When I am asked what insurance is, I have until recently thought it was sufficient to trot out one of two old faithfuls. I would either say that it is was the mechanism by which the premiums of the many pay the losses of the few or that it was a promise made to pay losses by an entity that can afford to pay them, to one that cannot.
As far as they go, in “insurance as usual” terms, these descriptions work. But I have now realised that they are typical of much shorthand; they have made me think too lazily about what insurance is and disguised what I am coming to think of as the inadequacy of “insurance as usual”.
Thanks to two recent conversations, I have had something of an epiphany; though at the time, for someone who thought he had been thinking about Insurance 2.0 for some time, it felt more like being slapped around the face with a wet fish…
I would be interested in hearing if this – with some clarification – gets a bit closer to the core of what insurance is?
Insurance is the mechanism that converts uncertainty into risk.
In thinking about insurance this way, I have also come to realise what Insurance 2.0 should be.
In Insurance 2.0, I will become my own intermediary between uncertainty and risk.
First, a couple of definitions and clarifications. Here I am using risk and uncertainty as the difference between being able to measure, or not, the possible outcomes in any given situation. In one situation – the uncertain one – there is, for example, insufficient information to measure the possible outcome(s). In the other, one can measure the risk of one outcome – or even a number of possible outcomes. Risk is measurable, uncertainty is not; it is as simple and as complicated as that.
As I have come to think about the inadequacy of insurance, the uncertainty I am thinking about is your and my uncertainty if, like me, you have a family, a job, a mortgage, you drive a car and are healthy. It applies equally well however, for a business with assets and resources, customers and debts, let’s say.
Both the business and I have a general idea of what could go wrong with any of the things that matter to us but neither of us – on our own – can measure the probability of a material detrimental event occurring, how bad such an event could be or what really works – and is worthwhile to spend money or time on – to improve either situation, whether before, during or after such an event. I am not sure which is the chicken and which the egg but I think the reasons may lie in and around the ideas that we all have too many other things to think about and, even if we wanted to, we have no yardstick against which we can make any kind of calculated risk judgement.
Risk on the other hand, as I am using it, is a very different concept. On the basis of detailed calculations using data on the past performance of portfolios and projecting forward by factoring changes to the data, insurers aim to put themselves into a situation where they have (say) just a 0.01% chance of loosing more than the premium they collect and their capital from losses arising from the multiple portfolios of insurance policies they write. This is carefully calculated risk.
So, the conversion process occurs when insurers make promises to buyers to relieve them of a little of their uncertainty in return for a premium, and in so doing, they accept the risk of how the sum of those promises will work out. The specific processes are:
1. Pick one of the things someone is uncertain about;
2. Issue a promise that covers some of it; and
3. Aggregate lots of as similar promises as possible.
Then, go out and pick something else someone is uncertain about, that is preferably uncorrelated to the last thing you picked, and repeat. And keep repeating until you have what you believe is the optimum balance of risk, premium and capital. Then adjust as environment changes require.
It is a bit more complex than that – but not by much – and I accept that there is a genuine and valuable promise made by the insurer, though some seem more willing to fulfill their promises than others. The problem is that the amount of uncertainty removed by any one promise or policy (and so the value of its removal) is tiny (a highly technical, quantitative term) and cognitively, the value might even be negative given the known difficulty of dealing with insurers – but I digress a bit.
The more central point is that every policy is tightly focused on a particular peril and has limits, deductibles and other qualifications that make it, by design, incomplete even for the peril it addresses. I haven’t worked out the math (pun intended…) but even if I bought every single insurance policy I could possibly buy, I couldn’t insure (even if I could afford to) everything, so I would still be left with residual exposure. And I would still have done precisely nothing to make any of the events insured against any less likely to occur or any less damaging if they did.
I have no problem with insurers – or anyone else – making a profit and I expect profit to be earned but, with insurers making a profit by turning my uncertainty into their risk without making any appreciable difference to my uncertainty, I am no longer sure they are doing enough to justify my premium or the profit they make from it.
I want a service that delivers more than that. And I think the tools are now available to deliver more in the form of Insurance 2.0.
Insurance is known as a risk management tool – but it is really only that when looked at from the perspective of the insurer, who creates risk – and its corollary, reward – by making many little, similar but very selective promises. Insurers turn uncertainty into risk for their benefit and, to the extent there hasn’t so far been any alternative, I have accepted what has been offered.
What I really want though, is a suite of tools to help me manage uncertainty. If, by using them, I can become my own intermediary between uncertainty and risk, that would be fine… I am sure it would involve some work but, for example, to have a clear understanding of what risks I have, whether I can take more or less of them and to understand the many different ways I can increase or reduce them – these would all be valuable. And I am sure it would be cheaper and more effective to buy risk protection than uncertainty protection, which is really all I can buy now.