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Transparent Reinsurance for Health

Transparent reinsurance programs could emerge as significant opportunities for healthcare providers, issuers, reinsurers, technology innovators and regulators to address health insurance.

The message is clear. Having to factor in higher costs associated with new entrants to the healthcare system gives insurance firms license to charge higher rates. If these new people were put into a reinsurance pot for three to five years with costs spread over all insurers, no one insurer would be unnecessarily burdened. After this period, costs for these entrants could be reexamined and a decision could be made on how to proceed with them, depending upon the deviation from the remaining population.

Several factors are coming into play. 

United Health Group indicates it will be leaving all but a few of the 34 states where it is offering health insurance under Obamacare.

A fresh Blue Cross Blue Shield study finds recent Obamacare entrants have higher rates of specific illnesses and used more medical services than early entrants. “Medical costs of care for the new individual market members were, on average, 19% higher than employer-based group members in 2014 and 22% higher in 2015. For example, the average monthly medical spending per member was $559 for individual enrollees versus $457 for group members in 2015,” the study found.

What emerges in conversations with economists, regulators and healthcare actuaries is a sense that properly designed, fair and transparent reinsurance could—and would—advance industry and public policy goals to continue insurance for all at affordable prices. This approach would represent tangible improvements over inefficient, incumbent systems. Information would be used by insurers and reinsurers, providers and regulators and, crucially, insureds to establish best performances for healthcare outcomes and expenses. Virtually everyone knows that state or regional reinsurance would have to be mandated, as voluntary systems could be gamed.

“The implementation of new policies, the availability of research funding, payment reform and consumer- and patient-led efforts to improve healthcare together have created an environment suitable for the successful implementation of patient-reported outcome measures in clinical practice,” fresh research in Health Affairs also indicates.

Risk analysis technologies could help issuers, reinsurers, healthcare institutions and citizens rein in the healthcare system’s enormous costs. Earlier this year, the Congressional Budget Office and Joint Committee on Taxation projected that, “in 2016, the federal subsidies, taxes and penalties associated with health insurance coverage will result in a net subsidy from the federal government of $660 billion, or 3.6% of gross domestic product (GDP). That amount is projected to rise at an average annual rate of 5.4%, reaching $1.1 trillion (or 4.1% of GDP) in 2026. For the entire 2017–2026 period, the projected net subsidy is $8.9 trillion.”

CBO/JCT published this stunning projection amid consensus that $750 billion to $1 trillion of wasted spending occurs in healthcare in the U.S. “Approximately one in three health care dollars is waste,” Consumer Reports says.

Key metrics should focus on estimates of risk using demographics and diagnoses; risk model descriptions; calculation of plan average actuarial risk; user-specified risk revealing and detailing information; drill-down capabilities clarifying research; monitoring and control; and calculation and comparison measures to address reinsurance validation.

Several major refinements yielding and relying upon granular, risk-revealing data and metrics would support more efficient reinsurance. All would, and could, update reinsurance information and address customer experience, trust and privacy concerns.

As the industry has noted, ledger technologies could play fundamental roles as blockchains. Indeed, blockchain technologies are just now being introduced in the U.K. to confirm counter party obligations for homeowners’ insurance.

“Advanced analytics are the key,” remarked John Wisniewski, associate vice president of actuary services at UPMC Health Plan. “Predictive capability that looks at the likelihood a patient admission may be coming is the information that we can give to doctors to deal with the matter. … Whoever develops algorithms for people who will be at risk—so providers can develop plans to mitigate risk—will create value for issuers, providers and members alike.”

Available technologies support the connecting of risk assessments with incentives for risk information.

Michael Erlanger, the founder and managing principal of Marketcore, said, “We cannot know what we cannot see. We cannot see what we cannot measure. These available technologies provide clarity for more efficient health insurance and reinsurance.”

Context: Three Rs: Reinsurance, Risk Corridors and Risk Adjustment

When Congress enacted the ACA, the legislation created reinsurance and risk corridors through 2016 and established risk adjustment transfer as a permanent element of health insurance. These three Rs—reinsurance, risk corridors and risk adjustment—were designed to moderate insurance industry risks, making the transition to ACA coverage and responsibilities. The Centers for Medicare and Medicaid Services (CMS) within the Department of Health and Human Services (HHS) administers the programs. All address adverse selection—that is, instances when insurers experience higher probabilities of losses due to risks not factored in at the times policies are issued. All also address risk selection, or industry preferences to insure healthier individuals and to avoid less healthy ones.

With the expiration of ACA reinsurance and risk corridors, along with mandatory reporting requirements this December, healthcare providers, issuers, reinsurers, technology innovators and regulators can now evaluate their futures, separate from CMS reporting.

Virtually all sources commend reinsurance and risk adjustment transfer as consistently as they deride risk corridors. Reinsurance has paid out well, while risk corridors have not. Risk adjustment transfer remains squarely with CMS. 

ACA numbers

While House Republican initiatives try and fail to repeal the ACA, and some news programs and pundits say it is unsustainable, approximately 20 million subscribers are enrolled in Obamacare: with 12.7 million as marketplace insureds, with others through Medicaid and as young adults on parent plans. President Obama, in March, remarked: “Last summer we learned that, for the first time ever, America’s uninsured rate has fallen below 10%. This is the lowest rate of uninsured that we’ve seen since we started keeping these records.” Subscription ratios are off the charts. Premium increases have been modest, approximately 6% for 2016, experts find. “I see no risk to the fundamental stability of the exchanges,” MIT economist Jonathan Gruber observed, noting “a big enough market for many insurers to remain in the fold.”

Transitional Reinsurance 2014-16: Vehicle for Innovation 

One of the great benefits of the ACA is eliminating pre-existing conditions and premium or coverage variables based on individual underwriting across the board. Citizens are no longer excluded from receiving adequate healthcare, whether directly or indirectly through high premiums. Prices for various plan designs go up as coverage benefits increase and as co-pays and deductibles decrease, but the relative prices of the various plans are calculated to be actuarially equivalent.

To help issuers make the transition from an era when they prided themselves on reducing or eliminating less healthy lives from the insureds they covered, to an era where all insureds are offered similar ratings, the ACA introduced reinsurance and risk corridors to cover the first three years (2014 through 2016), in addition to risk adjustment transfer, which will remain in force.

The concept is relatively simple: Require all issuers to charge a flat per-dollar, per-month, per-“qualified” insured and create a pot of money with these “reinsurance premiums” that reimburses issuers for excess claims on unhealthy lives. Issuers would be reimbursed based on established terms outlined in the ACA.

Reinsurance reimburses issuers for individual claims in excess of the attachment point, up to a limit where existing reinsurance coverage would kick in. Individuals involved with these large claims may or may not be identified in advance as high-risk. The reimbursed claim may be an acute (non-chronic) condition or an accident. The individual may otherwise be low-risk.

The important aspect is that all health insurance issuers and self-insured plans contribute. By spreading the cost over a large number of individuals, the cost per individual of this reinsurance program is small to negligible. Non-grandfathered individual market plans are eligible for payments. A state can operate a reinsurance program, or CMS does on its behalf through this year.

As a backstop, the federal government put some money in the pot through 2016—just in case the pot proved inadequate to provide full reimbursement to the issuers. In a worst-case scenario, the sum of the reinsurance premiums and the federal contribution could still be inadequate, in which case the coinsurance refund rate would be set at less than 100%.

As it turned out, 2014 reinsurance premiums proved to be more than adequate, so the refund rate was 100%, and the excess funds in the pot after reimbursement were set aside and added to the pot for 2015, just in case that proves inadequate.

Reinsurance functions on this timetable through this year:

Screen Shot 2016-04-11 at 1.41.01 PM

CMS transferred approximately $7.9 billion among 437 issuers—or 100% of filed claims for 2014, as claims were lower than expected— and it has yet to release 2015 payments. The results for 2015 are coming this summer.

From the outset, states could, and would, elect to continue reinsurance, the CMS contemplated. In 2012, the CMS indicated that “states are not prohibited from continuing a reinsurance program but may not use reinsurance contribution funds collected under the reinsurance program in calendar years 2014 through 2016 to fund the program in years after 2018.”

Subsequent clarification in 2013 did not disturb state discretion. Current regulation specifies that “a state must ensure that the applicable reinsurance entity completes all reinsurance-related activities for benefit years 2014 through 2016 and any activities required to be undertaken in subsequent periods.”

One course of action going forward from 2017 and varying from state-to-state could be mandatory reinsurance enacted through state laws. Healthcare providers, issuers, reinsurers, regulators and legislators could define the health reinsurance best suited to each state’s citizens.

Reinsurers could design and manage administration of these programs possibly at a percentage of premium cost that is less than what is charged by the federal government today. While these reinsurance programs would be mandated, they could include a component of private reinsurance. For example, reinsurers could guarantee the adequacy of per-month reinsurance premiums with provisos that if these actuarially calculated rates turned out to be inadequate in any given year or month, there will be an adjustment to account for the loss in the following year. Conversely, if those rates turn out to be too high, 90% or more is set aside in an account for use in the following year. This way, reinsurers could participate by providing a private sourced solution to adverse claims.

Risk Corridors

Risk corridors apply to issuers with Qualified Health Plans (exchange certified plans) and facilitate transfer payments. The CMS noted: “Issuers whose premiums exceed claims and other costs by more than a certain amount pay into the program, and insurers whose claims exceed premiums by a certain amount receive payments for their shortfall.” Technically, “risk corridors mean any payment adjustment system based on the ratio of allowable costs of a plan to the plan’s target amount,” as the CMS designated.

Issuer claims of $2.87 billion exceeded contributions, so the CMS transferred $362 million among issuers; that is, a 12.6% proration or a $2.5 billion shortfall in 2014.

Risk corridors are politically contentious. Sen. Marco Rubio (R-Florida) likened risk corridors to bailouts. The HHS acknowledged it will “explore other sources of funding for risk corridors payments, subject to the availability of appropriations… includ[ing] working with Congress on the necessary funding for outstanding risk corridors payments.” And, a knowledgeable analyst, Dr. David Blumenthal, noted that risk corridors are not bailouts.

Going forward, evaluations of risk corridors will demand due diligence. Several health exchanges failed from any number of factors—from too little capital for growth experienced, inadequate pricing, mismanagement or risk corridor payments.

Whether innovation can yield effective risk corridors or whether risk corridors will simply fade out as transitional 2014-2016 regulation will depend on institutional and industry participants. Risk corridors did not score unalloyed approbation among sources.

Risk Adjustment: Permanent Element of ACA

Risk adjustment remains in force and impels issuers with healthier enrollees to offset some costs of issuers with sicker ones in specific states and markets and of markets as a means toward promoting affordable health care choices by discouraging cherry picking healthier enrollees.

The HHS transferred approximately $4.6 billion for risk adjustment among issuers for 2014.

At first blush, one might postulate that risk adjustment does the job and that reinsurance and risk corridors could just as reasonably fade out. There is some logic to that argument.

On the other hand, state or regional level reinsurance could make up for risk adjustment shortfalls. In some instances, risk adjustment seems to be less friendly to issuers that take on higher-risk individuals, rather than rewarding high tech issuers and providers with back office capabilities coding claims in such a way as to tactically game risk adjustment.

Evaluating and cultivating these opportunities are timely amid the uncertainties of the presidential and congressional elections that may yield executive and legislative lawmakers intent on undoing ACA provisions, starting with risk corridors. Such legislation could produce losses for issuers and reinsurers.

Nelson A. Rockefeller Precedent

In 1954, then-Undersecretary of Health Education and Welfare Nelson A. Rockefeller proposed reinsurance as an incentive for insurers to offer more health insurance. S 3114, A Bill to Improve the Public Health by Encouraging More Extensive Use of the Voluntary Prepayment Method in the Provision of Personal Health Services, emerged in the first Eisenhower administration to enact a federally funded health reinsurance pool. Rockefeller intended the reinsurance as a means toward an end, what would eventually be dubbed a “third way” among proponents of national health insurance. President Truman and organized labor championed the approach into the mid-’50s. So did the Chamber of Commerce and congressional Republican adversaries of the New Deal and Fair Deal, who were chaffing to undo Social Security as quickly as they could. The American Medical Association also supported this third way because it opposed federal healthcare reinsurance as an opening wedge for socialized medicine. Despite limiting risk and offering new products, insurers demurred because of comfort zones with state regulators and trepidation about a federal role.

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Nelson A. Rockefeller, then-undersecretary of the Department of Health, Education and Welfare, presenting a federally funded health reinsurance plan, 1954.
Source: Department of Health Education and Welfare—now Health and Human Services

Rockefeller’s health reinsurance plan would “achieve a better understanding of the nation’s medical care problem, of the techniques for meeting it through voluntary means, and of the actuarial risks involved,” HEW Secretary Oveta Culp Hobby testified to a Senate subcommittee in 1954.

Rockefeller’s health reinsurance plan did not make it through the House. Organized labor decried it as too little, the AMA said it was too intrusive. Upon hearing news of the House vote, a frustrated Dwight Eisenhower blistered to reporters, “The people that voted against this bill just don’t understand what are the facts of American life,” according to Cary Reich in The Life of Nelson A. Rockefeller 1908-1958. “Ingenuity was no match for inertia,” Rockefeller biographer Richard Norton Smith remarked of industry and labor interests in those hard-wired, central-switched, mainframe times.

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“’It’s déjà vu all over again’ like Yogi Berra,” said one insurance commissioner immersed in the ACA on hearing Ike’s quote.

Source: Yogi Berra Museum & Learning Center

The idea of national health insurance went nowhere despite initiatives by Sen. Edward M. Kennedy (D-Massachusetts) in the late ’70s and President Bill and First Lady Hillary Clinton roughly 20 years ago, until Congress legislated Obamacare.

Innovative, Transparent Technologies Can Deliver Results

Nowadays, more than 60 years after Rockefeller’s attempt, innovative information technologies can get beyond these legislative and regulatory hurdles. Much of the data and networking is at hand. Enrollee actuarial risks, coverage actuarial values, utilization, local area costs of business and cost-sharing impacts on utilization are knowable in current systems. Broadband deployment and information technology innovations drive customer acquisition and information management costs ever lower each succeeding day. Long-term efficiencies for reinsurers, insurers, carriers, regulators, technology innovators and state regulators await evaluation and development.

Reinsurance Going Forward From 2017

So, if state reinsurance programs can provide benefits, what should they look like, and how should they be delivered?

For technology innovators—such as GoogleMicrosoftOverstockZebra or CoverHound—these opportunities with reinsurance would apply their expertise in search, processing and matching technologies to crucial billion-dollar markets and functions. The innovators hope to achieve successes more readily than has occurred through retail beachheads in motor vehicle and travel insurance and credit cards and mortgages. One observer noted that some of those retail initiatives faltered due to customer experience shortfalls and trust and privacy concerns. Another points out that insurers view Amazon, Apple and Netflix as setting new standards for customer experiences and expectations that insurers will increasingly have to match or supersede. A news report indicated that Nationwide already pairs customer management data with predictive analytics to enhance retention.

Reinsurers including Berkshire Hathaway, Munich Reinsurance Company, Swiss Reinsurance Company Limited and Maiden Holdings could rationalize risks and boost earnings while providing a wealth of risk management information, perhaps on a proprietary basis.

For issuers, state-of-the-art transparent solutions improve the current system by enabling issuers to offer more products and services and becalm more ferocious industry adversaries while lowering risks and extending markets. Smaller, nimbler issuers may provide more innovative solutions and gain market share by providing the dual objectives of better health outcomes with lower costs.

For regulators, innovative, timely information sustains the indispensability of state regulators ensuring financial soundness and legal compliance—while allowing innovators to upgrade marketplace and regulatory systems, key regulatory goals that Iowa’s insurance commissioner, Nick Gerhart, pointed out recently. Commissioner Gerhart envisions regulators as orchestra conductors, acknowledging that most insurance regulatory entities are woefully understaffed to design or operate such reinsurance programs themselves, but they will, and they can lead if the participants can provide turnkey capabilities.

Think of health insurance and reinsurance as generational opportunities for significant innovation rather like the Internet and email. When the Department of Defense permitted the Internet and email to evolve to civilian markets from military capabilities in the 1980s, the DOD initially approached the U.S. Postal Service. Senior Post Office management said it welcomed the opportunity to support email: All users need do is email correspondence to recipients’ local post offices by nine p.m. for printing, enveloping, sorting and letter-carrier delivery the following day.

Similarly, considerable opportunities chart innovative pathways for state and regional health reinsurance for 2017 and beyond.

One path, emulating the post office in the ’80s, keeps on coding and bemoans a zero sum; it would allow the existing programs to fade away and will respond to whatever the president and Congress might do.

Another path lumps issuer health reinsurance as an incumbent reinsurer service without addressing the sustainability of state health exchanges or, indeed, any private health insurers in the absences of risk spreading with readily available information technologies.

The approach suggested here—mandated state health reinsurance—innovates to build sustainable futures. Enabling technologies empower all stakeholders to advance private and public interests through industry solutions advancing affordable healthcare.

Is ‘Direct’ a Dirty Word for Insurers?

The second-worst-kept secret of the year, after the launch of Google Compare in the U.S., is Berkshire Hathaway announcing its plans to sell insurance directly to business owners over the web. Quelle surprise.

I recently spoke with a C-suite exec who told me that “direct” is a dirty word.

Perception is reality.

In reality, though, “direct” is a lousy term that doesn’t do justice to the implementations that today’s technology has to offer that are often in direct alignment with an insurance company’s business model.

The conversation becomes uncomfortable to some once the word “middlemen” is introduced. It doesn’t have to be.

There are two primary outcomes to direct selling: (1) eliminating the middlemen or (2) empowering them. For visualization purposes, consider the following three brands:

Quotemehappy.com occupies the left extreme of selling directly to consumers. A spin-off of Aviva since 2011, the online insurer only provides phone support if a customer has a claim. For all other inquiries, there is browsing. Then there are the Geicos of the world, where insurers offer the convenience of buying on the web with the assurance of speaking to an agent, when needed. To the right extreme, Plymouth Rock provides an example of an insurer that has a patent-pending technology that matches online quotes to agents either pre- or post-purchase. There are several other players occupying the comfortable middle with direct-to-consumer models that offer varying degrees of human interaction.

Typically the outcome is determined by the company’s original distribution channel: whether offline, web or mobile. The table below further illustrates how versatile “going direct” can be:

  • Geico, Policy Genius and Cuvva are examples of insurance companies that implemented a direct-to-consumer strategy from the get-go; here, direct is a no-brainer.
  • Plymouth Rock and Quotemehappy.com via Aviva signal companies that implemented a direct-to-consumer strategy in an attempt to address a change in the market.
  • Allstate acquired Esurance to buy its way into the direct market, and so did AmFam with the acquisition of Homesite.
  • Also, AmFam invested in insurance comparison site CoverHound.

When all is said and done, direct selling is first and foremost a marketing channel that empowers the consumer. Sans proper marketing and messaging, the online insurance journey is transactional at best, and players risk commoditizing their product.

“Commodity.” Now there’s a dirty word for you.

Is Change Really Happening So Fast?

Lots of people are saying these days that the insurance industry, after essentially not ever changing, is suddenly moving too fast to follow — for instance, the recent ITL article, “Feeling Like a Keystone Cop.” But in my 37 years in the industry, insurance has evolved continuously.

Insurers have changed from the days where syndicates consisting of individuals provided insurance coverage through the Lloyds market; today, China Re with a majority ownership by China’s ministry of finance, has a syndicate at Lloyds. Today, a large number of insurers are owned by multinational conglomerates.

Other types of evolution include Berkshire Hathaway’s use of insurance premiums as a means of financing its investment interests. Similarly, Fairfax Financial Holdings of Canada uses premiums collected from its insurance companies around the world to finance investment interests.

Financial services groups such as Suncorp Group in Australia now offer insurance through a number of brand names, such as Shannons (classic car insurance), APIA (Australian Pensioners Insurance Agency) and AAMI. Rand Merchant Insurance Holding Group of South Africa offers insurance in Australia under the name of Youi (https://www.youi.com.au).

In addition, some insurance companies, like Progressive, are taking a technology-only approach to offer motor vehicle insurance in Australia without a “brick and mortar” presence. Apart from the option of reporting a claim by phone, all other communications are through email or a web page. With this approach, Progressive in Australia will only attract those who use technology. Here is the link http://www.progressiveonline.com.au/car-insurance.aspx

People talk about Google, Walmart, Amazon and others possibly entering the insurance market — again, this isn’t something new. Brand names have been used by insurers for many decades. Coles, a large supermarket chain in Australia (https://financialservices.coles.com.au/insurance) (similar to a Safeway or Ralphs here in the U.S.), offers various insurance polices to its customers that are underwritten by Insurance Australia Group.

Whether Google, Walmart or Amazon actually decides to underwrite risks, act as channels for insurance or simply provide a means to compare insurer premiums remains to be seen, but, regardless, none of this is new. For example, InsWeb has offered car insurance price comparisons since the mid-1990s. Here is the link: http://www.insweb.com.

One thing that is certain, however, is that the insurance market will continue to be driven by price and service, especially service at the time of a claim. In his 2013 annual report, Warren Buffett made the following comment, “GEICO in 1996 ranked number seven among U.S. auto insurers. Now, GEICO is number two, having recently passed Allstate. The reasons for this amazing growth are simple: low prices and reliable service.”

Over time, risk types change, and insurance coverage follows. Boiler explosion insurance for example, was a major type of insurance through the 1800s and into the mid-1900s. It still exists but is only a very small percentage of the insurance market.

We will see changes to vehicle insurance coverage when driverless vehicles appear on our roads, as mentioned in the recent ITL article titled, “Beginning of the End for Car Insurance.” There are many risk coverage issues for potential exposures with driverless cars. Imagine if a child runs onto the street to retrieve a ball without looking (a common occurrence for those living in the suburbs). With advanced technology built into driverless vehicles, the vehicle would be programmed to make a decision about which action to take in the best interest of all parties (i.e. the child, occupants in the vehicle or nearby vehicles as well as pedestrians): (1) brake but still hit the child or (2) brake and avoid the child but possibly hit another object such as another vehicle or lamppost, injuring the occupants of the vehicles as well as nearby pedestrians.

All this will need to be addressed by laws and road rules when driverless vehicles are introduced, with insurance following on. Premiums and who pays are the least of the insurance complexities involved with driverless vehicles. If a manufacturer is required to obtain insurance coverage or volunteers to obtain insurance coverage, the premium would be factored into the price of the vehicle; otherwise. it would be paid by the owner of the vehicle. Regardless, insurers will receives premiums from one source or the other.

Another evolving insurance coverage relates to a disability occurring from a work-related, motor-vehicle or non-work-related incident. While U.S. jurisdictions ponder whether coverage for a work-related injury or illness should be through a workers’ compensation policy issued by a property/casualty insurer or through the opt-out option (a hot topic in the U.S. at the moment), Europe, Asia and Australia are focusing on what people with a disability can be doing and deciding on how best to achieve this, including funding. In this case, the evolution relates to who will pay the premiums. Will employers continue to pay for work-related injuries, or will individuals buy personal injury coverage to cover their recovery costs, no matter whether associated with a work-related, motor-vehicle or non-work-related incident?

In the evolution of insurance, technology has always played an important role in areas such as deciding which segment of a market companies want to attract, meeting reporting obligations and improving processing efficiencies. In workers’ compensation, a number of U.S. carriers have chosen to outsource many of their claims functions, as I outlined in my last article. Whether this practice continues remains to be seen, but something needs to change in the way the workers’ compensation insurer or its representatives (e.g.. third party payer) handle claims, because clearly what they are doing is not producing the desired outcome for the injured worker or the employer, and no form of state legislature or technology change will address this shortfall.

Products like IBM’s Watson and Saama that are able to use unstructured data in addition to structured data to perform analytics are part of the technology evolution, and there is high probability of success. But we saw something along the same lines during the early 1990s, when all the buzz was about neural networks.

In closing, I don’t feel as if I’m a Keystone Cop when it comes to professional development, either relating to insurance or the technology used now or offered in the future. I also don’t think the major players in the insurance industry (like Berkshire Hathaway, Fairfax, Suncorp and others around the globe) feel they or their personnel are operating like Keystone Cops. If they were, I’m sure their share prices would not be as high as they are.

Dinner With Warren Buffett (Part 1)

Recently, we received an amazing email from Warren Buffett, the Oracle of Omaha himself, congratulating us for InsNerds.com, confessing that he’s a big fan of our efforts and inviting us on an all expenses-paid trip (on NetJets, of course) to have dinner with him to discuss the industry. We had an amazing time over the three-hour dinner at Gorat’s Steak House. The best part was being able to pick his brain about the awesome industry we work in…

Sadly, then the alarm clock went off at 5 am, and I realized I was dreaming. There was no email from Warren Buffett, no invitation for dinner and no flight on NetJets.

alarm

 

But all is not lost. Uncle Warren has written extensively about the insurance industry through letters to the shareholders of Berkshire Hathaway, which he has published every year since 1977. All this wisdom is available to anyone online for free, or you can even buy a printed copy. All you need is the nerdiness, dedication and patience to read through all 763 pages of material.

Because we know you’re busy, and don’t have the time to do this, we did it for you. We went through all 38 years of Warren Buffett’s letters, and we extracted everything you need to learn about insurance from the Oracle of Omaha himself, largely in his own words, with some of our colorful commentary. There is a lot to learn from Omaha’s Oracle, so instead of overwhelming you with all 38 years worth of knowledge, InsNerds will be publishing a series of articles sharing his wisdom.

The letters contain a lot of the history of GEICO, Gen Re, Berkshire Specialty Insurance and his other insurance companies in the letters; we chose not to include that and instead focus on insurance knowledge that can be useful to today’s insurance professionals. Uncle Warren keeps hitting many of the same points over and over; in those cases, we generally chose the wording from the newest letters, because, like good wine, Uncle Warren’s writing got better with time. Our first article will share three insights on the fundamentals of insurance:

war

 

1. At the core, insurance is nothing but a promise, and being able to fulfill that promise is key:

“The buyer of insurance receives only a promise in exchange for his cash. The value of that promise should be appraised against the possibility of adversity, not prosperity. At a minimum, the promise should appear able to withstand a prolonged combination of depressed financial markets and exceptionally unfavorable underwriting results. ” 1984 letter, page 10.

Buffett is indicating that a company must be cognizant of the promise that it is making to its customers, which is that the company will have the funds to indemnify its customers after a loss. The company must manage its reserves and investments wisely to be able to fulfill its promise when there is a claim, so the investments must be able to withstand a down market and a year of catastrophic losses at the same time. One of the main things that makes insurance interesting is that, contrary to most other businesses, we don’t know the cost of our product when we sell it.

2. Uncertainty is okay, as long as it’s priced appropriately:

“Even if perfection in assessing risks is unattainable, insurers can underwrite sensibly. After all, you need not know a man’s precise age to know he is old enough to vote nor know his exact weight to recognize his need to diet.” 1996 letter, page 6.

The purpose of insurance is to manage risk. When taking on a given risk, it is not possible to know if you will see a positive or negative outcome. In choosing risks, one must make informed decisions, but if a company waits to make a decision it may lose the business. Insurers must determine how much uncertainty they are comfortable with. The company will likely not be able to attain every single bit of information that it would like before making a decision, but a decision must still be made.

3. Always remember the big picture:

“[…]any insurer can grow rapidly if it gets careless about underwriting.” 1997 letter, page 8.

Finally, in the business of insurance, a company should take on smart risks. It can be tempting to grow rapidly by writing any piece of business that comes your way. A company may take shortcuts in underwriting to put business on the books. However, if this practice becomes a habit, the profitability of your book will be unsustainable. Playing the long game is necessary in our business. This is something Uncle Warren is constantly talking about in his letters: Underwriting discipline, especially when the market gets soft, is his top priority.

These are three key observations about the basics of insurance that we found in reading Mr. Buffett’s letters. There are many more to be discovered, and we look forward to writing about some additional themes.

Spending on Agents Beats Spending on Ads

A recent research report published by Cliff Gallant and Matthew Rohrmann of Nomura Equity Research concludes that spending on advertising beats spending on insurance agents.  Once again, Wall Street gets it wrong.

Their logic is flawed. The authors choose to focus only on advertising spending in 2013 and limit their analysis to the top-10 auto insurers. They then compare the advertising spending to premium growth that year. Because GEICO spent the most on advertising and had the largest premium growth, the authors conclude that advertising beats spending on agents.

But one year of advertising spending does not account for GEICO’s 2013 premium growth. The company has spent decades building its brand awareness. Since the mid-1990s, GEICO has spent billions of dollars to become top of mind as the company to consider if you want to purchase cheap auto insurance (a.k.a., “1-800-cheap insurance”). If GEICO stopped advertising, its growth would stop because it has almost no other way to reach the consumer (“almost” because even the king of direct-response insurance has 150 insurance-agent locations.)

Instead, other important factors account for GEICO’s performance in 2013: namely, its strategy to grow premium even if unprofitably. GEICO can afford to grow unprofitably because its owner, Berkshire Hathaway, is more interested in generating funds to invest than in consistent profits. In 2011, for example, GEICO saw its profits plunge 48% while its advertising costs increased 9.4%.

A better way to evaluate whether to advertise or invest in agents is to look at the costs of acquiring and retaining customers.

While GEICO scores high in initial consideration, it lands in the middle of the pack when it comes to the actual insurance purchase, according to the McKinsey 2012 Auto Insurance Customer Insights Report. It costs GEICO relatively little to get a consumer to make an inquiry, but a lot more to have someone buy a policy. And agent-oriented insurers score much higher in retention than GEICO and other direct-to-consumer auto insurance companies do, according to the McKinsey report.

The high retention numbers for agent-based insurance companies demonstrate that companies that underinvest in their agents do so at their own peril. Local agents build long-term relationships with consumers. Advertising doesn’t.

With the advent of the Digital Age, companies can generate bigger returns on their investment in agents. This goes against conventional wisdom. However, cloud computing, digital marketing, and social media let agents compete against the industry’s “brand behemoths” in their local community. Forward-thinking insurance companies are designing programs for their agents to leverage these new capabilities. These companies are finding they get a much bigger return on investment than with traditional advertising spending.

Consumers want choice today, and they expect to do business with companies that can provide a multi-channel experience. A local agent whom a consumer can visit, call or access via a website provides the experience that today’s consumer demands.

Insurers that focus on investing in their agent distribution channel will win. Pressure on companies to increase their advertising led to the insurance advertising wars of the last decade, and many companies diverted dollars from their agents to pay for increasing their advertising. But that trend appears to be changing as companies realize the power of agent-based distribution in today’s auto insurance market. For example, Allstate recently announced a renewed commitment to grow its agency distribution channel after years of neglect.

A strong agent-based distribution channel creates a long-lasting and compelling strategic advantage. Blindly ramping up the ad budget is a simplistic, ineffective solution. Spending on ads just creates an indistinguishable commodity product where price and a cute mascot are the only differentiators.