Insurance – Underwriting at what cost?

The other day, I came across Rahul, an underwriter friend of mine from one of the insurance companies. While we started chatting about a client, his first question was: What is the price (premium) the client is willing to pay? I was stumped by the question, I retorted:

Why don’t you underwrite the risk rather than price it?

I later found out that most of the underwriters started with the same question in mind. Perhaps, that explained the underwriting losses of the insurance industry. The total underwriting losses of the Indian general insurers jumped 31% to USD 2.70 Bln in FY 2017 from USD 2.07 Bln in the previous year, according to industry estimates. (In the insurance world, underwriting income is equal to the premiums collected from underwriting the risk less Expenses and Claims pay out, if any)

While underwriters/CEOs of most of the insurance companies talk about inadequate pricing, they however fail to walk the talk when it comes to underwriting principles. Below are some of my thoughts resulting in such outcome:

  1. Incentive caused bias: The yearly bonus of many underwriters/CEOs is tied to the amount of business they generate, and not based on how profitable the underwriting business has been. This is one of the primary reasons why they are keen to take up business, sometimes at any cost or no cost. Investment income supposedly, substitutes for the low/nil underwriting income.
  2. Inability to sit calm: As Blaise Pascal had said “All of humanity’s problems stem from man’s inability to sit quietly in a room alone”. This is often the reason why underwriters/CEOs want to look busy rather than productive, often at the cost of doing unprofitable business.
  3. Inability to sustain large performance variation: If the underwriters/CEOs were to voluntary let go businesses which are sub-optimally priced, it would be subject to large fluctuations in their volume of business. Valuations of businesses are often derived by increasing volume and pricing. While pricing in commodity-like industry, like insurance is often market determined where the insurance companies are mere price takers, volume is the only way wherein increased revenues can be generated, often providing an illusion of enhanced value creation. 
  4. Low barriers to entry: With no major losses having been witnessed in the last couple of years in the insurance industry, capital availability is not a challenge, thereby underwriters/CEOs wanting to deploy cheap capital by underwriting businesses, often with an intention of generating float income alone.
  5. Information overload Fallacy: Since some of the underwriters/CEOs have been underwriting the same risk since many years in a row, they perceive that they know the account “inside-out”, thereby failing to see obvious or emerging risks. Often, the businesses are underwritten basis relationship rather than from a risk perspective.
  6. Sunk Cost Fallacy: Cumulative prior investment of time and effort often makes the underwriters susceptible to sunk cost fallacy, wherein they want to continue their decision of underwriting even if the expected underwriting loss outweighs the expected float income. It’s like sitting through a crap movie just because you have spent money on it.
  7. Everyone else is doing it/Envy Bias: This is one of the cardinal sins of underwriting. It takes huge underwriting discipline to select the businesses an underwriter would be keen to look at “independently”. Just because your neighbor is getting richer faster than you, you start to get envious; that’s foolishness.

While, Rahul did win the business of the client in question, it led me to wonder, at what cost?

Disclaimer: Please note that these are my personal views. I am NOT a registered Research Analyst as per SEBI (Research Analyst) Regulations, 2014. All investors are advised to conduct their own independent research into individual stocks or industries before making any decision. In addition, investors are advised that past stock performance is not indicative of future price action. 

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