PAYD usage-based insurance: how disruptive is the business model?

In a recent blog, Insurance Networking News’ editor Bill Kenealy drew a direct parallel between the rising wave of insurer interest in telematics to a thought-provoking essay in the Wall Street Journal by Netscape founder and venture capitalist Marc Andreessen about the propensity of software to “eat” existing business models and even entire industries whole.

What prompted this was Bill's attendance at Insurance Telematics 2011 Conference. He wrote that the ascent of telematics has meant that forward-thinking auto insurers have been able to offer insured usage-based or pay-as-you-drive policies, with Progressive’s “Snap Shot,” State Farm’s “in Drive” and Allstate “drivewise” programs being prime examples. And he cited examples of where the value proposition of telematics could be disruptive for personal and commercial lines auto insurers. For instance, it could have a broad impact on product pricing and policy administration, by allowing insurers to price more efficiently, and to redefine the customer experience. In claims, the impact is obvious. Insurers can know the precise time of accident and the cause, for example, and claims lifecycle times can be dramatically reduced.

In addition to Bill's list, there is another significant, highly-disruptive impact: the potential for first-movers to be able to cannibalize the book of business of those companies that either cannot afford or cannot currently support usage-based insurance (UBI) offerings. The result is an across the board re-pricing of premium that leads to the loss of preferred customers - low-mileage, lower risk – to companies that are quicker to offer UBI/PAYD options, and higher rates for the remaining higher-risk policies. Insurers’ books of auto insurance that are usually so finely balanced become unstable.

Hollard Insurance executive Roger Grobler, whose company offers both telemetry and non-telemetry PAYD (using Exigen Suite), has spoken compellingly of this conundrum for the slow movers. He likens it to the concept of Prisoners Dilemma, which is a game theory problem:

Two men are arrested, but the police do not possess enough information for a conviction. Following the separation of the two men, the police offer both a similar deal- if one testifies against his partner (defects / betrays), and the other remains silent (cooperates / assists), the betrayer goes free and the cooperator receives the full twenty-year sentence. If both remain silent, both are sentenced to only one year in jail for a minor charge. If each 'rats out' the other, each receives a five-year sentence. Each prisoner must choose to either betray or remain silent; the decision of each is kept quiet. What should they do?

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How does this apply to PAYD insurance? Grobler explains it this way:

In traditional insurance, people who drive less, pay the same as people who drive more … [But] PAYD introduces accurate pricing for mileage, and by doing so low mileage drivers can receive a more accurate and fair premium.

If you are an existing insurance company with a large book of existing car policies, you most likely have a finely balanced book that is profitable, albeit with thin margins. Your pricing is working, and the cross-subsidies between high mileage and low mileage drivers are balanced. If you introduce PAYD you will charge low mileage drivers less (and a fairer price) and high mileage drivers more. High mileage drivers will most likely leave you and take insurance from someone else who still provides traditional insurance. As an insurance company you face the prospect of losing a large part of your book before you can replace it with low mileage drivers (where you are in fact competitive). That is a daunting prospect. You have a large infrastructure in place which you've built up painstakingly and which is well matched to your current size and volume. If you lose material volume your expense ratios will blow out, which will in turn very quickly eat through your thin margins, leaving you unprofitable. That is not an appetizing scenario for any insurance executive.

So this is where the multiple prisoner's dilemma comes in. If nobody acts (i.e. nobody offers PAYD), then status quo remains, books remain finely balanced and life goes on. The first large player to offer it faces the uncertainties listed above, and may take some short term strain. After the short term strain however, the first mover(s) will start benefiting from attracting more and more low mileage drivers and having a competitive offer for arguably 50% of the market.

What does that do to the other companies? As their low mileage drivers start abandoning them, their book becomes unbalanced. They have less low mileage drivers to cross-subsidize their high mileage drivers. Over time their margins will erode, and arguably in time they will be forced to switch to PAYD.

The Prisoner's Dilemma is not a trivial problem for existing insurers to overcome, and I think it will take many years for them to do so.

Watch Roger Grobler speak at ACORD LOMA Forum about PAYD here.