Chapter 22

Profiting from the Dynamics of Insurance

In This Chapter

Knowing why everyone should be in the “insurance” business

Understanding what you’re losing if you’re not in the insurance game

Coming up with an insurance plan that increases your profitability

Everyone should be in the insurance business. If you’re like most businesspeople, you probably have a bad taste in your mouth simply at the mention of insurance, let alone at the suggestion of entering the insurance business. I’m being facetious. I don’t want you to start an insurance company. In this chapter, however, I do examine the foundation of the insurance business and show you how you can profit from borrowing some of the fundamental underpinnings of the insurance business model.

Defining Insurance

At its most basic level, insurance is nothing more than accepting risk in exchange for money. I can’t afford to write a check to rebuild my house if it’s destroyed by a tornado, so I pay an insurance company to assume the risk of the destruction a tornado may cause in exchange for an annual payment. The company assumes risk for money. Insurance is profitable. This year’s Fortune 500 boasts 35 insurance companies, accounting for more than seven percent of the total profits of all companies on the list.

Most people view insurance companies as stodgy and conservative. To the contrary, insurance companies take massive risks every day. If they don’t take risks, they don’t collect premiums. The difference between insurance companies and virtually every other company is that insurance companies want to take risks and seek them out, whereas everyone else tries to avoid them. Insurance companies are very adept at assessing risk and then selling customers elimination of that risk for more than it costs the companies to do the risk taking — in other words, their profit.

Understanding the Core of Insurance Profitability

Insurance companies do more than accept risk in exchange for money. They pool risk, invest monies at above-average returns, and offer financial products. However, the core of insurance companies’ profitability is risk acceptance. Two powerful dynamics power their ability to profit from risk acceptance: insurance companies have the ability to assess risk much more accurately than others, and insurance companies capitalize on customers’ misconception of risk.

Accurately assessing risks others can’t

I have no idea how someone predicts the likelihood of a tornado, a ship sinking, an athlete’s knee blowing out, or life expectancy, but insurance companies do it well. Over decades of data analysis and modeling, insurance companies can predict with some accuracy risks others can’t. This ability to statistically assess any risk with the same precision you can rate the odds of rolling a seven in a craps game enables insurance companies to make massive profits. The formula is simple — assess risks as accurately as possible, and then sell the assumption of that risk for much less than the cost of the risk. It’s just like Las Vegas with a much higher vig for the house.

For instance, the odds of a tornado destroying a million-dollar building may be 0.01 percent. Statistically, the cost of that risk is $1,000,000 multiplied by 0.0001 or $1,000. The insurance company sells the assumption of that risk for much more than the “true” cost of $1,000.

Capitalizing on misconception of risk

Neuroscientists at the USC Brain and Creativity Institute have identified distinct brain regions with competing responses to risk. A study gave volunteers a task that measures risk tolerance and observed their reactions with functional magnetic resonance imaging (fMRI). The researchers found a difference in brain activity between those with high risk tolerance and lower risk tolerance. No one likes unnecessary risk, but some of your customers may view risk much differently than others.

If a tornado blows down my house, I know it will cost me hundreds of thousands of dollars to replace the house and contents. I have no idea whether the risk of this happening in the next 12 months is one in ten or one in a million, but the magnitude of the loss of my house plays tricks on my psyche. Human nature causes me to fear the loss more than I should and to view the odds as far worse than they actually are. I don’t want to accept the risk of tornado and want the risk removed for a reasonable price. I don’t really care about the statistical value of the risk. I simply weigh the psychological value of the removal of the risk with the cost of doing so.

If the price to remove risk is reasonable, markup is irrelevant. Take a look at these two examples:

Example 1: High markup but low cost

Your daughter, like mine, keeps losing or breaking her cellphone. For $8 a month, you can have the cellphone carrier assume this risk. For a diminutive price tag, you can save family strife, so you buy the policy. This is a low-risk/low-cost combination.

Policy cost: $8/month

Average time before claim: 24 months

Total policy cost over 24 months: $192

Approximate policy payout: $100 (used phone)

Policy markup: 92%

Example 2: Low markup but high cost

Your 62-year-old grandmother’s health is declining a bit. You realize she may need to enter a nursing home, so you research long-term care insurance. When you find out the cost will exceed $9,000 per year, you decide her health isn’t that bad after all.

Policy cost: $500/month

Average time before claim: 120 months

Total policy cost over 10 years: $60,000

Approximate policy payout: $50,000

Policy markup: 20%

Even though the markup on this policy is far less than the cellphone insurance policy in Example 1, the high-cost/high-risk combination reduces the attractiveness of this offer to both the provider and the purchaser.

By removing risks at a price reasonable to customers, insurance companies continue to generate outstanding profitability.

Denying Your Customers Insurance Is Costing You

Your business model can benefit from the same dynamics the insurance companies benefit from — accept risk in exchange for money. Your customers have some risks they want to be reduced or removed. If you deny customers the opportunity to do this, you’re costing yourself money.

Ask yourself whether your customers take risks by doing business with you. Most people immediately respond, “No.” They’re wrong. Customers accept lots of risks for the privilege of doing business with you.

Take the example of a plumber. Many customers ask themselves questions like the ones in the following list. Each question centers on risks the customer is forced to accept.

Will the plumber show up at the scheduled time? If you’ve taken off work to let the plumber in or rearranged your day, the answer to this question is a big deal.

Does the plumber have the necessary tools? If not, will I be billed for him to obtain them?

If the plumber doesn’t have the right tools, will he try to perform the work with the wrong tools and ruin something?

How skilled is the plumber? Is this his first day or 20th year on the job?

Was the plumber out late drinking with his buddies last night?

Am I safe alone in the house with the plumber?

How full is the plumber’s schedule? Will he rush my work or drag it out?

Does he have the parts necessary on the truck or will I be charged for an unnecessary trip to the hardware store?

Wouldn’t the customer like to remove some of these risks? Businesspeople tend to focus on excellence delivering their product or service, assuming well-delivered service equates to lack of risk. It doesn’t. Look at these questions again. No matter how well the service is delivered, you can’t eliminate these risks. Someone has to take the risk; it won’t just disappear. Generally, businesses push risks onto their customers. The old adage, “The customer comes first” isn’t true when it comes to risk assignment.

How many of the risks in the list would a typical customer pay to remove? The answer is several. Think about purchases you’ve personally avoided simply because you didn’t want to assume the risk. For instance, you need a good used car but don’t purchase one from your friend because you’re not sure it’s reliable. Over your lunch break you take your phone in for repair. The service technician assures you your phone will be fixed within an hour. You need your phone right after lunch so you tell the technician “never mind.” In both these situations, traditional business decisions such as price, quality, and brand had nothing to do with making the sale.

In order to make the sale, the risk needs to be removed, or the customer simply won’t buy. If you can figure out how to remove unwanted risks, you can increase customer satisfaction, attract new customers, and increase profits. This adds up to a better business model.

I’m going to add a layer to the contention, “Insurance is accepting risk in exchange for money.” You could bet $1 on the flip of the coin. I’ll give you five-to-one odds on your bet, thus accepting risk in exchange for money. However, I’d be accepting too much risk for too little money. So I change the definition to:

Profitable insurance is the acceptance of risk for more money than the risk is expected to cost.

Instead of insuring the flip of the coin for $5 when true odds are $1 wins $1, I want to offer you a quarter if you win the flip for a dollar bet. Now the odds are stacked in my favor. Imagine if I made bets like this over and over. True odds for a coin flip value the “insurance” at $1, yet it costs me only a quarter if I lose. This is exactly what a profitable insurance company does.

You have stacked odds like this with your customers. Because your knowledge of your business is vastly superior to your customers’, you know the true cost of any risk. The customer is just guessing. You can use this disparity of knowledge as a profit center.

Take the customer’s uneasiness about the skill level of a plumber. A poorly skilled plumber costing $150 per hour can run up a bill several hundred dollars more than a highly skilled plumber doing the same job. The customer views this risk from the angle of the worst-case scenario and attaches a several-hundred-dollar risk price tag to the risk. The plumbing company knows the skill level and performance of each plumber quite well and knows that the true cost of this risk is much less. In addition, the plumbing company controls the activities of the plumber and can mitigate some of this risk through training, procedures, and operational plans. The plumbing company has the opportunity to remove this risk for a reasonable fee and make a handsome profit.

You can’t remove the inherent risk in a business transaction. The risk doesn’t go away. Someone accepts the risk — you or your customer. Instead of forcing the risk onto an unwilling customer, why not profit from it instead?

Consider the following:

Insurance is accepting risk in exchange for money.

Insurance is very profitable if you can properly assess risk.

You have superior knowledge that allows you to assess risk better than customers.

Your customers unwillingly accept risk from you.

Your customers will gladly pay a reasonable sum to remove risk.

The amount the customer will pay to remove the risk greatly exceeds the statistical cost of the risk, thereby creating profits for the company.

Therefore, your secret profit formula is:

Superior knowledge + Risk acceptance = Outrageous profit

Instead of looking for ways to avoid risk, look for ways to accept risk — for a profit.

Charging Insurance in Creative Ways

It’s doubtful that a plumber can literally charge an insurance premium. Can you imagine him saying, “For an extra $3 we can guarantee the plumber who shows up will be competent?” Instead, you need to get creative. Charge a fee for what is essentially an insurance premium but not obviously so.

Many companies have profited from creative insurance premiums.

Extended warranties sold by Best Buy and Circuit City in the mid-2000s accounted for 60 percent of Best Buy’s profit and all of Circuit City’s.

Comcast guarantees on-time service or the customer receives $20. Comcast doesn’t charge a premium for this insurance. However, its profitability is directly tied to customer retention. By assuming the risk of timeliness, retention is increased and profitability with it.

Guarantees are a form of insurance. The company knows the quality level of its goods much better than the customer. The company charges more for the product and provides a product guarantee. The additional sales price represents the insurance policy against product failure. The company knows the cost of replacement will be far less than the additional monies generated.

Reputation management is a form of guarantee. A plumbing company spends significant time and money building and managing its reputation. Efforts spent on the Better Business Bureau, Yelp, Angie’s List, and an online presence are expensive. Effectively managing a good reputation results in new customers feeling less risk and more business for you. The cost of creating and managing the reputation is less expensive than the next best solution.

Prepaid dental plans accept the risk of the client’s bad teeth. However, these plans also ensure the client will use the dentist for the highly profitable cleanings.

Health clubs sell memberships based on their knowledge of average attendance. Large health clubs can have as many as 15,000 members. If 10 percent of these members showed up at the same time, the health club couldn’t accommodate them. The health clubs’ ability to accurately predict show rates allows them to sell more memberships.

Airlines intentionally sell more tickets than seats available on a flight. Surprisingly, airlines can more accurately predict whether you’ll miss your flight than you can. The airline knows that a certain percentage of travelers will miss their flight. Selling phantom seats provides the airline with tremendous profits for an item with no delivery cost. However, if the airline guesses wrong and ends up with more travelers than available seats, the airline must bribe flyers to change flights. When this happens, the airline loses money on the phantom ticket.

Cellphone loss/replacement plans are extremely profitable for cellphone carriers. The carrier will replace a lost, stolen, or carelessly broken phone. In addition, if customers lose their phones, they may have to pay a steep price for a new unsubsidized phone. Only eight dollars a month to avoid this potential pain seems cheap. The customer’s perception of the risk is high. The carrier understands the actual risk is much lower. Most likely, most customers won’t lose or break their phones. If customers do require a new phone, they receive the same make and model — not a brand-new one. This detail dramatically lowers the cost of replacement and dramatically increases profits from the replacement plan.

Energy management firms assume the risk of rising utility bills for large manufacturers. These firms agree to long-term (five or ten year) contracts that cap gas and electric bills at current levels. This is a great deal for a manufacturer who may be spending $1 million a month on utilities. The removal of the risk of spiraling energy costs entices the manufacturer into the contract. The energy management firm doesn’t have superior knowledge of energy prices, but it does have superior knowledge of how to reduce energy consumption by as much as 20 to 30 percent at most factories. The energy management firm evaluates potential customers to ensure savings can be captured and then retrofits lighting and motors in the factory and introduces ways to reduce natural gas consumption. The energy firm accepts the risk of an increasing energy bill, but enjoys the benefits when the bill drops by 30 percent.

An IT firm charges $1,000 per year per workstation for all technology-related services. A company with 20 workstations pays $20,000 annually for everything, including necessary software, support desk, wiring, server hardware, any new hardware needed — including monitors, keyboards, and computer — training, and software updates. The IT company removes all technology risks, allowing customers to focus on their business rather than IT headaches. The customer feels great about not having to purchase expensive hardware and software. The IT company understands that hardware doesn’t break often and doesn’t need to be replaced often. The difference in the customer’s perception versus reality provides a profit opportunity for the IT firm.

Solar companies insure sunshine. Solar firms will pay to install panels on your home and buy back the electricity.

Value-based pricing pushes the onus of a desirable outcome to the provider. Firms like cost consultants have identified areas most businesses can save. These consultants charge nothing for their services other than sharing the savings. The risk of the project being successful is assumed by the consultant.

A medical waste disposal company charges by the week rather than by the industry standard of per container or pound. Customers simply call when they need a pickup. The company assumes the risk of excessive volume. This plan has resulted in 2.3 customer pickups per month versus 4 prior to the plan. The savings associated with 1.7 fewer pickups per customer saves the company on vehicle costs, fuel, labor, and overhead.

Voluntary- or tip-based pricing can yield a higher average sales price. Some organizations allow customers to pay what they want for purchases. The company accepts the risk that customers will grossly underpay. For instance, a training company offers a suggested price per trainee but allows customers to pay whatever they feel is fair. The company’s analysis shows the voluntary payment system yields $22 per trainee more than if the company asked for a fixed sales price. The company accepts the risk that customers will underpay and benefits when they don’t.

Bumper-to-bumper warranties are a form of extreme guarantee popularized by automotive companies. The reputation gained by guaranteeing everything, instead of just major components, was significant from a marketing perspective but insignificant from a cost perspective, because all the expensive components were already covered under the old warranty.

All-you-can-eat buffets accept the risk that a customer will eat more food than the price charged.

All-inclusive resorts know many guests stay on the beach or in their hotel rooms rather than using cost-intensive services. Guests intend to use these services extensively at the time of purchase, but use them less than intended. The resorts profit from their knowledge of “the eyes are bigger than the stomach” phenomenon.

Zipcar rental has no mileage or gasoline fees. Zipcar assumes the risk that the driver will overuse the vehicle. Because its cars are available primarily in urban areas, the company understands that drivers probably won’t drive the cars far. By accepting the risk of long trips that will wear out their fleet, Zipcar can offer an attractive all-inclusive price with a profitable insurance policy bundled in.

Costco sells products at a lower margin than traditional retailers in exchange for a membership fee, essentially making the membership fee a purchased advance discount. The consumer pays $55 to $110 per year to get lower pricing. Costco makes very little profit as a pure retailer due to the reduced margins. Costco makes almost all profits on membership sales ($694 million last quarter). Costco accepts the risk that the customers won’t overuse the $55 advance discount.

Some landscaping and snow plow companies sell by the season. They accept the risk of weather. They don’t have the ability to predict weather better than the customer, but they do know that the law of averages can lead to better profitability. The customer desires cost predictability, so the company charges for the expected number of mows/plows and adds an insurance premium.

Lawyers’ retainers are effectively reverse insurance. The client guarantees the lawyer a certain number of hours will be purchased.

Fixed fees contain an insurance premium. For instance, a logo designer charges $350 for the logo, accepting one primary risk — that the client will require too many redo’s. The logo designer may charge only $50 per logo rendering, but the client has no idea how many renderings will be required. The logo designer knows that number to be 4.7 historically, and charges the difference between 4.7 renders and 7 as an insurance premium.

When an hour isn’t an hour

I saved the best for last. The best way to capitalize on the dynamics of insurance is through the use of a flat-rate hour. A flat-rate hour redefines 60 minutes.

Here I use the example of automotive repair, because flat-rate hours are commonly used in the industry. When you take your car to the repair shop, you may have noticed a sign showing a $70 per hour labor rate. In the automotive world, an hour isn’t an hour. Automotive repair shops use reference manuals like Mitchell’s to tell them how long a repair should take. The repair shop charges you the hourly rate times the hours in the Mitchell manual — not the actual time it takes to fix your car.

This system has many benefits for customers. The customer knows the total cost of the repair before work begins. More important, the risk of poor workmanship, bad planning, and cost overruns are shifted to the repair shop. If you think about it, no one wants to buy anything by the hour. Try it. Name something you prefer to buy per hour. When you purchase hours, you always feel the pressure of tick, tock, tick, tock. Almost everyone prefers the removal of that feeling. If you buy by the hour, you accept the risk of time overruns, and it creates a win-lose relationship between vendor and customer. The customer benefits if the repair happens fast. The vendor benefits if the repair goes poorly and takes longer. Fixing this misalignment benefits both vendor and customer.

However, the flat-rate hour system benefits the auto repair shop tremendously. A skilled mechanic can accomplish most general repairs in half the time stated in the Mitchell manual. Highly skilled special team mechanics (engines, transmissions) can complete work in one-third the time. The repair shop is billing two or three “hours” for each hour actually worked.

By redefining an hour as the amount of time needed by an average mechanic to complete a task, the repair shop creates a profit center for mechanics of greater skill. A good mechanic doesn’t get paid twice what a bad mechanic makes, but under a flat-rate billing system, the good mechanic bills double.

Example of creative insurance: Enron

Enron is famous for many bad business deals, but the company had an outstanding program that leveraged the power of insurance. Enron would approach large manufacturing facilities with a tempting offer to lock in the cost of their utilities for five or ten years. Large facilities such as automotive assembly plants can spend more than $1 million a month on utilities. Enron wanted to add customers like these to its energy brokerage business.

Fearing uncertainty about rising energy costs, factories were very receptive to Enron accepting the risk of rising electricity and gas costs. Enron used the customer’s desire to eliminate risk to its advantage. Here’s how:

An Enron division specialized in increasing efficiency of large facilities. This division would retrofit lighting to significantly more efficient products; replace old, inefficient energy-sucking motors; install superior insulation; detect and repair air leaks; and more.

Typically, these energy retrofits cut the utility bill by 25 to 50 percent.

Because Enron accepted the risk of rising energy bills, it also accepted the benefit of lowered energy bills.

Due to Enron’s superior knowledge in the arena of energy retrofitting, the company was able to accurately predict the amount of energy savings available at the plant. This amount was compared to the potential increase in energy costs. If the comparison was favorable, Enron agreed to hold energy costs constant.

Enron’s timeline for payback for the cost of retrofitting the plant was usually 12 to 18 months. When this payback period expired, Enron’s profits were significant. Energy costs may have inched up a few percent, but energy savings may have cut the bill in half.

Worksheet: Creating an Insurance Program

Clients always tell me, “I like the concept of insurance and see how it can improve profitability, but I don’t know where to begin.” Here’s how you begin:

1. Analyze the risks your customers or clients want to eliminate. Some of these risks will be obvious; some won’t be. Customers have been trained by vendors that many risks are nonnegotiable and can’t be removed.

In the 1960s, athletes had to self-insure against a knee injury. Today, they can buy a policy from Lloyds of London paying them if their career ends early. Your customers are still in the 1960s. They haven’t considered that some risks can be removed. You may not discover any of these latent risks, but if you do, you may have a game changer.

2. Think about the possibility of the customer or client paying to remove the risk. When you go to the car wash, a flock of geese could fly over your car immediately afterward, ruining the beautiful wash. The car wash could insure against this possibility, and you may even value it, but you probably don’t value this insurance enough for it to be a viable option.

3. Consider how much the customer would pay. Best Buy made a fortune selling extended warranties on $17 calculators for $5. Personally, I don’t know how customers justify this math, but people bought these policies. Remember, it’s not what the insurance costs; it’s what it’s worth in the customer’s mind.

4. Decide the logistics of how you’ll deliver the insurance. As you can see in Figure 22-1, some insurance can be a different marketing angle, a pure insurance policy, a guarantee, or another creative vehicle.

5. Determine what the insurance will cost. Is the cost-benefit relationship worth the effort? If so, go for it.

Figure 22-2 is a blank worksheet for your use in creating profitable insurance products in your business.

Figure 22-1: Potential insurance opportunities.

Figure 22-2: Creating your insurance business.