Wednesday, May 8, 2019

Why don't insurers try to mitigate risk?

Allison Shrager's terrific book, An Economist Walks into a Brothel, contains all sorts of innovative risk mitigation strategies pursued by people in all walks of life (see earlier blog post, How are Jet Skis like Financial Derivatives).  So why don't insurance companies spend more time figuring out how to mitigate risk?

The answer is simple:  Risk mitigation is not a source of "sustainable competitive advantage:"
Argument #4: mitigation is easy to copy. Underwriting risk selection is much less tangible and secrets can be a protected source of advantage. People can reverse engineer a dongle but not underwriting strategy. Once copied mitigation provides a one-off benefit to the market, changing the rate level but not the profit level (bit of a negative inventive because lower claims means lower premium and so less float!).

 Instead, insurers spend most of their time classifying risks (classification strategies are proprietary) which offers the benefits of diversification:

Argument #3: Improved classification allows for stratification and so diversification. Insurers are diversifiers. If you can segregate genuinely distinct classes of risk, portfolio volatility will drop.

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