Short story: All the value goes to the consumer
I previously wrote about my skepticism surrounding insuretech’s ability to succeed. Today, I will focus on why innovation won’t succeed for incumbents either.
Let’s agree on some definitions first. A successful innovation is one that improves the competitive position and financial returns of the company who develops it. An innovation that improves the customer experience but does not help the insurer strategically or financially is a neutral innovation. When a neutral innovation costs a lot of money to develop, it is called a charitable act. Those more cantankerous than me would call a charitable act a really bleeping poor business decision.
If your takeaway from the definitions is that what follows will be “I bet he’s going to say there are a lot more charitable acts than successful innovations”, congratulations! Johnny, tell him what he’s won…
Revisiting Economic Rents
At the risk of everyone clicking away, I am going to drag you back to econ 101 with a brief reminder of economic rents. This is surely something everyone knows even if the terminology is rusty. Rent is a proxy for profit. It basically is profit above a market norm.
If you produce a commodity like corn and you sell it at the market price and your production costs equal that of the average farmer, you have created no rent. If you used technology to lower your production cost, that difference means you have created rent while your neighbor farmer still has none. Similarly, if you can find a way to sell above market, you have created rent (think of the gas station owner who raises prices before the hurricane hits).
Most good businesses have created rents. They either can produce cheaper or sell at a premium. Perhaps they have a distribution advantage or a popular brand. There are lots of ways to create rents.
The Rents of Insurance Innovation
Insurance is a funny product. Even though people know they need it, many only buy it because they are compelled to, either by regulation or contractual obligations. Thus, the demand curve doesn’t work like a normal industry. Lowering the price will not create more demand (yes, in some cases people will buy more limit but that is not the norm). All it does is transfer market share until pricing finds a new equilibrium.
So while spending a lot of money to create a better claims experience or to simplify the quoting process sounds great in theory, it is no more than a charitable act. A gift to the customer. They will not buy more policies because you made it easier to get one. They may stay with you longer if you make claims less frustrating, but once others emulate you, the added retention benefit gets passed along in lower prices to chase the smaller pool of new shoppers.
Let’s go back to that farmer who lowers his cost through a technology breakthrough. He initially creates rent for himself. But can he sustain it? Unless he can protect his IP, eventually it will be copied and everyone will get the benefit of it. When this happens, everyone’s costs come down, but then the cost of the corn comes down too. Rent goes back to zero. In other words, the rent got transferred to the consumer, in the form of lower corn prices. The “technology breakthrough” was no more than a charitable gift to the customer.
This is what will happen with “insurance innovation”. You can spend a lot of money making the product more user friendly and claims less stressful, but to what effect? Yes, there is value in the industry being viewed as less adversarial and more customer friendly (as long as we’re not measuring it with BS like net promoter scores!), but there is no lasting financial benefit.
The Consumer Always Wins
If say you cut claims cost by 10%, once everyone else sees what you did and copies it, they will lower pricing by 6% (assuming 10% off a 60% loss ratio) and margins end up in the same place.
Worse is you do something that raises your cost structure to improve the “customer experience”. This is all the vogue today. The problem is, if others can crib it, then all we’ve done is raise everyone’s cost structure for no revenue benefit because customers will not pay more for this benefit. This is not Amazon where I buy more stuff on Prime if you make it better. People might move carriers for a year for a simpler application, but they will not pay more. As with the farmer, all the rent goes to the consumer.
The best case outcome is you gain an edge for a few years which then gets competed away. This can be a viable strategy if that edge is big enough relative to the cost. Probably the best example of this was the early days of credit at Progressive. They opened a window where they could grow faster at better loss ratios (through favorable selection) for several years before others caught on. However, eventually everyone did catch on and credit is now table stakes to play in the auto insurance market. The same thing is happening today with Progressive and telematics, but again it is a limited window that will only stay open for so long.
The Only Way To Increase Demand
If the trick to successful innovation is to increase demand, how does one do that? Very simply actually! You have to create new products. The true innovations in insurance have been new classes like environmental and D&O. Cyber may be that but it is too soon to say.
As an aside, cyber has been a gigantic disappointment in my view, as it has been overly competitive and underpriced from day one. Yet, it is the one insurance product a corporate CEO cares about. They are far less price sensitive about cyber than workers’ comp. There should be pricing power here, but there hasn’t been.
Back on point, new products means new revenue and typically better margins. That was certainly the case in environmental and D&O. Those are real rents!
What could be the next new product? The most obvious one is residential flood. I know all the reasons it is hard. That is precisely why there are rents available to someone who can figure it out. Technology should make it a lot easier to solve than it used to be. There are a lot of potential premium $ to be collected here. Yet, whenever I suggest this to a company, they recoil like I asked them to eat bugs (which are actually a cheap source of protein!). Note, these are the same companies spending hundreds of millions of $ on likely charitable acts.
That leads to a final thought: True innovation is the willingness to do something different and hard rather than copying what everyone else tells you is innovative but nobody can explain why it actually matters.