P2P Insurance Auction
In this post we examine how peer to peer insurance coverage could be priced in an eBay style auction, assuming no artificial regulatory constraints. We relax this assumption in subsequent posts that deal with the real world practicality of introducing peer to peer insurance to the market, but this thought exercise serves as a useful reference point for the purpose of conceptualizing a purely market-based pricing mechanism.
The following example illustrates how the bidding process would work for a business seeking commercial insurance coverage for a factory:
- The business seeking coverage for a factory submits an application to the peer-to-peer insurance platform. The business submits a request for bids, providing information on the factory, historical data on incidents and claims, current insurance arrangements and that they are seeking $1m in cover. This information is all provided to (professional or amateur) underwriters who may analyze the information and determine a fair premium. During the application process, the business specifies that they wish to pay $25k in premium, which serves as an automatic binding rate if it can be achieved. This $25k value is not provided to underwriters.
- After one week, the following bids have been received (‘rates’ are per 100% of the risk):
- one underwriter has bid to accept 5% of the risk at a rate of $50k
- another has bid to accept 10% of the risk at a rate of $40k
- another has bid to accept 5% of the risk at a rate of $20k
- another has bid to accept 10% of the risk at a rate of $10k
- These bids are reflected in the chart below. Since 100% of the risk has not been accepted at any price, the risk cannot be bound yet. This stepped line is effectively the supply curve for the risk transfer.
- After another two weeks, enough bids have been received across 15 different underwriters to produce the chart below.
- At 100% on the bottom axis, the left axis is $40k. This means that at a rate of $40k, there is enough capacity from underwriters to absorb 100% of the risk. This $40k rate is reported back to the business, and is updated live as bids are added or withdrawn. This $40k is effectively a crowdsourced insurance quote.
- If the business accepts this quote then the underwriters who bid for a rate below $40k are then bound to that risk at a rate of $40k. Each underwriter receives premium proportional to their bid percentage times the premium and is at risk for claims in proportion to their bid percentage, subject to a total claim limit in this case of $1m. Note that all underwriters bound to the quote receive proportional premium and pay proportional claims irrespective of where their particular bid was ranked among the successful bidders. For example, if the lowest bid was 10% of the risk at a $10k rate then that underwriter would still received 10% of the $40k premium not 10% of the $10k they bid.
- The automatic acceptance premium entered by the business (at which the risk would automatically bind) was $25k. If the rate at 100% on the supply curve falls from $40k to $25k then the coverage would automatically bind. This just allows the business to not have to manually check and accept the going rate.
- Underwriters may withdraw their bid any time prior to binding. Insureds should not wait too long to accept a price above the equilibrium price. Underwriters may withdraw their bids if they think the risk won’t be bound at an attractive price.