Insurer Innovation Comes Under the Rating Agency Microscope

Underway for some time now, the disruption of the insurance industry has moved into a new phase, following the announcement by A.M. Best that it may soon begin scoring insurers’ innovation efforts. Journalist Russ Banham spoke with ratings agencies, thought leaders and an industry exec to discuss the varied responses to A.M. Best’s announcement that it may begin scoring carriers’ individual innovation efforts as a component of ratings.

In mid-March, the venerable insurer ratings agency sent out a draft report on its plan to incorporate a score on an insurance company’s innovativeness within its overall rating of a carrier. The report—”Scoring and Assessing Innovation”—affirms the disruptive risk that digital and data technology presents for insurers that fail to invest in innovation or invest unwisely.

Certainly, the importance of innovation is not news to industry participants. Over the past several years, hundreds of startup InsurTech companies have sprung up like mushrooms after a long-needed rainstorm. Many of the startups (and certainly their deep-pocket investors) saw an opportunity to enhance the business of insurance, leveraging technology to increase back-office efficiency, enrich the customer experience, and improve underwriting, pricing and claims administration.

The breathtaking pace and breadth of the startups’ technological ingenuity suggested an industry ripe for disruption. In response, many large insurers have increased their capital budgets to invest in similar enhancements, evident in their digital and data transformations. Pressed to do the same, many midsize and smaller insurers are following suit, moving their on-premise IT systems to the cloud and investing in data and analytics initiatives.

A.M. Best’s plan to assess and score each carrier’s innovation investments and their outcomes will likely further these efforts, given the vital importance of an insurer’s financial strength to customers’ trust in their claims-paying ability. Life, health and property/casualty insurers have until May 13 to express their comments about the draft report to A.M. Best.

The process by which the ratings agency will assess and score innovation is laid out in the draft report, which may alter as carrier comments are received and incorporated. A.M. Best expects that all rated companies eventually will be scored and assigned a published innovation assessment.

“None of this is final yet and it’s possible things could change,” said Stephen Irwin, the Oldwick, N.J.-based rating agency’s senior director, Credit Rating Criteria, Research & Analytics. “We’ve been talking about innovation with companies for some time, but we are now moving toward more of a way of formalizing these discussions.”

Different Strokes

Like other ratings agencies, A.M. Best has its own formula for rating carriers. Key factors include an insurer’s balance sheet strength, operating performance, business profile and enterprise risk management (ERM). The plan is to include a score for innovation within the business profile component of a carrier’s overall rating. The reason, the agency explained in a press release, is to “consider whether the company’s innovation efforts, or lack thereof, have had a demonstrable positive or negative impact on its long-term financial strength.”

While innovation has always been an important factor in an insurer’s financial performance, the blistering speed of technological development has made it increasingly critical to a carrier’s long-term prospects. At its most basic, the score will consider two elements: the components of an insurer’s varied innovation efforts and their respective impact on the carrier’s financial performance. The resulting score is the sum of these two evaluations.

Assuming all goes according to plan, the rating agency will have made a bold if not historic decision, one with extraordinary ramifications for individual carriers. Although the firm suggests the innovation score will not automatically translate into a positive or negative rating for a carrier—possibly due to the time it takes for innovation to make a decided difference in an insurer’s financial performance—over time it will carry more weight. Nevertheless, for carriers that have not made investments in innovation, clearly the time has come to reappraise this decision. No longer can this be a viable option, given the dire risk of a ratings downgrade. As the draft report states, “The cultivation of innovation will become a leading indicator of companies with defensible market positions.”

Fitch, Moody’s, S&P

Carrier Management reached out to the three other major insurer ratings agencies to determine whether or not they plan to follow the example set by A.M. Best, if indeed its plan to score an insurer’s innovation efforts sees the light of day. All of them—Fitch, Moody’s and Standard & Poor’s—responded negatively.

“I don’t disagree that innovation is a crucial determinant of a carrier’s financial performance, but we don’t need to break this out into a separate score since it already bleeds into every component of our analyses,” said Jim Auden, managing director at Fitch Ratings.

Moody’s Investors Service shares this perspective. “Clearly, we’ve seen rapid progress by insurance companies to innovate inside the organization or partner with InsurTech firms to do the same,” said Manoj Jethani, the agency’s vice president, senior analyst, life insurance. “We don’t have an explicit factor assigned to innovation in our rating methodology, as we already incorporate it throughout our analyses.”

So does S&P Global Ratings. “In assessing innovation through our current rating framework, we would need to see a carrier demonstrate sustainable operating performance as a result of the innovation,” said Anika Getubig, an associate director at the ratings agency. “For example, if the innovation results in a better user experience or a more differentiated brand that materially improves the company’s market position, we would consider this in the overall assessment of the carrier’s competitive position.”

All the ratings agencies said they discuss each insurer’s innovation efforts with its senior management team to discern the amount of capital investments, where this money is earmarked, why it is being spent and the expectations for a return. Subsequent conversations ferret out whether or not the investments are reaping the anticipated returns. These varied details are compared with other carriers’ innovation efforts. This process conforms to the way A.M. Best has historically captured innovation—indirectly through the various building blocks of its rating process.

The discussions with senior management of insurers are considered a serious matter for all four ratings agencies. “An insurance company that is not delving into innovation would be viewed as a credit negative, as we expect it will lag behind its peers over time and find it increasingly difficult to secure preferred customers,” said Getubig.

Auden appeared to share this opinion. “With growing computing power and capacity, and technologies like machine learning, robotics processing, big data analytics, cloud and blockchain, there’s no question that carriers can do things more efficiently, less expensively, and provide better products and services to customers,” he said. “All insurers need to be investing in these technologies to harness their benefits. We’re analyzing these efforts as they relate to their core risk and performance factors.”

Insurers that fail to invest in innovation are at risk of enduring a ratings downgrade. “A carrier that doesn’t keep pace with its competitors’ innovative digital capabilities will lose market share,” Auden said. “If it isn’t using advanced analytics in underwriting, for instance, it may be overpricing its best-performing business. Someone using the tools then comes along, charges a lower rate and takes it away.”

Nothing is writ in stone, of course, meaning that the three other major rating agencies may eventually change their minds (or A.M. Best may jettison its plans). Jethani noted the difficulty in ascribing a score to something as idiosyncratic as innovation. “Innovation would be hard to measure as a separate metric accurately, given the subjectivity involved and the difficulty in determining if a carrier is actually making the right [technology] decisions,” he said.

“What if the technology you’re investing in today to modernize the infrastructure, or improve distribution or operations, is the wrong technology? What if it is replaced by something better in a short period of time? You’d end up artificially inflating one company’s rating to the detriment of another company that did not invest in that technology.”

Pluses and Minuses

Whether or not innovation is scored as a separate metric, the clear message to all carriers is that they cannot be complacent with status quo operations and business practices—not in an era where continuous innovation is a key factor in their financial performance.

The challenges are many. Large global insurers have the capital clout to invest in advanced analytics, deep learning and other emergent technologies but are nonetheless confronted with selecting the optimal solutions. Smaller insurers need to carefully assess these expenditures against other growth capital priorities. Mutual insurers that have a fiduciary obligation to protect their policy owners’ capital have additional pressures to exercise caution and prudence. Undoubtedly, some carriers will be unable to maintain pace and fall by the wayside.

“I think we’ll see a washout,” predicted Guy Fraker, chief innovation officer at Insurance Thought Leadership, which calls itself a global network of thought leaders and decision-makers transforming the insurance and risk management marketplace. “It is a mistake for any insurance company not to be experimenting in innovative ways to improve their products and services, customer value proposition and hiring practices. What A.M. Best has done is the right thing to do, as it screams the importance of innovation from the rooftops.”

Fraker is not alone in this perspective. “Our empirical surveys and other research have clearly indicated for some time that insurance customers want a better insurance product,” acknowledged Mike Fitzgerald, senior analyst at Celent, a research and advisory firm focused on financial services technology. “What A.M. Best is doing may serve as a ‘hammer’ to pound home just how important innovation has become for the industry. It should motivate carriers to innovate faster to the benefit of their customers; otherwise, they will risk disruption from industry competitors and other players outside the industry that make these investments.”

Fitzgerald makes an excellent point. In recent years, venture capital has flowed into startup insurers like Lemonade, Next Insurance and Root, each with a compelling customer value proposition. Technology giants like Amazon and Google also have floated the possibility that they, too, may provide insurance solutions. Even major automobile manufacturers might become formidable car insurance competitors, once autonomous vehicles hit the road in greater numbers.

Against this backdrop of disruptive competition, A.M. Best’s contemplations to possibly score innovation may someday be viewed as a very prescient decision. “I think the other ratings agencies are missing the boat,” said Fitzgerald. “Down the line, they will view this as an opportunity missed.”

Fraker seems to agree with this opinion, to a point. “The other ratings agencies may be telling you they have no plans to score an insurer’s innovation efforts, but wait 18 months and then ask them the same question,” he said. “On the other hand, they may be exercising prudence in taking their time and letting A.M. Best take the first bullet. There’s a high degree of skepticism in how a rating agency will develop the expertise needed to understand something as complex and subjective as technological innovation to score it accurately. That said, I’m thrilled they’re moving forward in this direction.”

How do carriers feel about the possibility of A.M. Best rating their innovation efforts? Dr. Henna Karna, chief data officer at global insurer and reinsurer AXA XL, is bullish on the idea. “It certainly is a good thing and adds to the pressure on innovation in a way that can have sustainable business impact for carriers, in a measurable manner,” said Karna. “But I’m concerned that the scoring is not just linked to doing better with traditional technology, as opposed to true digital and data transformation. This is where future disruption will emerge.”

In other words, while a carrier that moves data into the cloud from the on-premise mainframe computers is making an investment in innovation, is this investment on par, score-wise, with another insurer’s investment in a comprehensive digital and data transformation?

“There is a view that if a firm is spending millions of dollars moving legacy technology into the cloud or rolling out gadgets on a smartphone, that it’s an innovative firm,” said Dr. Karna. “That’s just catching up, a necessary continuous improvement. True innovation involves decisions to achieve game-changing, data-driven business growth outcomes. Frankly, that cannot happen with technology alone. It requires invention, boldly rethinking how everything is done today to achieve sustainability tomorrow.”

Irwin from A.M. Best agreed that innovation in the context of an insurance carrier represents more than technology. “Technology has been with us for hundreds of years. In our consideration of innovation, we’re looking at leadership, culture, organizational processes and not just the [technology] toolbox,” he said.

Tomorrow’s Industry

The intrepid decision by A.M. Best to possibly score carriers’ individual innovation efforts as a component of the firm’s ratings is bound to result in a profoundly different insurance industry. Many insurers will be motivated to innovate further, resulting in more refined and competitive products and services of greater value to customers. Alternatively, carriers that make meager or unwise investments in innovation will become vulnerable to more agile and responsive insurers. “Spending wisely is key,” said Irwin.

Asked if A.M. Best will score the innovation efforts of different sized carriers on an apples-to-apples basis, Irwin said only insofar as the outcomes of these investments. “Just because you spend a lot of money on something doesn’t mean it will produce the intended outcome,” he explained. “The more important question is whether more rapid access to better data, for instance, improves carrier underwriting and the customer experience. Ultimately, this is all about the customer.”

This is an edited version of an article originally published in Carrier Management, the publication for P/C insurance carrier C-suite executives.