Why strong underwriting is insurance’s ‘alpha’

Why strong underwriting is insurance’s ‘alpha’

Capital markets investors are in a perpetual search for ‘alpha’. They see opportunity in market dislocation, often utilizing complex financial instruments, clever trading strategies, unique and proprietary data, and even the placement of servers closer to exchanges to shave milliseconds in transaction latency. These tactics enable the savviest investors to find pockets of trading arbitrage to achieve superior returns (alpha) which consistently exceed the market’s average performance (beta).

While a sound investment strategy for the float is an essential component of insurers’ economics, the ideas and methods used by increasingly tech-enabled capital markets investors are particularly instructive in guiding the ‘insurance’ side of any carrier’s operations. Indeed, the core business of underwriting risk presents tremendous opportunities to deliver superior risk-adjusted returns.

Alpha vs. Beta in Insurance

Simply put, performant underwriting represents the true ‘alpha’ in insurance. Carriers which can consistently deliver superior combined ratios have an enduring and expansive edge over their competitors. Such carriers can offer better coverage and rates while maintaining profitability; they can negotiate more favorable reinsurance agreements; they have access to a lower cost of capital; and they can deliver a compelling value proposition to any distribution partners in order to access new customers and growth. All of these benefits are recurring and compounding, further growing the gap between strong and weak underwriting organizations.

By contrast, nominally strong product distribution, without superior underwriting, only yields magnified ‘beta’ returns. Even in today’s low interest rate environment with plentiful access to capital, a lack of underwriting proficiency implies that rapid growth in distribution only amplifies and accelerates losses, leading to an increased reliance on reinsurance capacity or a constant stream of cheap capital to finance expansion and fund losses.

Growing insurer market share through ongoing injections of new capital — the typical approach of fast-growing technology companies — rapidly runs out of steam as the promise of improved unit economics never arrives. In insurance, unlike with other industries, the economies of scale and network effects that make a distribution-centric strategy sound are offset by more onerous regulatory and capital requirements from reinsurers and other providers of paper or capital. This leads to a vicious cycle of weak underwriting leading to adverse risk selection which then leads to inferior access to capacity and capital and, ultimately, to a more poorly rated and deteriorating insurance product. Customer acquisition cost (CAC) keeps on growing and Lifetime value (LTV) keeps on shrinking: hardly the recipe for success.

What this means for carriers new and old

In order to win in a competitive marketplace, carriers must focus on generating ‘alpha’ and avoid the allure of seemingly easy ‘beta’ solutions. This requires that leadership place an emphasis on first principles.

Carriers and their partners need to ensure that they resolve the information asymmetry which plagues the typical insurance transaction. By focusing on the actual exposures and controls of every risk, underwriters can better quantify and price risk. Doing so will allow carriers to construct a book that is profitable, fast-growing, and which provides their customers with the protection that they need. This is the way insurance should work.

Effective use of technology can make a huge difference in delivering sustainable profits in insurance, just as it has for capital markets. When tightly coupled with excellent human underwriters, artificial intelligence can unlock key insights on every risk, reducing opacity and friction from each transaction. Furthermore, AI-powered underwriting can enable insurers to act on those insights rapidly, while continuously providing feedback which helps the AI learn faster, allowing it to deliver increasingly impactful recommendations and more profitable risk. This is a consistent, compounding, and enduring arbitrage: insurance alpha in action.