Innovations are supposed to make things better, but sometimes, they, inadvertently, make things worse.

How so? Because they can create some bad game theory incentives. Companies feel pressured to do something that is a positive if only they do it, but, once everyone copies it, results in a lower equilibrium.

A great example is streaming TV. When it was just Netflix, it was a good option. Now that everyone is doing it, it costs more than cable for a worse experience (more on this below).

In the insurance world, you might think of insurance linked securities (ILS). The idea of ILS made a lot of sense. The problem is it led to overcapacity at lower returns and ruined cat reinsurance for a decade.

How ILS Ruined Cat Re

A quick ILS history recap: Investors were willing to fund catastrophe risk at bond like returns rather than equity like returns. This was done through arbitraging the capital models by fully collateralizing risk and, therefore, removing the need for a rating.

By removing the onerous capital needs for tail risk, ILS structures could charge less and win market share from traditional reinsurers.

Savvy reinsurers realized that, if someone was going to sell ILS to their clients, then they should get in on the game. Many created units to originate this risk themselves on behalf of fixed income investors.

At first, this seemed like a genius move. Reinsurers got paid higher multiple fee income and didn’t have to commit expensive capital to grow their franchise. Returns would go up over time and they would get revalued!

And then reality hit. Reinsurers failed to understand that by normalizing ILS as equivalent to traditional reinsurance, that it would lower the price of their own product.

After all, the buyer wasn’t going to pay a premium to get rated paper. The reinsurer’s capital constraints weren’t their problem.

Thus, reinsurers landed on a new equilibrium where returns were lower across the board. This eventually led to some prominent reinsurers exiting cat risk altogether.

In other words, innovation that may have seemed short term financially appealing was long term value destructive.

How Streaming Ruined TV

We are seeing the same dynamic currently in the TV market. Viewers often complained about the “cable bundle” being too expensive and having to pay for things they didn’t watch.

Why, they asked, couldn’t someone disrupt this and let you only pay for what you want? Everyone cheered the success of Netflix and rooted for Hulu to succeed, but this led all the incumbent content producers to realize, they too needed a streaming service!

Does this remind you of all the reinsurers creating ILS entities?

We now have more streaming services than one can count. The cable industry is entering a death spiral as it sheds viewers. The streaming services are bleeding money because they spent so heavily on new content.

But is the viewer better off? Did they get what they wanted? Not from my perspective.

The Cost To Unbundle

First, let’s look at the cost. The average cable bill is somewhere around $150, maybe even more. Streaming is great because it saves all this money, right? Uhh, right?

Well, let’s do the math on that. You need to start with a base package for all your old cable channels. Youtube is $73/month.

Next, add Hulu ($18), Disney ($14), Peacock ($12), and Paramount ($12) for all the shows you used to be able to get on regular cable, but now are tied up in a streaming service. That’s an extra $56, so we’re at $129.

Then, you have the equivalent of the premium channels you needed to get that had the one or two series you liked. That’s Max ($16), Netflix ($15), Apple ($9), and Prime ($7). We’re now at $176!

So you actually pay the same or more than cable! How is this benefitting anyone?

Sure, you don’t have to take all those services, so now it’s your “choice”, but, it also means you’re getting less programming.

The Broken User Experience

But there are other choices you lose by moving to streaming. I no longer have the choice to change the channel and have it switch immediately. Or to use the previous channel button.

I no longer have the choice to rewind or fast forward to any place I want (the 10 or 15 second skip button is trash).

I no longer have the choice to find my recorded content in a coherent manner. I no longer have the choice to use a guide that quickly finds the channel or program I want.

I no longer have the choice to not find out who scored a touchdown at the same time as my neighbors with cable (streaming has greater latency). This also means you live bettors out there are at a huge disadvantage.

And can someone please explain why it takes a minute to load the app for each service? We improved upon slow booting PCs to insta boot ipads and phones, but our TVs now take forever to “load”?

If you’re of a certain age, you may remember the old TVs where when you turned them on they had to warm up before the picture showed. It’s nice to know we’re back to the 60s!

Nothing about streaming is more convenient or easier to use than cable. So I’m paying the same amount for a worse product. How is that an improvement?

Once again, we have landed at a lower equilibirum.

Prisoner’s Dilemma

Why do we get these negative outcomes? It’s a classic case of prisoner’s dilemma.

If you let your competitor build capacity and you do nothing, they gain incremental profit at your expense. But if you both build new capacity, you depress industry pricing and margins and you’re both worse off than if you did nothing.

In the case of ILS, existing players should have done everything they could to discredit the product as inferior to rated paper and leave it as a niche for Nephila and Shaw.

This would have minimized its industry impact, even if there would have been some near term pain from lost market share.

But it would have prevented the wider pain from normalizing ILS and confusing the market about why it should pay a premium for rated paper.

For the streaming services, every major content provider felt pressured to roll out its Netflix killer, so as not to be left out. These came with major new investments in distribution and content to attract subscribers.

Since the customer wasn’t going to pay more for this, it could only result in lower industry profits.

The simpler answer was to stick with the cable infrastructure and allow for more a la carte packages similar to HBO and Showtime. This would have avoided the extra spending while providing the consumer a better value.

The cable providers would have gotten the double leverage out of their pipes (charging for internet and cable) rather than falling back to only internet, so they had every incentive to change their pricing strategy.

Netflix would have its own niche but, let’s be honest, Netflix’s programming is pretty mediocre. I’d rather have all the cable channels with more new content.

The Fatal Flaw of Fast Following

It should also be noted that, like streaming TV, the end user of ILS was worse off for the experience too.

Those bond like returns they thought they were getting proved harder to earn than they expected and had other complications like liquidity limitations they didn’t anticipate.

Now, the bond buyers have lost their taste for the asset class and won’t even commit money today when returns are far higher than they were back when they were so eager to buy.

The intent of Prisoner’s Dilemma is for the police to win and the criminals to lose. But there is often a disconnect between theory and the real world.

In reality, prisoner’s dilemma often results in the end user losing too. It’s like they got both criminals to confess, but then they had to drop the case because they collected evidence improperly.

Companies need to consider the all in cost of innovation, especially when it comes to being a fast follower. The fast followers often end up causing the most destruction of value.