I was having a look at Freedom Insurance Group Ltd (ASX: FIG) after its plunge recently. 4x-5x EBITDA is the price level where 10foot gets interested, especially when there’s embedded value in the existing customers and commissions. Ultimately I’m not comfortable with the business model (cold calling) and probably won’t invest. Freedom is an insurance broker and doesn’t have any claims liabilities, but as I was thinking about FIG I started thinking about the life insurance business model.
I became intrigued by the idea of ‘reverse-engineering’ the profitability of life insurers and I started a spreadsheet this afternoon to try and model an ‘average’ life insurer’s profitability based on every input I could think of.
Caveat: While I have a background in statistics I’m not typically a huge modeller.
It was a yuugely ambitious project and I spent most of my time going ‘aw, crap’ and rewriting the model again. Simplistically, there are the first year of premiums, from which you subtract the cost of acquiring the customer (CAC; advertising + commissions). Then you subtract management expense ratio (MER), then you subtract the payouts incurred based on # of people that died (+ the death rate changes every year), then you multiply what’s left by the expected return on bonds, then you do it all again with the year 2 premiums. Except in year 2, you also have to calculate the further compound growth + MER of the year 1 premiums and ongoing expenses like trail commissions etc. By the time you get to year 11, you’re calculating 11 different versions of each year’s premiums with a gazillion different adjustments and your spreadsheet looks like a dog’s breakfast.
After about 3 hours I abandoned my model and settled for some much simpler calculations about the likely future value of current premiums based on customer lifespans and so on. In the process I came to a realisation about the life insurance business: It’s stuffed.
When I did very rough calculations assuming a 5% annual yield on bonds, 11 year customer lifespan, and low MER/ CACs and trail commissions, I got obscenely high future values based on compounded bond returns + death rates. Life insurers could, in a different universe, be sickeningly profitable. At this point I realised that a huge amount of the industry’s value is lost in friction.
Suncorp Group (ASX: SUN), for example, reported about a 6% underlying NPAT margin ($53 million) on $804 million in life insurance premiums in 2017. Claim expenses were $519 million, but this includes all sorts of trauma and disability claims, not just lump sum life insurance. Have a guess where the other $285 million went? It’s a bit more complicated than this because Suncorp has reinsurance etc, but it spent $167m on acquiring new policies, and $174 million on maintaining them. Maintenance I guess is a pretty high-cost process because it is done manually, management is talking about digitising their systems to ease adviser + customer interactions. They don’t list their retention rates either but you would have to assume high losses to churn.
Rough estimates reported in the media currently suggest that industry churn is about 19%, implying a ~5 year customer lifespan. The CAC can be 15% or higher, and first-year commissions are capped at 60% of 1yr premium with a 3-year clawback, almost inviting churn. Ongoing trail commissions can be 20% p.a.. Freedom Insurance says it has a maintenance cost as % of ongoing insurance-in-force of 15.9%, and this is as good a figure as any other, really. Suncorp’s general insurance MER is 20%. Medibank’s is just under 10%.
I think the whole business model can be done a lot better, given that the cost of life insurance is the biggest cause of churn.
All insurance policies are, simplistically, bond investments, although it’s the insurer investing and promising a payment in the event of a problem. With household/auto insurance however, which most people buy online, there is typically no serious entry or exit fees for the consumer. A life insurance policy is different. Imagine that you had an investment fund with a 60% entry fee and a 20% trail commission every year, while at the same time you also lost 10% to management expenses each year, and you as a customer changed providers every 5 years. This is not unusual in the life insurance business, and there is no compounding here, only friction and wasteage.
And that’s why Amazon, or an Amazon-like, is needed in the life insurance industry.
The Amazon of Life Insurance
The company I am envisioning would aim for a low-cost, commoditised, universal model of life insurance. It wants everybody who is married/has children to have life insurance. It markets peace of mind + prudence + disaster insurance at a very affordable price. It uses the universality of its coverage and its low-cost, low-churn model to claim market share and force down the overall cost of insurance.
It would be very hard to sell this business idea because of how embedded the commission structure is, and it is also hard to motivate customers to change. What’s more, only a well-funded visionary company would have the guts or the funding to pull something like this off, which would necessarily involve running large losses until scale was reached. But if it worked – and no guarantees there – it would stomp the existing business model into the dirt.
Under this system, my guesstimate is that the cost of life insurance – single lump sum payout on death – could be cut in half or more. Just a guesstimate, but look at all that friction above and I would be surprised if you didn’t come to a similar conclusion. That is cutting the premium from ~$15,000p.a. as a 50-year old to $7,500 at the same stage of life, adding huge value to customers, while still retaining similar or better profitability.
This business model needs a few things:
- Scale. Unachievable without it, or without the funding + vision to build for scale.
- Cut advisers out of the picture. Online-only and minimal to no commissions.
- Longer customer lifetime. You need to double or triple it. (Not actual life expectancy, but the # of years people pay premiums for).
- Low churn. I’d suggest the use of contracts e.g. 10yr contract paid annually, and fixed pricing by age. If you are the lowest cost competitor by a clear margin, you can convince consumers to use contracts despite their negatives.
- Compounding for longer. You could also use discounts in some circumstances, for example a discount on a 10-year life insurance contract for up-front payments of the whole premium.
- Standardisation and ruthless simplification, of course.
- You also need a universal brand name like Apple, Amazon, or Alibaba because otherwise there is no trust and network effects are not strong enough to attract any meaningful percentage of the population
- You need to start educating people in school or university on the need for life insurance. This means that you could be looking at a ~20 year lead time on your future business, just as there was with ETFs. Something like Amazon (or Vanguard!) however might also steal enough customers from existing suppliers to make a living in the present day.
- Clever subsidisation. You can suck younger investors in here. St Louis Fed data, albeit from a different market to ours, suggests that life insurance coverage peaks at age 68, which is very late given that US life expectancy is about 79 years. Simplistically, this means you need to price insurance as though your customer will die within 11 years – in other words, it will be very expensive. If you can attract younger people and move the average age of coverage lower, it can reduce the cost of insurance. Increasing the expected customer lifespan from 11 years to 13 years, for example, means that the implied payout (say $500k upon death) is spread over 13 years of premiums instead of 11, becoming significantly cheaper. With price being a key customer pain point, there is a huge opportunity to attract more young customers.
There is a price point at which life insurance becomes attractive, even for younger people who don’t have much money. Most young families would be stuffed if the breadwinner died but equally, most are under-insured against that eventuality. There is an opportunity here to sell what is effectively disaster insurance at a low price.
For example, the population-wide death rate in Australia is around 1% per annum. It does not rise above this level until you exceed 69 years of age. There is a significant opportunity to use young people to subsidise the old people. (As a younger person myself, this is a bit how-ya-goin, just like all those
transfer payments Sydney properties we’re buying from old people.)
Unfortunately this only applies to married couples, really poor people (supporting family), and those with children. There’s no point insuring yourself if you’re alone. We also know that people are marrying and having children later. However if you look at 30- and 40-year olds in relationships, there is a very long lead-time before you have to start paying any sort of serious death claims to them.
Conceptually I think you could offer life insurance to young people for some nominal sum – maybe even $1000 a year or less. There would be three benefits to this:
- Young people could subsidise older people
- If the price is right – and it has to be low enough to sell peace of mind with limited financial stress – all else being equal you should get longer customer lives due to less churn. Evidence from Canstar suggests cost is the primary reason for life insurance churn.
- By expanding the universe of people that you are insuring you should get closer to the ‘average’ citizen, bringing down your average death rate and reducing the impact of self-selection of old and sickly people into life insurance programs.
(I know that there are policies with different pricing for smokers and rules against pre-existing conditions etc, but logically, only people that need life insurance – those that are more likely to die, or have more at risk – buy life insurance. If you can lower the cost of risk mitigation, it should become more appealing to a wider audience).
To give some estimates, based on the future value of 11 years of a 30-year old male’s life insurance premiums, a 5% bond return, and 11 years of compounding them (see pic below), you need ~10.2 customers to pay for every 1 death you have, at a nominal $500,000 payout. However, 10.2 ‘average’ young males have a cumulative age-specific death rate of maybe 6% over an 11 year period. Once you subtract the benefits of lost compounding, the likely loss in future value could be equivalent to 1-2 customers. This means that for every 10.2 customers (30yo males) you take on, you pay just ~2 ‘customer values’ in claims and lost compounding, keeping the other 8.2 customers for yourself, before fees and commissions etc. Suncorp’s experience suggests current insurers pay closer to 5/8ths in claims (albeit not just pure insurance against death) but even so, if you can cut churn, commissions, and MER to the bone, the implied 62.5% (i.e., 5/8ths) claim expense ratio is very good. Suncorp’s $800m in premium implies only 308,000 30y/o male customers at $2600 p.a. Most disturbingly, this implies just ~53,000 older customers with premiums of $15,000 a year – and Suncorp is no small provider. There is a significant opportunity to increasingly universalise insurance coverage.
Here is a basic look at what premiums for a ~30y/o male (~$50/ week) look like when they grow at 5% p.a. over 11 years, assuming premiums themselves also grow at 5% per year (reflecting an ageing customer):
Admittedly this is hugely optimistic, based on compounding 5%p.a. and zero friction (fees etc). By introducing even a little friction, returns would plummet. However, death rates are so low – even at relatively ‘old’ ages like 70+ – that any customers below the age of 55 or so should be quite profitable if you can drag commissions, churn, MER, and CAC low enough and keep the customer for longer.
Because of the nature of the opportunity, the ‘Amazon of Life Insurance’ must necessarily be low cost and aim for razor-thin margins. However, if it can drag prices low enough and achieve enough scale, it could make the entire existing industry obsolete. My rough figures suggested that premiums could be pulled 50% lower under this model, and I think there’s no way the reduction would be less than 30%. Suncorp only has a 6% UNPAT margin. It would be totally stuffed if it had to compete with a competitor priced that much cheaper.
Obviously there are a bunch of risks, especially around disrupting the adviser model, which would be very difficult. Most people don’t even think about life insurance until they’re prompted by their adviser. Still, no existing Australian life insurance company is capable of pulling this off, not least because they depend on the adviser model to get a lot of their business.
What is the actual business opportunity?
The opportunity is not in selling low-margin life insurance. The opportunity is in disrupting the entire industry because your competitors would be unable and probably also unwilling to compete with you on price. The market share opportunity is far, far larger than any ordinary life insurer could ever hope to achieve in the current competitive environment. If this company could achieve scale, it would be self-reinforcing and it would be nearly impossible to disrupt it in turn – probably also granting it serious pricing power.
Normal insurers could not compete without being willing to trash their own margins + the adviser model, and we’ve already seen with Amazon that most companies don’t have the grit to destroy their own business and build it anew.
Whatever you might think of this idea – and there are a number of flaws that come quickly to mind – I think it is quite accurate to say that current life insurers cannot compete with a business that could provide the same product 30%-50% cheaper.
Actually providing it 30%-50% cheaper requires a revolutionary new approach, and that is why the life insurance business needs Amazon.
I have no financial interest in any of the above companies mentioned or implied. I also have no relationship whatsoever with any sort of life insurer or their representatives.