Note: Don’t miss today’s other post on 10-K reserves!
Last week AM Best announced a new ratings criteria for innovation. This is such a bad idea. Even if you think Insuretech will take over the world, this is still such a bad idea. Why? Let us count the ways…
#1 You Can’t Quantify Innovation
You can’t measure something intangible like innovation in an effective way. Just because one insurer has hired a few people to lead “innovation” doesn’t mean they are good at innovation. It also doesn’t mean they are better at innovation than companies who innovate quietly without an explicit showy effort.
I’ll say it more plainly. I don’t think an individual insurer can know if it’s good at innovation. How in the world is an outsider like Best going to be able to judge who is good? It’s a beauty contest, not a ratings variable, but Best has tried. Here is their definition:
AM Best’s evaluation of a company’s innovation level is based on two elements: (1) innovation inputs—or the components of a company’s innovation process; and (2) innovation outputs—or the impact of the company’s innovation efforts. The resulting innovation score is the sum of these two evaluations.A.M. Best
Oh, boy. This is going to be like when you fill out one of those customer service surveys and rate questions on a 1-5 scale (except Best has gone with 1-4). This is about as subjective as it gets! More on this in the postscript.
#2 It Interferes With Competitive Balance
Ratings agencies should not create regulations or impose their view of how to run a company. An agency’s job is to call balls and strikes based on the actions of management and financial results, not to step on the field and play.
By dictating their view of best practices, they are affecting the way the game is played. While they don’t like to be called a regulator, when they dictate behavior in this way, they are acting an awful lot like a government office.
#3 It Tries to Solve a Problem That Doesn’t Exist
Companies have plenty of incentive to innovate now. I don’t think any CEO is saying “I’m not going to try to do things to make the company better so I can grow book value, make a bigger bonus, and have my stock be worth more.” What is the problem Best is trying to solve?
Note, when the agencies created criteria for cat risk or ERM, this was done because there was an incentive for companies to cut corners and hope bad things didn’t happen to maximize earnings. There is no similar incentive here.
#4 It’s Already Implicit in the Rating
Did innovation only start to matter now? Did it not matter when auto insurers started using credit as a rating variable? Did it not matter when reinsurers started using cat models? Did it not matter when the large commercial writers rolled out better management systems for their agents? I can give dozens of examples of successful innovation in insurance.
Guess what? It was in the ratings back then too! You know how i know? Because those companies had better financial results, lower combined ratios, and more growth. It was ALREADY REFLECTED in the rating. We don’t need to double count it.
#5 Innovation Happens Organically Not By Mandate
Notice some of those examples above. None of them were “we are going to disrupt the world of insurance”. They happened organically to meet a market need. That is how innovation happens. Not by hiring some people with fancy titles and throwing money at startups who have cool sounding ideas but don’t understand why they don’t work in the real world.
Telematics for auto insurance is far more powerful than any Insuretech startup’s idea. Companies have plenty of incentive to invest in innovation on their own!
#6 It Creates Perverse Incentives
In an effort to show Best they are doing something, we will inevitably see companies put money into bad startup ideas to tout their innovation (I know this will happen cause it has already been happening). So Best is creating incentives for foolish behavior at best and at worst will inflate an insuretech bubble.
#7 It Ignores the Opportunity Cost
There is an opportunity cost to pursuing innovation. Good, boring ideas don’t get the same management attention as “transformative” ideas. In a world of limited resources, if management is diverting resources from blocking and tackling to pet projects that get them lots of back slaps at RIMS, they are in all likelihood hurting, not helping, the company given the low success rate of most of these initiatives.
#8 It Will Backfire By Incenting Bad Investments
Which brings us to the paradox of this whole exercise. By incenting “innovation”, Best will cause some companies to DESTROY VALUE and hurt their rating. If I get an A+ for my innovation effort, but my book value doesn’t grow cause I offset my earnings with goodwill writeoffs, should I really be proud of my good grade for innovation?
Let the Market Work!
The fundamental lesson is let the market work. There is plenty of reason for insurers to innovate if it is in their best interest. Don’t create bad incentives by putting a thumb on the scale and forcing companies to do phony innovation because they want to win a trophy.
For those who want more detail on how Best will calculate the innovation score, here’s a little more detail.
As mentioned above, the score is the sum of an “input” score and “output” score. What does that mean? Let’s explore…
The input score “capture(s) both a company’s innovation capacity—i.e., the resources the company has dedicated to innovation—and its potential innovation ability, or whether the structural elements of the innovation process are positioned in such a way that the company can leverage its available resources and create value.” (emphasis added)
If you can’t figure out what that means, don’t feel bad. I doubt you’re alone. Here’s the “formula” if that helps.
𝐼𝑛𝑛𝑜𝑣𝑎𝑡𝑖𝑜𝑛 𝐼𝑛𝑝𝑢𝑡 𝑆𝑐𝑜𝑟𝑒A.M. Best
= 𝐿𝑒𝑎𝑑𝑒𝑟𝑠ℎ𝑖𝑝 𝑆𝑐𝑜𝑟𝑒 + 𝐶𝑢𝑙𝑡𝑢𝑟𝑒 𝑆𝑐𝑜𝑟𝑒 + 𝑅𝑒𝑠𝑜𝑢𝑟𝑐𝑒𝑠 𝑆𝑐𝑜𝑟𝑒
𝑃𝑟𝑜𝑐𝑒𝑠𝑠𝑒𝑠 𝑎𝑛𝑑 𝑆𝑡𝑟𝑢𝑐𝑡𝑢𝑟𝑒 𝑆𝑐𝑜𝑟𝑒
So basically Best will assess four arbitrary metrics and give you a score from 1 to 4 (4 being the best). If you think I am being harsh calling it arbitrary, see what the difference is between a 2 and a 3 on resources and tell me how you think you would make that differentiation.
2: The company devotes some resources to innovation, but its strategy for managing these resources is not linked to its critical operational goals and the use of these resources is not tracked effectively.
3: The company devotes resources to innovation, and its strategy for managing these resources is linked at least in part to its operational goals. However, there may be some inefficiencies that diminish the overall effectiveness of its resource allocation.A.M. Best
That’s clear? OK, good, didn’t think so.
Next let’s move to the output score. “Output Score is based on two components: (1) results and (2) level of transformation” (emphasis added). Well, that’s at least easier to understand although still somewhat subjective and the difference between a 2 and 3 is similarly murky.
I will make one prediction here: Lots of companies will manage to massage their way to a high input score. Few will accomplish high output scores. In other words, innovation is hard and just because you check a lot of boxes on squishy, subjective criteria doesn’t mean you will add value.
One thought on “Innovation Has Jumped the Shark”
This is the rating agencies getting in on the consulting game best they can, where the big money is. It’s that simple.
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