Future Profit Models for Insurers and Their Agent/Broker Partners
I read an article written by a former carrier CEO who is now a consultant and private equity backer to insurance ventures. The main point of the article was that insurtech, or any paradigm shifting insurance entity, will not really make a difference until 75%-80% of every premium dollar is returned to insureds (meaning in claims dollars, which means loss ratios of 75%-80%) rather than the 55%-65% that exists today.
If carriers can run loss ratios of 75%-80% and remain adequately profitable, they will revolutionize the industry. This is without question because their price advantage would be tremendous.
The author referenced some big numbers and that is why the article caught my eye. At first, I thought he must be nuts like some of the headline grabbing start-ups. Before concluding he was nuts, however, I thought I would analyze the numbers. A carrier achieving adequate profitability while running 75% loss ratios will put a lot of other carriers out of business so at least a cursory analysis was justified.
Carriers are already quite cognizant that they must decrease their expense ratio. The ONLY two ways to be adequately profitable at a 75% loss ratio (at least legitimately with straight accounting) is to decrease expenses or increase investment income or some combination of the two.
Some carriers think a reciprocating saw cutting commissions and staff drastically is the solution to reducing expenses, while the smarter ones understand a surgical approach is a better solution. It is their billion dollar enterprise to build or ruin and the CEOs are paid far more than I make, so maybe the gross approach is correct?
Over the last 10 years the average property/casualty loss ratio has been approximately 65%. The average underwriting profit margin has been about 0%. The average combined ratio has been 100.2% per A.M. Best. To get to a 75% loss ratio, carriers can then cut their rates by about 10 percentage points. They would then lose about 10 percentage points of profit. Many, and I mean many, carriers do not even achieve a 100.5% combined ratio so those carriers would lose so much money, so fast, they would fold.
To avoid selling or death, they must cut 10 percentage points of expenses. The average LAE is 10.2% as of 2021 (a huge improvement over the 10-year unweighted average of 11.4%). Carriers are working hard to cut their LAE with a goal that somewhere around 80% of all claims will be settled without a human claims adjuster. Time will tell if they are successful. With a generic mix of business, the best case LAE today is around 9% (some carriers are focused on easy-to-settle claims and are down to around 8% but difficult lines are correlated with much higher percentages, around maybe 18%). Let’s say they achieve an improvement from 10% to 9%. That leaves another nine percentage points, at a minimum that must be cut from underwriting expenses.
The average underwriting expense ratio was 26.3% in 2021, a full percentage point improvement over 2020 per A.M. Best. With each incremental improvement, the next incremental improvement becomes more difficult to achieve. This is the Law of Diminishing Returns.
The largest single component for most agencies is commission expense. Carriers cannot really cut postage or IT enough to make much of a dent. Even if they cut staff, and given how bare some already are, cutting further has serious limitations, the additional savings is probably only a point or two, at best, unless they are currently being severely mismanaged. Carriers can buy less reinsurance, which for some is a major expense. But when they buy less reinsurance, all else being equal, they lose capacity. They could cut their dividends, but their shareholders would be unhappy.
The one fat target is commission expense for carriers that pay full commissions. The average commission rate for the industry is a misleading number given how some carriers pay no commission and because of how much reinsurance some carriers purchase, their commission expense is materially negative on a net basis. Of the carriers that pay full commissions, some when contingencies are included, carriers pay nearly 20%. That model will not survive. Sixteen percent is common among the regional carriers and that is rich, especially considering how little some (not all) agencies do.
If you are a carrier and you have an agency with $300,000 in premiums, 0% growth and an average 55% loss ratio over five years, that agency is not worth a 16% commission. They are not worth a 12% commission. Much less if you are paying 16% in commission simply because they are part of an aggregator/cluster.
Cutting everyone’s commission is the reciprocating saw approach. Paying for performance is surgical and smart.
I did a study for a carrier and the surgical approach works for carriers with the best leadership. Executives must possess a spine so they do not just mail out new contracts but take the time and energy to explain the process in detail. They must be able to take the grief they will get but still stand their ground.
Given the technology available to autofill applications, map each property in detail and other upfront underwriting tools, price can be applied more accurately, especially when combined with the right predictive modeling software. Carriers do not need to pay agents to complete applications and upfront underwrite if the carriers possess the right technology and use it well. Those carriers that cannot/will not, are already losing market share every year even if they show growth because the carriers that are doing it well are growing so much faster.
To achieve a 75% loss ratio, these carriers are going to have to cut between three and eight points from commissions.
The former insurance executive is probably correct that winners will have a model that returns around 75% of premiums to insureds by running a 75% loss ratio.
The level of leadership and intelligence required to be successful with such a small margin of error will be high. All the slack will be removed in this model and frankly most carriers are not equipped to run so precisely as of today. I think that is an open secret.
For agencies, this means emphasizing efficient operations. Sales mindsets have always been the primary focus of agencies but going forward operational efficiency must be elevated to an equal level. It is the only way, other than cutting producers’ commissions, to save enough money.
Improved operations also means better errors and omissions (E&O) protection because improved operations, if achieved, must, absolutely must, follow the rule of invariable practice. In other words, everyone in an office must follow the agency’s procedures, all the time and every time. Invariable practices result in staff being able to effectively service more business in the same amount of time. Good practices also means helping producers to stop chasing lousy accounts. This, by itself, saves an enormous amount of time.
One does not have to go “corporate” either to achieve standardization. It just means not allowing people to do whatever they please.
The future is pretty obvious. Carriers and agencies must cut their expenses. The winners will do so and the losers won’t.