The Law of Large Numbers
I read a consumer's comment regarding purchasing a renter's policy from a well-known, low price direct carrier for $25 a month and getting a quote for $5 a month from a well-known, though brand new start-up type of carrier. The consumer asked online of the start-up, "Are you real?" One of their executives replied, "Yes and we can charge so little because of our technology!" (I'm paraphrasing slightly for confidentiality.)
That is some kind of technology to legitimately charge 80% less. If the technology is that great, everyone else should just pack up and quit now. But first, I will go through some simple math. I'll use the incumbent carrier's results using publicly available data. The limitation is that I do not have line item expense data down to the renters' policy level. This might make a small and material difference but since the price difference is 80%, the difference is not material enough to matter for the purpose of this explanation because expenses do not vary in personal lines by dozens of percentage points, especially with low cost carriers.
The incumbent's overall expense ratio excluding loss adjustment is about 14% of written premium. For comparison, the overall industry average over the last ten years is 27.1% and in 2016, it was 27.7%. Expense ratios tend to be quite stable and stubbornly so when companies need to decrease them. Their profit margin excluding investment revenue was approximately 5%. Therefore, they pay out approximately 70% of premiums in claims (total industry average for all lines is approximately 59%). This means that if this carrier had no expenses and no need for profit, it would have to charge $.70 instead of $.95 just to break even.
The new competitor (let's call it "NewCo") is charging approximately 80% less. NewCo is too new to use their actual expenses as comparisons (their profit margin was hugely negative last year which is normal for a startup, even one with great technology). 80% less though is less than the incumbent's expense ratio when loss adjustment expense is included (LAE is approximately 10%). In other words, the incumbent's expense ratio including LAE is approximately 30%, one of the lowest in the industry and yet NewCo can justify a rate of $.20? To the best of my knowledge, no developed personal lines company has a sub-20% expense ratio including LAE. I suppose if everyone worked for free, if reinsurance was free, and if the great technology was free, it might be possible.
Therefore, for NewCo's executive to be accurate, their technology must be so good that their great technology, his salary, others' salaries, auditing fees, license fees, all other expenses and all their losses must be less than $.20 on the dollar. So, is the executive correct? We'll have to wait and see.
Giving them the benefit of the doubt, the only way a company can make money at 20% is the technology must identify prospects that will not have claims except in a highly unlikely scenario, such as maybe Black Swan events making the policy really a de facto catastrophe policy even though the insured does not see it as such. Another possibility is that the forms are not comparable which means NewCo's form is disingenuous or a de facto cat policy from a different angle. Based on the executive's response though, no indication was made their coverage was less so I'm going to assume the forms are comparable. If I am wrong, a serious disclosure should have been made.
I am going to extend the benefit of the doubt further. If NewCo's technology really is that good, to select people highly unlikely to have a claim, then those people do not really need insurance. They are just wasting much less at $60 per year than $300 per year.
Going further into the implications for the industry, insurance is based on the law of large numbers. Today, due to large data, their technology bases insurance on small numbers. Only, relatively, small numbers of clients are so highly unlikely to incur a claim that rates can legitimately be 80% less. The law of large numbers is based on the concept that a company cannot, within reason, predetermine which of 100,000 renters will have a theft or fire. They can identify the probable number of claims and the claim dollars they'll incur from these 100,000 renters collectively. If the carrier charges enough for all 100,000 policyholders (law of large numbers) but do not identify specifically who will have a claim because historically (and maybe still today) that is not predictable, and collectively then the company can make a small profit. The profit on some clients will be 70% and on others it will be -1,000%, but collectively, the underwriting profit will be 5%.
If NewCo's executive is correct, what he was really saying is that their technology knows exactly who will have a claim--true predictive modeling down to the individual level. In this case, it is the individual who will not have a paid claim. This means the consumers likely to have claims will pay much, much, much more. The carriers and agents stuck with these unfortunate clients will have serious problems too because the rates they have to charge may be so high as to be unaffordable. As much as people hate paying premiums that are always too high, historically insurance was egalitarian in many ways because all clients in a pool were treated somewhat equally.
Of course, NewCo could just be seriously underpricing their product like hundreds of new carriers that have gone beforehand and often failed. Insurance history is littered with the tombstones of carriers that have "figured out something smarter" but were really just underpricing. It would not be the first time and it will not be the last where an executive thought their key advantage was technology when in reality, the carrier did not even possess a competitive advantage. I recently heard another insurance C-suite executive advise their advantage was technology when a review of their financials suggests they are not even investing in technology beyond some interesting reserving models.
There was one other aspect of the web based conversation between the consumer shopping renters' insurance and NewCo's executive. When asked if the company was real, the executive also advised that NewCo was real because regulators have licensed them. Please understand that just because regulators have licensed a company does not always mean much in the real world. I believe that almost all insurance companies that have failed were licensed. For an executive to use this as proof of "being real" causes just a smidgen of skepticism, especially when combined with a need to write to a combined ratio of 20%. The logic doesn't add up.
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Coverage Discussions: Relating Words to Lives
My favorite consulting service is teaching the clear communication of coverages. I find plenty of producers and CSRs have the required coverage knowledge. Often though, they do not know how to convey the importance of coverages to actual clients and prospects. An example is personal umbrella coverage. It is one thing to know what it does and another to explain it in a way that causes people to understand quickly how important it is they have this coverage. An agency owner's ability to explain it is inadequate because they are not the ones who talk to most of the customers! I enjoy helping people learn the skills required to help their own customers understand the need for specific coverages.
I find plenty of experienced agency personnel who do not possess adequate knowledge too. Sometimes, I'll be honest, they are just stupid or unethical. However, most such people are good people who just do not know their coverages. They have tried. Some have their designations. Some have bluffed their way for years and decades but they do not really know their coverages. What I've learned is that sometimes they do not know their coverages for the same reason regular people do not understand coverages: they cannot relate the words to their lives. If they cannot relate personally, they probably cannot explain the coverages to clients.
I really enjoy training and teaching producers and CSRs how to truly understand coverages on a human level and then teaching them how to talk to regular people about those coverages. The benefits are increased sales but probably more important, agencies decrease their E&O exposure when people purchase the coverages they actually need!
Maybe an even more valuable benefit is the confidence it gives people which in turn, decreases the stress people feel all the time when dealing with coverages they do not themselves understand. They stress about getting questions they cannot answer. They stress about E&O exposures because they are not selling coverages they need to sell but do not know how to sell. They stress because they feel they have to know all the answers and they don't even know all the questions. One of the keys I teach is how to ask the right questions because knowing the questions is more important than knowing all the answers. No one ever knows all the answers. As one of my favorite clients of all time said upon retirement at 83, "I'm sad to retire because I was thinking that I was just beginning to know what I was doing!"
Understanding the questions and how to articulate coverage information in a meaningful way makes life much more fulfilling. Client relationships are better and clients get better coverage making their lives safer. If this is a relationship business, doesn't it make sense to improve your communication skills with which to build those relationships?
Call me if you want to enjoy this experience.
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Has your CEO, COO or CFO cost your company $1 million?
I have seen CEO's, COO's and CFO's at large agencies and brokers cost their organizations lots of money. I have seen it happen regularly and in much larger denominations at carriers. I have seen it happen in smaller denominations at smaller organizations. I have had clients describe insurance proposals that showed the insured's CFO, for example, made mistakes costing the firm literally millions. These are not ambiguous losses. These are real. These are not honest mistakes in the sense of "everyone makes mistakes sometimes." The executive is not being malicious or fraudulent. However, the losses are not completely honest because these are losses resulting from incompetency and the person has usually attempted to hide their incompetency.
Sometimes these mistakes occur because a person has been promoted above their ability, proving the Peter Principal. Sometimes the mistake occurs because the executive is simply and legitimately too busy, which is often indicative of another issue (a control freak unable to delegate). Sometimes the firm is painfully unprofitable and cannot afford additional resources. This makes such mistakes even more injurious. The reasons vary why these losses happen and I am not sure the reason really matters provided the reason is not nefarious. Blame really need not be assigned for the mistake itself.
The key element is: what happens when the loss is discovered? Does the person thank the discoverer or do they blame the discoverer (shoot the messenger)? Do they hide or try to make the discoverer look bad? Do they conduct a cover-up?
The most common scenarios I see are when the CFO has made the mistake. At an insureds, the CFO simply buys the wrong insurance or the wrong amount of insurance. A famous E&O case was Isidore Newman School versus J. Everett Eaves, Inc. The way I read the court's ruling, the CFO was repeatedly offered the opportunity to purchase more business income and never did. The school had a large BI loss, sued the agency, and lost because it was clear the agency had offered the school much more coverage than the CFO was willing to purchase. Larger accounts often create more complex scenarios involving deductibles, self-funding, and so forth, but regardless, the CFO has not made the correct analysis and therefore, what happens next? Do they own up and recommend more coverage going forward or try to justify a poor decision? Do they cut a behind-the-back deal with a vendor to cover up the mistake?
With CFO's at agencies and brokers, the mistake I most often see is their controlling nature causes them to limit outside ideas from penetrating their organization. Over time, the thought process becomes antiquated and virtually useless. Examples include understanding carrier contracts, internal profit sharing, compensation plans, and valuations. The latter is especially a sensitive topic.
With carriers, the examples I see continually are the inability or unwillingness of CEO's/CFO's to understand how their actions in underwriting, servicing, and compensation actually affect agency placement. Their understanding of what drives placement versus reality is an awfully expensive mistake made continually and seemingly, perpetually. The topic is so sensitive no one will broach it. The emperor could run around stark naked, spouting off the most ridiculous strategies and no one is going to tell them differently -- so nothing changes. So much opportunity is wasted here.
Sometimes though, the party wasting money is a key shareholder. I have been the target of many a shareholder when I pointed out how to better protect the business. They were so embarrassed/angered/chastised or experienced a dozen other negative emotions that they simply could not accept the possibility the suggestion had merit. One example occurred while I was assisting with fixing a large agency's extremely serious IT problems. I am not an IT consultant but the solution was quite obvious, simple, and inexpensive. The key shareholder simply came unglued and refused to implement the solution because he was so embarrassed. I should have made the solution unnecessarily complex. I should have disguised the solution as having an external cause. I should have done a number of things differently but the solution was so simple and obvious that I just stated what needed to be done thinking that cheap, simple, and immediate would be appreciated. Not a smart assumption because I didn't factor in the emotional cost.
That is the problem in these situations. Knowing who will take offense and take defensive actions to prevent their culpability from being discovered beforehand is next to impossible. Adding to the difficulty, I have discovered the hard way, though I am probably only the 10 millionth discoverer, is that such a person is often ingenious at disguising their culpability. You get hired to solve a problem and in the process of solving it, you run into one heck of a buzz saw. Not a great experience.
If you run a company or an agency and you want to minimize the risk key people (including yourself) are costing you a small fortune (or a large fortune) and especially if they are consciously covering up their incompetency, think alignment. The main reason situations like this happen upon discovery, not necessarily prior to discovery, is because the individual's best interest and the company's best interest are not aligned. For example, the individual's best interest is to continue appearing to be bright and competent. The company's best interest is discovering the incompetency. The misalignment could not be starker.
How can alignment in this situation be created? After the fact, I'm not sure if anything other than great leadership works. Leadership to simultaneously convey the mistake is not fatal and an appreciation of the person's abilities and your desire to understand their strengths better while helping delegate their weaknesses away. Furthermore, convey the person can be more successful but that another such situation will result in a demotion or firing so the person needs to become more diligent, be in alignment with the company, and think bigger picture.
On a go forward basis, the key to alignment is creating accountability and compensation that aligns with success and the lack of success. Focusing on the positive, alignment happens when the person is charged with and succeeds in moving the firm forward, not in stasis, not in the status quo. Where is the proof the person is moving the firm forward? I find firms that have this perspective but then find a mistake look at the mistake as an opportunity. "Yes -- I blew it! I own the mistake and thankfully it was not fatal but I am not going to make the bigger mistake of covering up! Let's fix it, build a safeguard if possible to prevent it from happening again, and enjoy the fruits of the investment we made in that mistake!"
That kind of alignment is easier said than done but if you identify a mistake and your stomach clutches, what do you do next? Do you think of the investment you made and the improvement you can now make or is your tendency to deny/cover up? If you recognize the emotion, you have a great opportunity to make life better. If you work with someone who needs help making that distinction, can you help them? Life is better growing from mistakes than hiding from mistakes.
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Underwriting & Risk Management: Which is Which?
I recently read an article regarding British pub beer drinkers. The industry (I'm not sure which industry but I assume it is the equivalent of the restaurant and bar association here) caused pubs to begin serving drinks in plastic or toughened glass. The result was a decrease in violence between strangers at pubs. Such violence had constituted 13% of stranger on stranger crime. The new glass rules decreased this to 4% of such crimes (Economist, 1-7-17).
Historically an underwriter might ask, or an application might ask, "What kind of glass is used for drinks?" The rate or even acceptance of the risk might depend on the answer. What if, though, the agent made the recommendation to switch to heavy glass (which breaks without sharp edges making it a less useful weapon when broken)? "Heavy glass makes an almost useless weapon when broken and will therefore decrease your liability exposures and your hassles of cleaning up blood. It makes it easier to get insurance and customers not looking to be sliced, avoids having police crawling around your premises asking other questions, maybe makes future licensing easier, and of course, decreases your insurance rates." This is risk management.
The future for the best and brightest agents is in risk management. Rather than being complacent or reactive to underwriters, letting the carrier ask the questions and make the decisions, does it not make more sense to ask the same questions from a proactive risk management perspective? It gives you the opportunity to be the hero. It gives you the opportunity to prove you are doing something for your commission/fee. It gives you the opportunity to build a partnership/relationship with your clients in a much more positive context than helping them complete an application.
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Chris Burand is president and owner of Burand & Associates, LLC, a management consulting firm that has been specializing in the property/casualty insurance industry since 1992. Burand is recognized as a leading consultant for agency valuations, helping agents increase profits and reduce the cost of sales. His services include: agency valuations/due diligence, producer compensation plans, expert witness services, E&O carrier approved E&O procedure reviews, and agency operation enhancement reviews. He also provides the acclaimed Contingency Contract Analysis® Service and has the largest database and knowledge of contingency contracts in the insurance industry.
Burand has more than 25 years' experience. He is a featured speaker across the continent at more than 300 conventions and educational programs. He has written for numerous industry publications including Insurance Journal, American Agent & Broker, and National Underwriter. He also publishes Burand's Insurance Agency Adviser for independent insurance agents.
Burand is a member of the Institute of Business Appraisers and NACVA, a department head for the Independent Insurance Agents and Brokers of America's Virtual University, an instructor for Insurance Journal's Academy of Insurance, and a volunteer counselor for the Small Business Administration's SCORE program. Chris Burand is also a Certified Business Appraiser and certified E&O Auditor.
NOTE: The information provided in this newsletter is intended for educational and informational purposes only and it represents only the views of the authors. It is not a recommendation that a particular course of action be followed. Burand & Associates, LLC and Chris Burand assume, and will have, no responsibility for liability or damage which may result from the use of any of this information.
Burand & Associates, LLC is an advocate of agencies which constructively manage and improve their contingency contracts by learning how to negotiate and use their contingency contracts more effectively. We maintain that agents can achieve considerably better results without ever taking actions that are detrimental or disadvantageous to the insureds. We have never and would not ever recommend an agent or agency implement a policy or otherwise advocate increasing its contingency income ahead of the insureds' interests.
A complete understanding of the subjects covered in this newsletter may require broader and additional knowledge beyond the information presented. None of the materials in this newsletter should be construed as offering legal advice, and the specific advice of legal counsel is recommended before acting on any matter discussed in this newsletter. Regulated individuals/entities should also ensure that they comply with all applicable laws, rules, and regulations.
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Copyright 1995 - 2017, Chris Burand