Disruptive technology to reshape insurance and ILS

Disruptive innovation happened in photography, destroying Kodak when the company failed to foresee the potential of digital technology and clung on to film. It happened in film rentals, when online streaming made Blockbuster’s video and DVD business model obsolete. And it happened to US Steel when mini mills elbowed out integrated steel mills.

It will happen in insurance too. Technology is shifting the pockets of value. It is eating away at the traditional business model whereby insurers create value from offering loss protection, and is building a new model that focuses on mitigating risk. But that is not the only threat. The insurance industry is already scrambling to respond as investors in search of higher yields pour money into insurance-linked instruments (ILS) in the capital markets, disintermediating reinsurers. Technology could accelerate this trend and broaden its impact on insurers. As a result, those who stick too long with the old model will fade as premiums and their balance sheets shrink. Those who thrive will learn to ride the wave of disruption to capture new opportunities – although whether they will still be known as insurance companies remains to be seen; they will have to reinvent themselves entirely.

Auto insurance shows premiums and balance sheets under threat…

Developments in car insurance illustrate the perils. Car safety is improving rapidly. When current traffic rules were written more than 50 years ago, speed limits were set assuming that a car driving at 60 mph needed 250 feet to come to a stop. Today 75 feet is nearer the norm. Collision avoidance systems are becoming mainstream, using radar and sensors to warn drivers of imminent danger, or taking over the brakes or steering automatically to avoid a collision. The effect is that highway fatalities in the United States are already 40% lower than in the 1970s.

It is not hard to understand why some industry analysts predict that safety measures will reduce today’s pool of car insurance premiums by as much as 30% in the next 10 years – premiums that account for as much as 80% of the total premiums written by some leading personal lines companies.

In fact, even this premium remnant is in danger. Most car manufacturers and leading technology companies, such as Google and Apple, are developing driverless cars. Google’s version, which is due to be launched by 2020 at the latest, will have no steering wheel, accelerator, or brake pedal, making it difficult to see how the “driver” will need personal auto insurance when they have no control over the vehicle. Personal car insurance premiums, worth a total of $190 billion in the United States could disappear entirely.

Whatever liability remains is likely to reside with the providers of the transportation and the infrastructure – car fleet owners, highway operators or car manufacturers. Volvo has already said it will accept liability when vehicles equipped with its forthcoming self-driving system are operating in autonomous mode. This type of liability would be covered in the commercial market.

Therein lies the second threat. Some $80 billion of third-party capital is currently invested directly in insurance risks through capital market instruments. That figure could rise to $150 billion by the end of the decade, according to forecasts. With so much money in search of an investment, why would a car manufacturer not bypass insurers and go straight to the capital market to cover its liability?

Some in the insurance industry are inclined to play down the technology threat: of the 115 million cars sold in 2025, it is estimated that only 250,000 will be driverless. But remember what happened to Kodak, Blockbuster, and US Steel.

Moreover, the disruptive technological forces apparent in car insurance are encroaching upon other P&C insurance lines.

….But new opportunities are arising from risk mitigation

Yet what is equally noteworthy is how technology is simultaneously opening up new value-creation opportunities in risk mitigation.

Take connected thermostats that measure temperature and humidity in the home and adjust heating and hot water automatically, or enable the homeowner to do so remotely through an app. These devices, now commonplace, make homes more comfortable and help owners save energy. But they also lower risk. Some will alert the owner if the temperature drops so low that there is a risk of water pipes freezing. Some have occupancy detectors – occupancy being the primary variable for fire risk. Used in conjunction with a smoke detector, these devices can draw on a shared database to develop a risk profile of a house or apartment and, in real time, assess the risk of a fire.

Consider too the internet refrigerator. It knows what it contains and therefore your diet. Then pair the fridge with an internet toilet, of which prototypes already exist! Like the fridge, it can analyze its contents – perhaps to monitor blood sugars and cholesterol, detect a pregnancy, or analyze levels of prostate-specific antigen (PSA) – and give rise to a significant amount of health data that accident and health insurers will find valuable in risk pricing. Data can be used to lower the risk of poor health, functioning as an early warning system that might encourage people to change their diets or see a physician.

These examples indicate how technology’s ability to make our lives less risky could, as with car insurance, lower the cost of health insurance, and open up new value-creating opportunities for those in the business of risk mitigation. Any liability that results from the failure of a device will probably be placed in the commercial market or even the capital markets.

We cannot know precisely how a host of emerging technologies – the Internet of Things (IoT), wearable and mobile devices, big data and analytics, and social media and marketing automation – will be applied. Nor can we foresee all the entirely new technologies that might appear. The intention of this paper is not to discuss them, but rather, as the examples above suggest, to illustrate the power of technology, in conjunction with capital markets, to reshape traditional insurance value networks, and to ask how well insurers are equipped to succeed in the new configurations?

The new value network

The examples above show the transformative power of the IoT, arguably the most disruptive technology confronting the insurance industry today. By 2020, it is predicted that there will be as many as 30 billion objects connected to the internet and embedded with electronics, software, and sensors that enable the collection, storage, and analysis of data.

The IoT has three value-generating components:

1. devices that collect data
2. the data itself
3. the analysis of that data to reveal insights upon which business decisions can be made

Some companies might generate value from just one component; some from all three. But many of today’s insurers could come to find they are not well placed to capture value from any.

Data-collection devices

Clearly insurers are not natural manufacturers of data-collection devices. Indeed, even distributing such devices has proven a challenge, as customers are wary of insurers tracking their behaviour in case it leads to higher premiums – as some car insurers have already discovered. Many now offer customers the option of using telematics as a means of lowering their premiums if they prove to be safe drivers. A simple device fitted to the car records mileage, braking patterns, and how much time is spent on the road at night, when most accidents occur. But relatively few customers accept the offer.

The data itself

It follows that if insurers do not own the devices that collect data, they will not have access to the second valuable component of the IoT, the data itself. Modern cars have built-in telematics that store data in the cloud. While these are marketed as diagnostic tools to improve performance, car manufacturers are arguably gathering better data with which to calculate insurance premiums, than car insurers themselves, as the latter rely on little more than a driver’s age, gender, and abode to calculate risk.

Data analysis

When it comes to the final component, data analysis, device and data owners cannot yet match insurers’ expertise in underwriting risk – or at least not on their own. OCTO, a telematics company, currently works alongside insurers and car fleet managers to underwrite policies. But how long will it be before OCTO or any other newcomer has the devices, data, and analytical capabilities to disintermediate insurers?

The same question can be posed of capital market disruption. Insurers’ and reinsurers’ skill and profits lie in dealing with uncertainty. But technology reduces uncertainty, allowing for much greater standardization by generating large, homogenous data pools and automated analytics and underwriting. For now, most third-party capital is invested in property catastrophe risk, but this standardization will make different types of risk increasingly suitable for securitization and attractive to investors.

Why insurers need to disrupt themselves

Insurers need to make bold moves while there is still a window of opportunity. New data is being generated and is owned by the distributors of things, but insurers have valuable historic data with which it can be married, along with risk analysis expertise.

Within a few years there could be so much accumulated new data that insurers cease to add underwriting value. As things stand, insurers have relatively few skills and capabilities to offer in the emerging value-creating opportunity – that of mitigating risk. They will therefore need to seek partners if they are to remain relevant in this new value network.

By doing this, insurers will in fact disrupt their own business model. Returns will come under threat as profits are shared with partners. Insurance distributors will be alienated as products are marketed through device owners, and premiums will be driven lower by technologies that mitigate risk. An alternative would be for insurers to sell their existing data to device manufacturers or other data owners and become consultants.

With so much pressure on companies to deliver short-term profitability, such bold moves will be hard to make. But history is full of companies that failed because they made only small, incremental changes in the face of disruptive innovation. Incumbents tend to cede the territory, thinking it better to focus their resources on more complex and often more lucrative business.

But as technology improves, it relentlessly conquers more of the market. That is what happened to Kodak. When low-quality, low-margin digital cameras came on to the mass market, the company could not conceive that they would impact the lucrative professional market for film. Kodak therefore stuck to the business it knew. However, in time, the quality of digital cameras became good enough for the semi-pro market, and eventually the digital SLR camera for professional use was born, rendering their films obsolete for the mass market.

The same pattern is likely to emerge within insurance. Today, it seems clear how technology is disrupting value networks in auto insurance – the simplest of insurance policies. But over time it will reduce premiums and shift the focus to risk mitigation for more complex insurance products, such as life assurance.

Wearables can already monitor our health, and genomics can predict the probability of illness and life expectancy. Combine this with medical advances in diagnostics and treatment, and it is not hard to see how life insurance premiums could fall as reams of data emerge that enable life to be extended. Given the appeal of longevity, those able to collect and analyze such data will surely be part of a valuable network. This will however be a complex network, including, for example health providers and pharmaceutical companies as well as device manufacturers.

There will also no doubt be complex ethical issues to resolve. Today’s insurance model works by pooling the risks faced by large numbers of people to minimize the costs of those that pose the highest risk. Personalized data is breaking that model. While many might argue it is reasonable to use driving data gathered from devices to force dangerous drivers to pay higher car insurance premiums, the use of personal health data for determining life insurance is far more controversial. For example, there is already fierce debate as to the extent genetic tests should inform life insurance premiums. In this network, value will lie in collecting, owning, and analysing data. Whether insurers can be part of such a network will depend on the extent to which they embrace disruptive innovation.

Many insurance companies are investing heavily in technology, though too often they are still aiming for incremental improvements to their business rather than daring to face head on the disruptive innovations afoot. History records hundreds of companies overtaken by such disruption. But so too does it offer shining examples of companies that had the courage to embrace it. Which camp will today’s insurers find themselves in a decade from now?

Rafal Walkiewicz is Chief Executive Officer, Willis Capital Markets & Advisory (WCMA).  He joined Willis in 2014, bringing over 15 years of international experience working with financial institutions and, in particular, insurance companies. He has a long track record of successful execution of multi-billion and mid-market transactions in developed and emerging markets.