InfoSys 296a.3

Fall, 1996

Instructor: Prof. Howard Besser Term Project

Internet Commerce in Insurance Market

by: Ziun-Yih Yeh

SID: 120-396-01

Ziun-Yih Yeh, Department of IEOR, fox@pivot.berkeley.edu


CONTENTS ________________________________________________________________________

1. Abstract

2. Introduction

3. Insurance Industry Practices

4. Past Predictions, Current Situations, and Future Predictions

5. Technical Criterion for Insurance Internet Commerce

6. Impact of Insurance Internet commerce

7. Conclusion


1. ABSTRACT

Technology has taken a giant leap since the popularization of internet in the early 1990's. Internet has impacted on human life in various ways. Since the beginning of financial service via internet in 1994 by some pioneer brokerage companies, internet commerce has been disseminating into various financial service sectors. Insurance industry has long been watching the internet application development. Technology constraints are no longer impossible barriers for the insurance internet application. Instead, legal constraints and business units resistance are playing down the wide adaptation of insurance internet commerce. However, soon, the market competition force will make the shift to insurance internet marketing inevitable. Insurance marketing may be changed forever after.

2. INTRODUCTION

Insurance is an old business. It has been around since the 17th century. Until today, technology evolution did not cause any evolution in the insurance industry. Business conduct in the insurance industry is very much the same as what it was three centuries ago. The internet opened up endless possibilities for the human society. Insurance industry, like all other industries, has been watching the development of internet ever since the internet gained broad media publicity. Due to many obstacles, the insurance industry has only been able to utilize internet as one of the avenues of advertisement and public relationship. Insurance internet commerce, which means insurance companies can sell insurance products through internet, is not yet a realizable practice.

Under the free enterprise environment in the United States, it won't be long for the first genius to emerge in the insurance internet commerce arena. Technologies to achieve insurance internet commerce are in existence today. However, utilizing those technologies involves politically disputable practices. Among them, privacy issues and fairness issues are the most salient ones. When insurance internet commerce happens, the way people purchase their insurance will be changed forever; so are the definitions of privacy and fairness.

3. INSURANCE INDUSTRY PRACTICES

Insurance industry is a line of business that assumes all or part of an unknown adverse event of the insured party for a certain amount of monetary resource for a specified time period. An insurance company conducts its business by offering insurance policies. Customers purchase insurance policies from the insurance company to avoid some possible adverse events against their interests. If the adverse events occur, the insureds (who purchase insurance policies from the insurance company) obtain monetary or physical object compensation from the insurance company for the insured interests that have been lost. If the adverse events do not occur, the insurance policies expire without loss generated.

3.1 Revenues and Expenses of Insurance Company

An insurance company gets its revenues from two sources: premiums received from the insured and investment income. On the other hand, it has three expenses to pay: losses from insurance policies, agent commissions, and operation cost. Despite the hefty premiums charged from the general public, insurance companies in general are operating on a very thin profit. Excluding the investment income, a majority of insurance companies are operating on negative underwriting profit territory. A more detailed break down of a typical insurance company's income and cost structures is as follows:

While the general public is blaming the insurance companies for insurance rate hiking, it is really not a cheap business to run.

3.2 Marketing Structure of Insurance Company

Insurance companies are breaking into three main categories in terms of their marketing methodologies: direct companies, agent companies, and mixed companies. For direct companies, they have headquarters and branch offices. The sales staffs are salaried employees. Thus, direct companies do not have to pay the commissions as high as that of agent companies. However, the down side of the direct companies is that up keeping the sales staffs and the branch offices loads burden on their operation expenses. For agent companies, the headquarters and a few branches will be processing all business that the agents bring in. The agents may be captive agents, who sell only one insurance company's product, or free agents who sell multiple insurance products for many insurance companies. The agents receive commissions for the business they acquire, not salaries from the insurance companies. The agent insurance companies are able to expand their market shares through the agents without having to maintain many branch offices and sales staffs. However, they have to pay a larger portion of the insurance premium as commissions to the agents. For mixed companies, it has both features of the direct companies and the agent companies.

In the United States, direct companies are not the majority. Most insurance companies are either agent companies or mixed companies. Since the business of insurance involves moral hazard and averse selection, knowing the customer is a very import factor that no insurance companies can over look when attracting new clients. Thus, the insurance companies are happy to depend on the agents to bring in new business with a common belief that the agents know their customers before the agents send the applications to the insurance companies. From consumers' view points, the insurance policy is a legal contract that has pages of confusing terms and conditions. People rely on the insurance agents that they personally acquainted to suggest and explain the best insurance products that suit their needs. Thus, although conducting insurance business through agents makes insurance business an expensive business to run, the insurance companies and the consumers find it as the most trust worthy way to sell/purchase insurance products.

4. PAST PREDICTIONS, CURRENT SITUATIONS, AND FUTURE PREDICTIONS

4.1 Past Predictions

Since the world wide web became popular in the early 1990's. The academic field and the media gave it a very promising out look in the way human's life will be fundamentally changed by the internet. Insurance companies were speculating the idea of conducting insurance business through the internet and cutting out insurance agents. Agents were thought to be technologically and financially disadvantage to confront with the train of agent-less insurance environment.

4.2 Current Situations

As was expected, all major insurance companies have set up their own web sites in the past two years. However, the scenario of agent-less insurance internet commerce did not occur. Quite contrarily, insurance agencies were able to kept up with the pace of technology and used the internet to leverage with the insurance companies. The agencies set up their own web sites, too. By utilizing the features of web browsers, the agencies introduced a lot more varieties of insurance products for internet users to do one- stop shopping. By completing one insurance information form, an internet users can obtain hundreds of insurance quotes for the insurance products that fit his/her specifications. Although it takes quite a bit of the hassle to have to fill out all insurance information at a detailed level, it certainly beats the bigger hassle of having to call hundreds of insurance companies to get the best quotes. Thus, the importance of agencies did not diminish with the advancement of technology, rather it magnifies.

However, the advancement in technology did impact the growth of insurance agents. Since the agents can process more insurance inquires than what they could before, the number of insurance agents did not grow although demand for insurance has been growing steadily. Rather, the number of insurance agents are shrinking due to efficiency improvements.

Web sites of all major insurance companies are serving as information stations for internet users. The expected insurance internet commerce did not happen for a number of reasons. The most significant ones are:

Regulation constraints come from the regulatory body of the state insurance committees. Since the insurance industry is regulated by the state insurance committees, an insurance company will have to comply with all of the states' regulations for which it is conducting business in. The state insurance committees are mostly conservative in relaxing new insurance practices. So far, only Utah approves insurance internet commerce.

Business units resistance comes from the inside of the insurance companies. Although some CEOs with vision foresee the immense potential of insurance internet commerce, the business structure may not be set up for it. Since most insurance companies in the United States rely on agents to gain new business, the insurance companies are cautious in competing directly with the agents.

4.3 Future Predictions

Insurance internet commerce is destined to arrive in the future. Direct companies are already enjoying better than average profit results because of not having to pay hefty commissions to the agents. The internet provides yet an other marketing and advertisement channel for the direct companies to appeal to a broader audience with much more details on their products at a much cheaper cost. Once the regulation gives green lights to insurance internet commerce, the direct companies will be able to accept and process insurance applications on the internet. Soon, the efficiency improvement of these direct companies will reflect on their insurance premium reduction (state insurance committees only allow certain percentage of profits for insurance companies to make. If an insurance company makes too much money, the state insurance committees will request the insurance company to review its rates.) . Market force will then force agent companies to cut commission rates and attract more new business directly in addition to agency referral. Eventually, insurance agent will become an occupation that can only be found in the history book.

As a result of massive efficiency improvement in the insurance industry, insurance company mergers will assume the current train in financial institutions (banks and saving and loans). The merged insurance companies will be able to consolidate and reduce their operation cost and eliminate agent commissions. The insurance market will gradually evolve into an oligopoly market with only a few big insurance companies left, operating on the efficient front. A large portion of insurance employees are document processing staffs. Those positions will be eliminated when the insurance companies conduct business through internet. Large scale layoffs are an inevitable consequence of the business efficiency improvement. Insurance agents have been playing an important role in the insurance market. The insurance agents are the humans that the insurance applicants interact with. The insurance applicants gain knowledge and trust about an insurance product through having conversation (face to face or by the phone) with the agents. To fill in the vacuum of knowledge and trust that are created after insurance agents have been eliminated, some of the document processing staffs or the insurance agents can assume the role of customer service. Since technology can't replace the human touch yet, the insurance companies need to have abundant customer service staffs answering the questions that people have in a timely fashion. However, this massive customer service staffs will be trimmed as people gain confidence buying insurance through the internet. Toward the end, the insurance companies may look very much like the web banks with only a few technical and mission critical staffs operating the seemingly giant organizations.

5. TECHNICAL CRITERION FOR INSURANCE INTERNET COMMERCE

Insurance companies are all computerized to process vast amount of information. However, the operation system in most insurance companies are of legacy systems. Computer systems work as book keeping machines. Computer files are mostly in COBOL formats. Quite frequently, the operating system itself is older than the programmer who maintains it. For the insurance companies to be able to conduct business on the internet, modern database management techniques must be employed. Distributed database structure and Object Oriented database all have successful precedent examples in banking and financial data processing arenas.

Traditionally, quoting an insurance rate takes up 20 minutes of an agent's time. In this digital world, 10 seconds of waiting time is considered to be too long. The insurance companies need to set up fast servers which have well programmed scripts to process massive insurance quotation inquiries in real-time mode. Some technically advanced servers setup by the insurance agencies already have the function of instant quotations on hundreds of similar insurance products.

To be able to make an underwriting decision in an instant, the underwriting process can't be done by human any more. Scoring technology has to be utilized to achieve fast underwriting process. The scoring technology is a scientific way to evaluate insurance risk on an individual based on the individual's risk profiles. For each individual, the scoring model generates a score which rank orders the level of insurance risk associated with the particular risk profiles that the person has. The scoring technology has already been used in a number of major insurance providers in the automobile insurance market.

Thus, the technologies needed for insurance internet commerce to happen are already in place. When regulation gives the permission on insurance internet commerce, the insurance companies will be able to transform to adapt to the new way of insurance marketing.

6. IMPACT OF THE INSURANCE INTERNET COMMERCE

There are most certainly pros and cons on insurance internet marketing. The new ways of insurance marketing conduct will have the four major impacts:

Those impacts all have positive side and negative side of effects. Despite these effect's good and bad, it is a way of life in the digital age.

6.1 Privacy Intrusion

For an insurance company to be able to transact insurance policies on the internet, knowing the information about the insurance applicants is extremely vital. Since agents are not used in acquiring new applicants, the insurance company has to rely on background checking to acquire and verify the information about the applicants. Since the fine line on the distinction of private and public information is not clearly drawn, background checking is almost guaranteed to intrude some information that are deemed to be private by most people. For example, credit reports inquiry is a hot issue debated between the insurance companies and the state insurance committees. While statistical evidence has strongly supported the insurance companies' argument that credit performance is highly correlated with insurance loss performance, the state insurance committees in most states are barring the use of credit report in making insurance underwriting decisions. The state insurance committees' concern is that credit information on individual level is an issue that cause the concern of the general public. It is difficult to convince the general public that insurance companies have the right to peek into their credit standing.

Besides the credit reports, court records, criminal records, and police records are sources of information that the insurance company will need to obtain about a new client. Although court records, criminal records and police records are deemed to be public records, so as attract less concern from the state insurance committees, frequent inquiries generated by the insurance company when conducting insurance internet commerce will most certainly draw the attention of the consumer groups. In general, it is difficult to balance the insurance companies' need to know and the consumers privacy right.

6.2 Debate of Fairness

"Red Lining" is an insurance term that describes the unfair insurance practice of not offering insurance policies to a significantly underserved area or community. Downtown areas of all major metropolitans are facing the problem of "Red Lining". It has been statistically proven that downtown areas have higher than average loss performance. Thus, many insurance companies are specifically ruling out doing business in downtown areas. To guarantee the right of insurance of the residence of downtown areas, the state insurance committees prohibit the practice of red lining and require the insurance companies to take certain share of business in underserved communities.

When insurance internet commerce is conducted, the insurance companies will need to rely on statistically derived underwriting models to make underwriting decisions in a matter of seconds. The models will typically identify a certain group of applicants that fit some risk characteristics as the highly undesirable clients. Those undesirable clients will most likely to be denied insurance coverage from almost all insurance companies. People most certainly find it difficult to accept that due to some scoring models' analysis outputs that they are denied of their insurance coverages. It will be the responsibility of the state insurance committees to ensure everyone's right of insurance. Thus, a different kind of "Red Lining" issues will be debated and new laws may be passed to ensure people's right of insurance.

6.3 Impact on Society

As insurance internet commerce becomes a realty, many jobs will be eliminated. The vast amount of insurance agents will be phased out as insurance companies adapt to internet commerce as their main business conduct. After internet commerce has been fully utilized by all insurance companies, mergers are likely to occur. Since the adaptation of internet commerce will simultaneously require the insurance companies to automate their internal business processes, efficiency will be greatly improved. As the result of mergers and efficiency improvement, many non-business critical jobs will be eliminated. Massive work forces will be laid off; much like what is happening today in the banking industry.

After being able to eliminate agent commissions and reduce operation cost, the insurance companies will be able to do what they were supposed to do in the first place, providing coverage for insurance. The premium will be lowered to about the same amount of the expected loss. People with low risk profiles will be offered with much cheaper rates, while people will high risk profiles will be offered with higher rates to reflect their high risk potential.

6.4 Impact on Human Life Style

The immediate impact is people will begin worrying about their personal records being inquired so frequently. Since insurance policies are renewed semi-annually or annually, and insurance companies usually re-evaluate their book of business for loss control purpose, personal information will be inquired from all sources (questioner to the insured, government records, third party information vendors, ...etc.) when renewal time comes. The personal profile revealed by those information can tell to a great extent of detail about a person's life events. People may behave a lot more carefully to avoid adverse records being generated.

The second effect on people is that brand royalty will be reduced. In today's insurance market, only 10% of the book of business is new business, the rest of 90% is renewal business (i.e. people who stay and continue the next terms). When insurance internet commerce goes in effect, people can buy insurance policies in a manner of minutes instead of hours (when sum up the time on the phone, driving to see the agent or waiting for the agent to come, listening to the long explanation of the contract terms, ...etc.). People can afford to give the other companies a try to quote better prices. Then, the insurance market will become completely price driven. Since insurance industry is still under stringent regulations, material misrepresentation is not likely to become an issue. So, people will always opt for the lowest price insurance policy offer.

The third effect of insurance internet commerce is that most people will be released from heavy insurance premiums, while a small group of people will be burdened with greater insurance payments. Since 90% of insurance loss comes from less than 5% of insured population, the majority of people will be charged a smaller premium amount while the small portion of the population will be identified as high risk and charged a higher amount of insurance premium.

7. CONCLUSION

Insurance internet commerce is at a starting point. The necessary technologies for the insurance internet commerce are in existence today. The only thing missing is the regulatory body's permission on the new means of commerce in insurance products. Technology advancement and market competition will eventually crack open the gate on insurance internet commerce. When the insurance internet commerce happens, massive layoff will occur and insurance premium in total will be reduced due to efficiency improvement. While in the process of applying the technologies, people's life will be impacted and intruded. Hopefully, through the debate over privacy information right, the society can find a middle ground between insurance efficiency improvement and personal privacy information safeguard.

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Ziun-Yih Yeh, Department of IEOR, fox@pivot.berkeley.edu