No Free Lunch

Let’s start with the premise that we all know what a free lunch is. We also know what insurance-to-value (ITV) is. Is either of these things a reality? Perhaps it’s more appropriate to ask why ITV is so important. It seems to be a newsworthy topic as of late. Why does it attract so much attention and so much angst?

The ideal form of ITV is 100%. In this instance, a policy limit matches exactly what it would cost to rebuild the insured property at the time of loss. For example, a building that cost Cdn $500,000 to rebuild would have a structure policy limit of Cdn$500,000. Sounds simple, right?

But if your neighbor pays a premium amounting to only 60% ITV — which is 40% short of what they should pay — who gets hurt? This is the “free lunch” in this story: it is a free lunch for your neighbour. If many consumers are not paying what they ideally should (and therefore proper rating can’t be determined), then insurance companies are not collecting enough premiums for continuing operations. Since the premium shortfall can’t be pinpointed to one home (or risk), this could result in higher rates for all the policies in a portfolio, because the company needs to remain solvent. This is where we learn, once again, that there is no free lunch: in the absence of 100% ITV, we are all paying for our neighbors’ lunches!

Over time, insurance companies, brokers and consumers all stand to lose if a chasm widens between insurance policy limits and the actual cost to replace a structure. How does each of the parties lose? For carriers, understanding a risk is vital to charging adequate premiums. Adequate premiums are vital to keeping carriers healthy. If carriers do not charge enough premium for the risk, they won’t be able to cover losses and could become insolvent. If carriers become insolvent, brokers have fewer product options from which to select and fewer carriers for which to work. When consumers have fewer carriers competing for business, their rates tend to be higher.

ITV is not a new topic. In 1971, George L. Head published his book, Insurance To Value. It was the Kulp-Wright Book Award winner for 1975. Presented annually by The American Risk and Insurance Association, the Kulp-Wright Book Award goes to the author of a book considered to be the most influential text published on the economics of risk management and insurance.

Expanding on that book, Robert J. Kelley in 1994 wrote an article called ‘Homeowners Insurance To Value An Update.’ In it, he observed that ITV is “generally associated with the concept that the equitable, adequate and reasonable price… should vary with the amount of insurance.” He attributed the quote to George L. Head.

At the basic level, rates should change as values change and rates need to be adjusted for changing exposures. (Rates and prices are often confused, but that is another story for another time.) For consumers, brokers and carriers, it is important that each owner pays precisely what he or she owes for an insured structure or the risk. However, proper rates can’t be applied without understanding the cost to replace the structure. Proper understanding of the risk leads to proper pricing at a risk-adequate rate, allowing proper actuarial reviews and proper actuarial modelling.

Therefore, Head’s “equitable and adequate” requirement means that the rate changes with the exposure, and part of that exposure is the total value. In other words, no free lunches for a few, but rather lower-cost lunches for all.

After a catastrophic event like a hurricane or wildfire, the improper collection of premium can result in the dissolution of one or more companies. At the other end of the spectrum, proper ITV applied equally by all insurers would more than likely reduce the ultimate base insurance costs consumers pay; this in turn would keep more insurers in business competing for consumers’ business. In the ideal, proper ITV would allow a risk-by-risk adjustment of premium as opposed to wholesale increases on an entire book.

Head wrote his thoughts in 1971 and Kelley followed up in 1994. Therefore, ITV has been written about for at least 37 years. So why are we still discussing ITV and trying to achieve proper ITV?

One complicating factor is that homes are fairly large, complex structures that can take months or sometimes years to build. Furthermore, they are personalized for almost every owner; the cost of personalizing a home can equal the cost of personalizing several cars. Complicating matters further, there are basic homes, average homes and luxurious homes. There are homes in the woods, homes on lakes, homes in the city, homes in old neighborhoods and homes in new neighborhoods. In order to have proper ITV, every variation of a home must be valued correctly.

It is a complex process to value homes. Builders take days, if not weeks, to prepare detailed estimates. Valuations could not be produced in this way. Carriers and brokers don’t have the time to spend days or weeks on each valuation; homeowner premiums would be substantially higher if builder estimates were required for each insured property. Whereas there is a finite number of automobile manufacturers and variations (and we may have fewer of them in the next few months), there are an almost infinite number of homebuilders and variations.

The insurance market demands a quick and easy-to-use process that can be completed by a non-builder. That quick-and-easy process has been the Achilles’ heel of ITV. It is the hurdle to making ITV “equitable and adequate.”

Prior to personal computers, there were no easy, accurate and consistent processes to obtain proper ITV. The advent of PCs improved the situation, but limitations remained. Large, centralized computer systems could also be used, but they were not flexible enough to address the varied housing stock.

In the beginning, ITV calculation methods used pen and paper. The paper methods were later adapted to PCs. However, when the paper-based systems were transferred to PCs, which made them quicker to run, the systems were not reinvented for the computer. All these systems still relied on the individual’s skill in using the system; they also relied on the individual’s understanding of homes and the materials in a home. But inconsistent entries arising from inconsistent individual inputs led to wildly inconsistent applications of the systems.

Further, the data was disconnected. It was hard to study, review and refine methods and pricing since the data was spread out on individual PCs. The lack of a central repository for the data used to create the valuations meant actuaries were unable to easily review and analyze pricing, rate and risk evaluation.

A simpler process emerged, one that eliminated many of the problems with the paper-or PC-based systems. In the late 1990s, the Internet promised to provide the platform that would truly end the inequities in the ITV process. Automation and standardization, access to data and analysis of the entries and results all were attainable. With new resources available online, valuation providers would be able to determine the specific and true value of any property within minutes. The theory of ITV was put forth in 1971, but the true capability to arrive at proper ITV did not actually appear until 2003 with the availability and widespread use of true Web applications and broadband connections. Think of it as 32 years of struggle, with five years of refinement.

A Web-driven centralized process has the ability to factor in the qualities of the actual property, as well as up-to-the-minute and geographically tailored marketplace factors. These include inflation, worldwide changes in the cost of materials and local industry trends for any property in any country. Such a tool allows companies to operate on a real-time basis, achieving a true and objective assessment of replacement value.

So to advance ITV, historical technological development had to — and did — occur. In addition, changes to th e systems themselves needed to occur. The systems designed for paper and then adapted to PCs and mainframes were as old and outdated as 1972 automobiles. Building methodologies have changed. Markets have changed. Calculation methodologies have changed. To illustrate this, imaging putting a new motor in a 1972 Chevrolet. That does not make it a new Chevrolet. The basic technology and underpinnings of the 1972 car will restrict the new motor to within the capabilities of the old shocks, suspension and limited safety features. Yes, those items could be updated. But at the end of the day, it is an old platform and a mismatch of parts.

Ideal ITV can be achieved if carriers and brokers act with discipline and dedication, tapping into the increased capabilities of ITV providers along the way. If all parties keep their expectations high, co-operate and maintain a long-term view (i. e. looking beyond the next sales cycle), then 100% ITV could be as commonplace as airbags, antilock brakes and fuel efficiency.

Technology allows ITV providers and carriers to update methodologies faster, integrate faster and, more importantly, apply the right value to each home, thus eliminating free lunches. Business practices need to drive the process to enforce ITV. ITV can be a reality. Free lunches are not “free” for most of us: they are a delusion ultimately advantaging a few, while the rest of us pay for them. With correct ITV, though, we can all afford to buy lunch.

———

If your neighbour pays a premium amounting to only 60% ITV — which is 40% short of what they should pay — who gets hurt? This is the “free lunch” in this story: it is a free lunch for your neighbour.