many goals – a big one being financial stability of carriers. But these efforts do not solve a problem highlighted in this year’s Insurance Barometer Study: One-third of American households would have an immediate problem paying basic living expenses if the primary breadwinner died. And an additional one-third has no idea what they would do should they find themselves in this situation. See also: What’s Next for Life Insurance Industry?   Ask people inside the sector the question, “Why doesn’t everyone buy the coverage they need, and may even know they need?” Responses are variations on three themes: (1) potential buyers perceive the products as too expensive; (2) they don’t understand how insurance works and what its value is; and (3) they put it low on the priority list relative to other financial commitments. None of these explanations is flat out wrong. But settling for them risks derailing innovators from solving a problem that will continue to affect people in need and the rest of us, too. It is a problem worth solving. Insurtech has become a hot sector, but life insurance gets relatively limited focus from either startups or investors. Why? Experts offer a few theories: It is complex -- loss curves run for decades. Unlike auto and home insurance, there’s no requirement to own life insurance -- so there is no definite group of buyers. Asset growth in this economic and regulatory environment has become trickier. Capital requirements are tougher. And maybe founders and funders themselves don’t want to look death or the greatest personal catastrophe in the eye. While these reasons sound plausible, there is a way to think about how to uncover sources of value and solve a marketplace and social problem hiding in plain site. Here is a proposed three-part plan: 1. Reframe the problem. Life insurance has historically addressed the problem, “What if I die too soon?” The questions asked now about financial health sound more like, “How can I be sure I’ll cover my monthly expenses given my earnings?” “How will I ever retire?” And, “What if I live too long?” Fears about dying too soon have been pushed down the priority list. In an era of longer life expectancy and lower inflation-adjusted income for many Americans, the new priorities are smart. Consider, therefore, how to solve these problems. Listen to people’s desire for products that pay the living, provide coverage for long-term care and medical expenses and are designed with far greater transparency than today’s living benefit products. (Try to read an annuity contract, and you will get the point.) 2. Understand what motivates people. Loss aversion theory, first proven by Nobel Laureate Daniel Kahneman and colleague Amos Tversky, demonstrates that people prefer to avoid loss rather than pursue the opportunity to realize an equivalent gain. No surprise, then, that confronting one’s mortality is a topic to be avoided -- it is the ultimate loss. This is especially the case given that many see no upside to buying a life policy: “When I win, I lose.” There will be traction for those innovators who can get to a nuanced definition of “trigger events,” beyond the tired and obvious ones. Trigger moments are when people will be more likely to evaluate the loss/gain relationship in a new light. See also: 8 Start-ups Aiming to Revive Life Insurance   3. Don't just play around the margins of what already exists. Be open to the possibilities that: (1) Potential buyers who say your product is too expensive are trying to tell you that the price/value relationship is weak. (2) People don’t understand the value of many life insurance products because these products are too complex. (3) In a world, where people fear the consequences of living too long, a product that focuses on one’s death seems out of step. Test the receptivity for product concepts that include living benefits and allow people to make tradeoffs among features. On the critical path: (1) cracking the code to combine delivering value to the buyer and financial feasibility all the way through claims payment, (2) executing with minimal fine print and (3) creating products that can be distributed through a cost-effective, multi-channel platform that leans digital/call center, innovates on commission structures and defines a new agent archetype.

There’s politics, then there’s governing. As former New York Gov. Mario Cuomo put it, “You campaign in poetry. You govern in prose.” Republicans have been campaigning against the Affordable Care Act since its enactment with rhetorical flourishes along the lines of “repeal and replace” and “end Obamacare on Day One.” That is poetry (or at least what passes for poetry in politics). Come January, Republicans will need to prove they can handle the prose part. As discussed in my previous post, that won’t be easy. Repealing the law outright would cause chaos in the health insurance marketplace and take medical coverage away from millions of consumers. However, doing nothing would break a promise central to the GOP’s electoral successes in the past four congressional elections, not to mention the most recent presidential campaign. Either path could lead to voter retribution that would be devastating to the short- and long-term interests of the Republican party. See also: What Caused the ACA Rate Surge?   A GOP strategy may be emerging that aims to avoid this rock and that hard place. The idea involves passing repeal legislation as close to President Trump’s first day in office as is legislatively possible, but delaying the effective date of that legislation by a year or two. This enables Republicans to keep their promise to repeal Obamacare “on day one,” yet gives them time for the more difficult task of working out a replacement to the ACA. It’s a political two-step that Joanne Kenen has dubbed “TBDCare.” Yes, this would cast a dark cloud over the health insurance market for some considerable time and raises a host of questions: Is Congress capable of passing workable and meaningful healthcare reform? What happens if it doesn't? What would those reforms look like? Who would the winners and losers be under Republican-style reform?  Not knowing the answers to these questions is terrifying. For GOP leaders trying to avoid the wrath of voters, however, living under a frightening dark cloud for a couple of years might look better than ushering in the healthcare reform apocalypse. The repeal part of this two-step strategy is simple: Republicans in Congress eviscerate the financial mechanisms critical to the ACA through the budget reconciliation process. This type of bill requires only 51 votes in the Senate, which means no Democratic support is needed. Meanwhile, President Trump dismantles other elements of the law by either revoking President Barack Obama’s executive orders or issuing new ones. Both the legislation and executive orders become effective at the end of either 2017 or 2018 to allow for a “smooth transition.” Then the replace portion of the program would begin. Much of any new healthcare reform legislation would need to go through the normal legislative process and be completed before the effective date of the repeal. Given the Senate’s filibuster rules, this means securing at least eight Democratic votes in the upper chamber. (Here’s a list of the Democratic senators most likely to be recruited by Republicans). Both Jennifer Haberkorn on Politico.com and Albert Hunt on Bloomberg.com do a great job in reporting on this evolving strategy.  Meanwhile, opposition to TBDCare is already building, as evidenced by this editorial in the Denver Post. What should not be overlooked in all this pain aversion is that the Affordable Care Act was neither the cause nor the solution to America’s deep-seated healthcare problems. Long before Sen. Obama became President Obama, everyone knew that the key to successful healthcare reform was reducing medical costs. A few provisions in the Affordable Care Act address costs, but the legislation focused primarily on health insurance reforms because, well, reforming the health insurance market is a lot easier than reducing healthcare costs. If you were a politician, who would you rather take on, insurance companies or doctors, hospitals and pharmacy companies? See also: Obamacare: Where Do We Stand Today? Whether using poetry or prose, then, it would be nice if, once they get past the politics of health care reform, Congress and the new administration addressed the substance of healthcare reform. Let’s hope that’s not asking too much.

Technology is something of a double-edged sword for insurance brokers. It provides us with the perfect tools to offer accurate field underwriting, efficient claims and policy processing, thorough record-keeping and faster issuing of policies. But that’s just one side of the story. On the other side—the darker, far uglier underside—technology has opened us up to liabilities and compliance nightmares through data breaches, hackers and other cybersecurity risks. See also: How Safe Is Your Data?   While these cybersecurity threats should keep brokers on their toes, they don’t have to transform you into a tech-fearing Luddite. Here are six tips to help you avoid cybersecurity threats while still embracing technology: 1. Stay aware of the threats. From Trojans to worms, viruses to hackers, disgruntled employees to simple mistakes, potential data breaches lurk around every corner. You can stay aware of the changing threat environment and protect yourself with a system such as McAfee or AVG, but you also need to occasionally read tech blogs to understand what new threats are emerging. 2. Control your user permissions. With employees coming and going, people working remotely and more smartphones accessing company networks, it’s more important than ever to tightly control user permissions within your brokerage. Limit the access that offsite employees have and make sure to revoke unnecessary permissions when employees leave or change positions. Software such as Varonis can assist you. 3. Update passwords regularly and frequently. One of the easiest ways for a hacker to breach your system is by cracking your password—which is increasingly easy to do when the most popular passwords include “password” and “123456.” Make sure you and each of your employees changes passwords several times a year. You can use programs such as Dashlane Business to manage passwords, generate unique passwords and create two-factor sign-in authentication for device access. 4. Stay safe in the cloud. Brokers are increasingly relying on cloud-based data storage solutions, but not every cloud is created equal. Make sure the clouds you use have features such as encryption when files are being transferred as well as when they’re not. Secure clouds use data file “sharding”—a process in which data is broken up into several different portions, each of which is encrypted separately. See also: New Channels, New Data for Innovation   5. Create a post-breach action plan. None of us ever intends to be breached, but even if we do all we can to avoid it we could still become victims. If we do, we need to act quickly. That’s why it’s good to have a post-breach action plan as part of your general disaster planning. 6. Choose the right collaborative software. Whether you have employees working remotely or you have online meetings and webinars, you need to choose collaborative software that minimizes your risk of data breach. Choose tools that encrypt messages and have two-factor authentication at sign-in. There are many options, including HighQ and Syncplicity.

The Herald Tribune in Sarasota, FL, Nov, 14, 2016 stated a number of actions that employers need to take in the light of new workers' compensation regulations in Florida: “Effective claims advocacy, management and communication, along with robust risk management and work safety programs,” are required to follow regulations and run profitable businesses. Regardless of jurisdiction, implementing regulations is never as simple as it sounds, and they create challenges for both employers and insurers. The primary challenges are typically cost and resources. For Business: Workers' compensation is viewed as a regulatory and financial burden, with claims management being the major focus. Actively managing workers' compensation and the associated risk is good business practice, yet the majority of businesses (particularly small businesses) just can’t afford current risk management tools and methodologies. Internal resources are stretched, and, despite best intentions, it can be a difficult task to wade through a plethora of information to translate, implement and monitor regulatory compliance and risk management. As a result, there is often a reliance on consultants, at significant cost to businesses. See also: Does a Safe Workplace Create Large Profits?   For Insurers: It is not physically possible or economically feasible to conduct risk surveys, analysis and assessments on all of the employers in your portfolio, particularly in the small- and medium-sized sector. It is also not financially feasible to offer consulting services to assist in the risk management process. So what are your differentiators? How can you add value, ensure quality of service and further engage your clients without massive additional investment? If a simple risk profiling tool was offered by insurers, it would significantly boost their ability to assist employers in better managing their workers' compensation costs and impacts. RiskAdvisor has developed such a tool, which allows a business to:

• Assess the current status of health and safety risk;
• Benchmark performance within its industry using global A.M. Best data;
• Identify gaps in health and safety business processes;
• Prioritize resources;
• Offer specific solutions to better manage health and safety risk; and
• Facilitate continuous improvement.

The simple-to-use system highlights known industry hazards, good work/health/safety/injury management practice and what risk management controls are (or could be) in place. It delivers performance benchmarks and the ability for employers to provide their own risk ratings. Employers seeking to understand their broader risks can even use the RiskAdvisor system to profile industry-specific insurable and business risks. See also: Avoiding Workplace Disaster And Workers' Compensation Costs   This type of tool will help an employer prioritize its activities and means insurers can drive increased client engagement and deploy support more cost-effectively. Even more importantly, the tool shifts the focus away from purely reducing claims costs to actively minimizing injuries — a win/win for insurers, employers and employees. Here's a sample of a checklist from the RiskAdvisor system:

If you own or rent property; drive a car; or have cherished valuables, you are no doubt familiar with the intricacies — and, often, maddening complexities — of property and casualty (P&C) insurance. Nevertheless, most policyholders regard the purchase of insurance to be a necessary and prudent expense; however, many buyers do not appreciate how the structure of an insurer can be an important consideration in the buyers' purchasing decision and, ultimately, financial well-being.

Conventional insurance companies are typically organized around two common business structures: stock companies, which are owned by shareholders, and mutual companies, which are owned by policyholders. A third variant, the so-called reciprocal inter-insurance exchanges, or "reciprocals" for short, retain attributes of both.

A reciprocal is an unincorporated risk-pooling alternative to stock or mutual insurance companies where the members, known as "subscribers," agree to an exchange of contracts of insurance among themselves — thereby attaining a preferred level of risk pooling and diversification to indemnify the other members. The subscribers are part of an association in which the amalgamated risks are exchanged to cross-insure each other. A reciprocal is often likened to a partnership where each member is individually and severally liable, but, as is the case in — for example — a law firm, not jointly liable.

Organizational Structure of Reciprocals

A reciprocal, like a mutual insurer, is policyholder-owned but is typically administered by an independently owned managing agent called an "attorney-in-fact" (AIF). The AIF is a necessary aide-de-camp to a reciprocal and administers — in return for fees and commissions — its day-to-day operations, which include the signing of individual contracts, settling claims, establishing deposits and investing funds. The subscribers, through power of attorney or subscribers’ agreement (commonly contained in the same document) confer the authority, responsibilities and prerogatives to act on behalf of the subscribers. The AIF, while expected to maintain all and any underwriting standards, performs the role of an unbiased mediator to simplify and expedite transactions and may be an individual, partnership or corporation.

The organizational structure also includes a committee, known as a "subscribers advisory committee," (SAC) which represents all subscribers; supervises the AIF and the reciprocal's finances and operations; and acts in the subscribers' stead — except as limited by the power of attorney.

Many reciprocals are organized without any organic act other than power of attorney, which is used to set forth rights and obligations of the members, as well as the duties and powers of attorney.

Origin, Objectives and Definition of Reciprocals

The reciprocal insurance exchange can track its genesis to 1881, when six dry-good merchants in New York agreed to indemnify each other because of discontent with insurance companies. These merchants had buildings of superior construction and maintained them in good repair, but were charged premiums that did not mirror the potential losses for similar commercial buildings. Insurance companies of the time applied a broad brush in their classification of risk because sophisticated rate-setting techniques were only in their infancy. Being moreover well-capitalized to absorb certain losses, the merchants had the incentive -- and ability -- to "self-insure" to lower costs.

Reciprocals thus operate on the supposition that similarities and qualities within a specific grouping class establish a framework to achieve cost-saving for insuring specific risks that might otherwise not be properly rated by, for example, mutual insurance companies. The inherent homogeneity of reciprocals allows for an avoidance of being plodded together with a general underwritten community with uneven requirements and risk profiles, increasing the overall risk profile, premiums and profitability of traditional underwriters. Distinct groups of individuals or businesses generally have associated incentives to lower their exposure and increase their safety, thus producing a superior loss ratio. Although a reciprocal can lower the total cost of insurance over time, the structure can also create unique conflicts of interest between policyholders and the AIF.

Fundamentally, like any successful insurance company, premiums charged must cover all claims and expenses. A reciprocal is, therefore, a homogeneous association of individuals, partnerships or corporations with well-aligned interested and insurance requirements, vested under the terms of a common written agreement that is signed by each of the subscribers. The agreement provides that each subscriber, being a co-insured member, is protected by the other members; the purpose is to make each member whole at a cost, wherein no additional modifications within the association can reduce the total cost to the individual members over the period of their membership.

What you need to know

Like stock and mutual insurance companies, successful reciprocals pledge to be around for the long run, to process and pay claims and to provide affordable and consistent insurance coverage to their affinity groups. However, not all reciprocal insurers can keep their promises. When looking to sign up for a policy with a reciprocal insurer, you might want to ensure it meets some basic criteria:

1. Who owns the AIF, and are risk and reward aligned appropriately with members?

Reciprocals are often marketed as "policyholder owned," but their commercial mindset and culture will most likely reflect the owners of the AIF. For instance, if the AIF is owned by a stock insurance company, it will most likely have underwriting capabilities and return hurdles in line with the insurance industry. AIFs backed by private equity are likely to have the most aggressive return expectations for their investors with the shortest investment horizons, creating uncertainty related to possible material changes in control when a PE firm eventually unwinds its investment. Publicly traded AIFs are typically obliged to provide transparent disclosures and have return expectations commensurate with investors of insurance brokers and service companies.

A separately owned management company creates a conflict of interest as profitable fees are generated at the expense of exchange members. A study by Emilio Venezian of Rutgers University, which examined the arrangement and practical implications of AIF management firms, confirmed this. Venezian concluded that serious problems might arise in the management of reciprocals if the AIF holds direct sway over the managers' own remuneration rates, because the incentive to increase their own private welfare may become a priority above —and at the expense of — the subscribers'.

This potential conflict has resulted in several lawsuits brought by reciprocal members against AIFs, claiming a lapse of their fiduciary duties by mismanagement or excessive fees being paid to the AIF. This conflict is even more apparent when the AIF or its shareholders generate interest income through debt provided to the reciprocal or when reciprocal assets are used to invest in affiliates of the AIF or its shareholders. Prospective subscribers are to ensure the AIF has clearly disclosed and quantified all related party transactions when considering the credibility of an AIF.

2. Does the reciprocal make a profit?

The most important requirement for any insurance entity is that the premiums charged are adequate to cover claims and expenses. For reciprocals, this includes AIF fees, reinsurance and interest. A prudently managed reciprocal will generate a profit that can either be retained or returned to policyholders depending on capital needs.

Net income and return on members' capital is the ultimate indication of how efficiently members' capital is managed by the AIF, because poor underwriting or investment performance will erode member capital over time. A high expense ratio may indicate the charging of excessive fees by the AIF or a failure in operating the exchange efficiently. Premium growth should never be at the expense of sensible underwriting because high growth combined with poor underwriting is unsustainable. If investment yield is low or negative, the AIF is likely taking excessive investment risk, or interest payments are placing a burden on investment returns.

3. How well is the reciprocal exchange capitalized?

As owners of the reciprocal exchange, members should always consider its standalone financial strength. Subscribers should be aware of financials that consolidate non-member-owned entities and reports to members that are marketing-focused, and they should omit key financial information such as the reciprocal's net income. Low levels of capital leave policyholders exposed to claims not being paid, and a high percentage of debt signals additional financial risks. Reinsurance is typically required to protect a portfolio of insurance risks but an over-reliance on reinsurance is expensive for members and may indicate an AIF that is overstretched.  

Summary

A cursory look at the main players in the reciprocal market illustrates a disconnect between legacy brands such as ERIE (NASDAQ:ERIE), Farmers or USAA and new players such as PURE. While the first group boasts a solid customer base and a sturdy balance sheet (exceeding $5 billion equity), PURE appears to be a riskier choice.

This article first appeared at Seeking Alpha.

I/we have no positions in any stocks mentioned and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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. See also: Insurance Disruption? Evolution Is Better   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.