FinTech to Support Mutuality in Takāful

by Prof. Dr. Volker Nienhaus  

Takāful is often presented as a kind mutual insurance. Unfortunately, this is not correct for most takāful operators (outside Sudan). In a mutual insurance, the policyholders are the owners of the corporation, jointly bear the insured risk, and receive any underwriting surplus. In a proprietary insurance, the shareholders are owners of the company to which policyholders transfer their insured risks; the shareholders are the recipients of any underwriting surplus. In a takāful undertaking, the structure is a hybrid of proprietary and mutual insurance: The participants (policyholders) are supposed to jointly bear the insured risk and are entitled to any underwriting surplus (as in a mutual insurance), while a for-profit shareholding company initiates and manages the system for a fee. In practice, takāful operators skim off surpluses for the shareholders by surplus-related incentive fees. Thus, takāful participants and policyholders of proprietary insurers do not notice significant differences in practice. The takāful ideals of mutuality and solidarity have been lost in practice.

However, some FinTech concepts in conventional insurance are worth noting because they have created institutional arrangements that could also be applied in a takāful context (maybe by a start-up) to bring practices more in line with the takāful ideals of mutuality and solidarity.

Lemonade is a digital insurance company that offers fast and low-cost homeowners and renters insurance. It is operating in New York, California, Illinois, and New Jersey with plans for further expansion. As the website www.lemoande.com explains, Lemondae offers in most cases a direct approval of online applications with an insurance premium quote that takes into consideration the personal situation of the applicant and the quality and location of the object. Furthermore, a fast settlement of claims is achieved by a claims bot which takes immediate decisions in conclusive cases. The combination of digital contract management and a highly automated claim settlement give Lemonade a cost advantage over traditional insurers that supports, on average, lower insurance premiums.

 

What makes Lemonade an interesting case for takāful is not so much the application of FinTech for efficient processes, but its combination with a rather unique appropriation of the insurance premiums. The initiators of Lemonade had identified as the pain point of all conventional insurance a fundamental conflict of interest between policyholders and insurance companies respectively their shareholders (The concept has been explained by its CEO and Co-founder Daniel Schreiber in many speeches and interviews that can be found on YouTube. For a transcript of a comprehensive interview see Schreiber, Daniel (2016): Interview with Daniel Schreiber, CEO and Co-Founder of Lemonade, Wharton Fintech, 20 December 2016, https://medium.com/wharton-fintech/interview-with-daniel-schreiber-ceo-and-co-founder-of-lemonade-1a6aef384e2f#.stwtiim0z): Each dollar paid by the insurance company to a customer for claims settlement is a forgone profit for the company. Therefore, insurance companies are slow and reluctant in processing claims and distrustful of their clients. Many if not most customers reciprocate this distrust not by outright fraud but by “embellishing” their claims. This, again, justifies the distrust of the insurer, and so on. To overcome the conflict of interest between policyholders and shareholders, Lemonade only charges a flat fee of 20% of the insurance premium and earmarks the remaining 80% for claims settlement. Whether all of these 80% are spent for claim settlement (and reinsurance premiums) or only a part does not affect the income of the insurance company.

Any underwriting surplus will not be pocketed by the shareholders but will be allocated proportionately to a range of social projects or non-profit institutions (“causes”) which the policy holders can choose (“Giveback”). It is expected that policy holders will refrain from embellishing claims as soon as they realise that the excess would not by “paid” by the insurance company but hurts a cause that they want to support.

Public choice theory and behavioural economics suggest that the incentives for non-embellishment are rather weak if the policy holders see themselves as members of a large anonymous group and the causes are also large charities (The behaviour of each individual policy holder has no measurable direct effect on the others, the embellishment will go unnoticed (especially if the insurer has no strong incentive to scrutinise claims), and the forgone Givebacks are too small to be significant for a large charity). Therefore it is important that not only large charities but also smaller non-profits and local community projects can become causes to which policy holders could allocate Givebacks. Win-win-win situations could emerge if community member decide as a group to take insurance from Lemonade: If premiums are less than those of competitors, the individual members win. If surpluses are generated and the community project receives Givebacks, the community wins. Lemonade also wins, namely income from new policies.

It remains to be seen whether the Giveback scheme will become effective. Everybody can buy insurance from Lemonade, and the main attraction could be lower premiums and better service. This may be enough to attract a large number of ‘materialistic’ policy holders who do not care about any surplus for social causes from which they will not draw any personal advantage. For them personal gains from an embellishment of claims outweigh social losses from reduced Givebacks.

If social causes are not sufficiently attractive for materialistic policy holders to change their claims behaviour, financial refunds may provide better incentives against embellishment of claims. The logic of collective actions as well as behavioural economics suggest that the behaviour of individuals as group members depends on the perceived interlinkages between them. Roughly speaking, their reaction to the behaviour of other group members is different in large and small groups: In large groups, free-riding of individual members may not be detected; in small groups, where members know and observe each other and are perceptibly affected by behaviour of the others, individuals behave less egoistic and more group-oriented than “individualistic rationality” suggests. Insurance requires a large group of policyholders for the law of large numbers to become effective, but the subdivision of one large group into many small “affinity groups” may generate a behaviour of policyholders that is more group-conscious and solidary.

The model of German insurance broker firm Friendsurance (for mobile device insurance, home contents insurance, and car insurance) is based on the subdivision of large groups of policyholders into smaller affinity groups that could benefit from a group-conscious claim behaviour. The model requires that policyholders transfer existing insurance contracts to Friendsurance (The concept is explained on the website www.friendsurance.de. As a consequence of the transfer, Friendsurance will receive all future brokerage commissions paid by the insurance companies for existing contracts). The protection provided by these contracts remains the same for the policy holders, but the broker and the insurance companies agree to insert new or increase deductibles in the contract (The model can be applied only to those types of insurance where contracts with deductibles are used). This would result in a decrease of the premiums, but the money saved by lower premiums is not passed on to the policyholders but transferred to a solidarity pool. Smaller claims (up to the deductibles) will be paid out of this pool; larger claims (beyond the deductibles) are compensated by the insurers. If a surplus remains in the pool by the end of the year, the unspent money will be paid out to the policy holders. On balance, the policy holders will not pay more for their protection, but they benefit from the chance to receive a pay back if the costs of claim settlement have remained low.

The expectation is that claims will remain low because policy holders are organised by Friendsurance with P2P techniques into small affinity groups of approx. 10 members who all hold the same kind of insurance policies (e.g. home content). It is also possible that policy holders build their own peer groups with people whom they know and consider trustworthy (e.g. family, friends, neighbours, colleagues). A group of 10 is small enough so that any claim made by one member has a significant impact on the solidarity pool and is noticed by all other group members. It is highly probable that policy holders who want to be considered honest and whose actions are observed by the other group members will refrain from unnecessary and embellished claims. As the initial premiums were calculated by conventional insurers on the basis of their claims history, it is reasonable to expect that the actual claims ratio of Friendsurance will be lower than the ratio assumed in the initial calculation. Hence, a group-conscious behaviour should generate surpluses that can be shared among the group members.

Elements of Lemonade (in particular the flat fee and the digital administration and distribution channels) and Friendsurance (in particular the formation of small solidarity groups) could be combined and transposed into an Islamic framework. For example, a takāful undertaking that offers competitive premiums and generates surpluses that the policyholder donate collectively to social causes would combine protection with philanthropy in an Islamic environment.