Technology, Risk and Insurance

Technology means more than computers, and biotechnology is

making a big impact on insurance, and so are other kinds of technologies

Major developments

• On the computer front: This is a well talked about area but all aspects of risk management are never explicitly explored

• Biotechnology: Genetic engineering can potentially transform life/health business

• Applied mathematics of securitization: repackaging risks

• Note: These developments bring their own problems with them

Computer revolution

• Toffler’s view of three revolutions• Agriculture: Development led to settlement and

tremendous growth of stationary population• Industrial Revolution: Industrial development

transformed civilization• Electronic technologies: Computing and

telecommunication will have profound social and political implications

Insurance and technology

• Changes in corporate strategy

• Services strategy which allows decision making to move closer to customers– from head office to field office– from centralized to decentralized (autonomy)

• Already it has transformed the reinsurance business around the world

• Capital is very mobile via technology

Distribution channels

• Internet as a distribution channel– For many companies, it is becoming another

distribution channel– Banks are offering financial services via internet– They already had great success with telephone

banking and the ATM– Increases efficiency and reduces cost of

providing service (customers benefit)

Insurance Applications

• Four areas

• general communications

• product pricing

• agent support

• direct sales

General communication

• coordinated program or campaign to build awareness and build image with consumers– insurance businesses already have them in

newspaper, radio and TV advertisements– internet will provide another channel, and in

time, the biggest channel of communication

• Why?

General communication

– The Internet is a great medium for providing much more product detail and more current product detail than is typically available, and you can provide it much more cost effectively.

– In that regard, it’s a good medium for making major announcements and getting the word out on new developments, whether it be to your employees, to consumers, or to your agents

General communication

– A number of companies are using the Internet as the primary distribution channel for shareholder information—items that companies are required to make available by law and the type of thing that companies spend a great deal of money printing and distributing.

– They put it up on the Web. – It can be downloaded and printed out on

demand

General communication

– 1. Many are using the Internet as a tool to direct consumers to local offices and to local agents.

– 2. Others are using it to collect customer feedback and distribute customer satisfaction surveys and other types of feedback devices.

– 3. The most fundamental use of the Web now and what most people are using it for is as a stepping stone.

– 4. Using it as an electronic form

Pricing

• Agent function– Doing needs analysis and price quotes,

providing product detail and carrier detail and taking the application is easily accessible to a well-thought-out Web site, and it typically ensures a degree of consistency and accuracy that you don’t always get through the agent channel

Pricing

• Result– Days of most agencies are numbered– Bread and butter functions can easily be tackled

by the internet

• How do we know?– Look at banking– ATM has revolutionized banking as we know it– Most teller functions can be handled by ATMs

Pricing

• Front and back end efficiencies

• Offering eletronic form with built in help “wizards”– an agent or a consumer can fill them out, and

those data will be transmitted to all the necessary users of the data, the pyramid company, directly into the carrier’s underwriting system

Pricing

• Using the electronic decision maker– Before an application is submitted

electronically, it’s going to go through a screen that contains the basic underwriting criteria, and it’s going to make an immediate determination whether or not that applicant meets the basic criteria for the product. If the answer is no, the agent knows about it immediately and can direct the applicant to a more appropriate product

Pricing

• The problem with the current system– when a large percentage of these applications

come in, there’s a great deal of work done on them only to find out that the product wasn’t sold properly to begin with, that the applicant really doesn’t qualify for the product that he or she is applying for, and there’s a great deal of cost involved in that

Agent Support

• provide product details and updates– Announce when a new product comes out, or

announce a change in an existing product to the field personnel.

– Typically it costs a great deal of money and takes a great deal of time. Even then, the agents often don’t get it and don’t use it.

– When you make a change to product information on the Internet, it is available worldwide in seconds.

Agent Support

• Real saving– When a company spends money for new forms,

typically for many months after the new forms have gone out, applications still come in on the old forms. The Internet really solves all that. It’s a good way to provide financial planning or sales tools to your agents. Needs-analysis worksheets, state planning worksheets, telemarketing scripts, and telemarketing letters can all be put out there and downloaded and used by your agents very easily!

Agent Support

• Real time distribution– Most agents have the ability to provide price

quotes now, but the distribution of that information is fairly awkward. Usually it involves creating diskettes at the home office, trying to get them out to people in the field.

– The Internet provides an easily accessible, centralized place for storing all that information, and it ensures integrity of the data

Direct marketing

• What will the consumer get?– Consumers are going to have direct access to

information that, in the past, has been available only through the agents.

– They’ll be able to go online and assess their own needs using basically the same tools that agents use now. They’ll be able to get price quotes across hundreds of carriers where they can actually get an unbiased view of the marketplace without any pressure

Risks from technology

• Type of risk: low risk high cost events

• Electronic fraud– credit card problems– with electronic fund transfer, bank robber need not

enter a bank to rob money

• Laws currently cover “paper based” documentation

• With electronic means, plagiarism can be more widespread

The Y2K problem

• A problem that arises for computer dates that do not start with 19xx

• What is the problem? If the date does not have four digits for the year, at the turn of the century, they will all go back to the “beginning of time”

• How widespread is the problem?

Y2K

• A banking pass in the Netherlands has an expiration date of four years. My brand new bank pass shows an expiration date of '00'. After filling up my car at the gasoline station their computer find out that my pass expired. Although 2000 - 1997 =3 but 00 - 97 = -97

Y2K

• Card expiration date of VISA card is still MM/YY, although Visa has threatened to impose fines of $160,000/month on any of its merchants that fail to make their credit-card Y2K compliant

Y2K

• Set PC date on 23:58 1999, switch PC off , wait five minutes, set PC on, check date...result: Jan 4 1980! In case date is OK create a file and check the creation data. Investigation via Internet indicates that 75% of the PC will fail

• Try to set the date manually. Type DATE at the DOS prompt and enter 01/01/00. What did you get as a response?

Y2K

• In 1992 Mary Bandar of Winona was invited to join kindergarten because she was born in '88, in fact she was 104

• Last year a 106 year old woman in Sweden received letter for the first grade (born in 1890), Needless to say, Mary Bandar didn't have to buy crayons and a backpack

Y2K

• For Marks & Spencer, the nightmare began with a tin of corn beef, rejected on the ground that it was 96 years out of date

• Marks & Spencers are auditing their 700+ suppliers for compliance

Y2K

• New Year's Eve 31/12/1996 saw a software failure at the New Zealand Aluminum Smelter shutting down controlling computers without warning. Caused by a programming error that couldn't handle 1996 being a leap year, temperature control in the melters failed causing extensive damage. Replacing them will cost in excess of $NZ 1,000,000.

Y2K

• Two hours later, the problem was duplicated in Tasmania as Australia entered the new year. Both smelters used the same software

• The global Positioning System week number rollover at midnight of 1999-08-21 setting this number back to 1980-01-05 This system is on board of satellites and can not be corrected

Y2K

• Lufthansa recently announced they will be grounding their flights for a 24 hour period on 19991231-20000101. Apparently they are not concerned as much with the electronics on their aircraft as they are with the various national air traffic control systems and the tremendous risk of legal exposure.

• Other airlines are avoiding flight time

Why Y2K problem?

• Lack Of Widely Accepted Date Standards– Nobody has a standard representation of dates

that has been internationally accepted and implemented. For example, to an American, 1/4/96 means January 4th, 1996. To an Englishman, 1/4/96 means the first of April, 1996 - more colloquially known as "April Fools' Day".

Why Y2K problem?

– Attempts have been made since the mid 1970s to set such standards, and even as recently as the late 1980's the ISO-8601 standard advocated the yyyymmdd format for date storage. But the use of these standards was never internationally mandated and they never achieved critical mass in commercial acceptance. Many IT shops have never even heard of them.

Why Y2K problem?

• Computing Resource Restraints– Main memory, disk space and even punched

card space was at a premium in the early days of computing. Whatever could be squeezed to save space and money was squeezed to save space and money. In the early days of computing, it made sense NOT to include any extra digits for years. In In the early days of computing, it made sense NOT to include any extra digits for years.

Why Y2K problem?

• User Demand– Computers are designed to make life easier for

users and to relate to users in a manner consistent with their known world.

– Nobody wants to key in the century when he or she is not used to having to do it in other circumstances (for example, when writing checks).

Why Y2K problem?

• 4. Applications Have Lasted Longer Than Expected– When designing a new application, a typical

justification for using a date algorithm which would fail when processing dates outside the 20th Century was that the application wouldn't last outside that era anyway. The older style applications have been required to soldier on while their much vaunted younger replacements have fallen by the wayside.

Why Y2K problem?

• 5. Backwards Compatibility– As the reservoir of established applications grows

ever larger so each and every new application written is expected to maintain some form of compatibility with previous systems. If Windows had not been able to run DOS applications, Microsoft would have been dead in the water when their GUI was launched. Windows95 is faced with the burden of supporting DOS, 3.1.etc...

Why Y2K problem?

• Code Re-Use– It has always made sound economic sense not to

redevelop the wheel. Virtually all new applications have algorithms and even code incorporated from previous systems. This speeds up development and results (usually) in more reliable systems. The re-use of algorithms which have a hidden date processing fault is one reason why the year 2000 problem is so huge

Why Y2K problem?

• New complications with PC revolution– With the PC revolution, development and

control of many applications has typically passed out of the control of the IT professionals into the hands of the end users. So changing the core corporation data means immense inconvenience and cost to all those end users

Costs and Benefits

• Clearly, it will cost to fix the problem

• How much?

• There are benefits to be considered: the additional cost that companies would have had to bear if they had used YYYY instead of YY (this is the concept of opportunity cost)

• Which is larger?

Costs of Y2K

• Direct cost: The cost of fixing all the source codes

• Gartner Group estimates that there are 225 billions of lines of code to be fixed

• 1996 cost is around $1.10 per line

• Total bill $250 billion

• More recent estimates of cost per line has gone up

Costs of Y2K

• Some estimates put cost per line to be $3-$5

• If so, the cost can be as high as $6 billion

• Is this correct?

• The problem is routine fixing of lines

• It can be easily handled off shore: e.g., in India or in the Philippines

• Then, the cost can be lowered dramatically

Costs of Y2K

• Many programs with problem are mainframe programs

• They can easily be phased out

• Half the programs are not worth saving

• This can reduce the cost by more than half

• There will be cosmetic problems that are easily fixed by off-the-shelf program

• Thus, cost can be much lower

Benefits of Y2K

– In the late 50's and early 60's, when many of today's general accounting and core business systems were designed and programmed, a major constraint was the number of characters which could be recorded on an 80-column punched card. This physical limitation led us to record dates with only 2 digits representing the year to save precious space. This limitation was eliminated by disk storage when it became widely available in the early 60's.

Saving so far...

– Disk storage devices greatly enhanced the usefulness of computers because of their ability to access data randomly, but this new type of storage was very expensive.

– In 1996, as we upgrade and/or replace systems to accommodate the millennium change, the lease price of mainframe hard disk storage is under 10 cents per megabyte (MB) per month.

Saving so far...

– But in 1963, 1 MB of mainframe storage cost about $175 a month to lease (that's about $10,600 per year per MB in 1995 dollars or nearly 1 million percent more than the 1996 cost). So, to save money we continued to use 2-digit year fields. And economic reasons were why we continued this space saving practice.

Saving so far...

– By 1972 the price of mainframe storage was down to $36 per MB per month, but that's still over $1,600 per year per MB in 1995 dollars (or nearly 150,000 percent more than current cost)!

– By 1983 the price was just under $22 per year per MB in 1995 dollars (but still 2000% more than the 1996 cost). So just how much have we saved our organizations over the years?

Saving so far...

– Depending on the industry and application, about 3% to 6% of the data stored in organizational databases is dates. Using 4-digit, rather than 2-digit year fields would have required 33% more storage for dates (MMDDYYYY versus MMDDYY). Using the lower 3% figure for date density, we conservatively estimate that 1% more disk storage would have been required through the years if we had stored all 4 digits of the year field.

Saving so far...

– One percent doesn't seem to be very much until you consider several important factors: the large volumes of data stored by organizations, the historically high cost of storage, and the rate of inflation. So for every gigabyte (GB) of organizational data stored, a 1% savings represents 10 MB. Designing systems to save 1% of storage costs since 1963 has saved between $1.2 and $2 million per GB (in 1995 dollars) depending on how quickly storage equipment was upgraded.

Saving so far...

– Then, there's the cost of capital, as well as the opportunity cost had those precious dollars been spent on storage rather than invested in other ventures. Using only a 10% internal rate of return (IRR) on capital, $16 to 24 million (in 1995 dollars) has been saved per GB of total storage in the 30 years from 1963 through 1992. This is a more realistic indication of the economic benefits of our date storage decisions.

Saving so far...

– In light of these savings, the $10 to $50 million estimated cost organizations may incur to correct the "millennium bug" pales in terms of benefits accrued. One organization, currently storing 12 terrabytes of mainframe data and about 700 GB 15 years ago, estimates that if their average storage over the 30 years from 1963 through 1992 were only 10 GB, they saved over $100 million in 1995 dollars. They estimate that their actual savings may be 5 to 10 times that size!

Insurance and Y2K

• Is there insurance available to resolve the Y2K problem?

• Some. – AIG recently announced the availability of

"Millennium Insurance," which it describes as "a policy that provides business interruption and legal liability coverage in the event that 'Year 2000' information technology system solution/conversion efforts by the insured or a third party fail.

Insurance and Y2K

• The Millennium Insurance policy is comprised of three coverages: direct business interruption, contingent business interruption and third-party liability. – The direct business interruption coverage

covers loss of profits for business interruption resulting from unsuccessful conversion by the insured of its own systems.

Insurance and Y2K

– The contingent business interruption coverage covers loss of profits and extra expense for business interruption of the insured due to an unsuccessful or incompatible conversion by a third party that results in the failure or interruption of a third-party system or data transmission capability. The third party liability coverage includes errors and omissions (E&O) and directors and officers (D&O) insurance and covers an insured's legal liability resulting from its own or a third party's conversion efforts.

Liability problems for internet

• If I post an anonymous message against you on the usenet, who is liable?

• Technology can create problems with privacy rights– credit card information, telephone records,

medical records, educational records, insurance records, police records can be cross referenced and build profiles of people

Biotechnology

• Pharmaceutical advance– drugs: old method-mostly biological– new: synthetic-example-plasma-it requires

matching by blood types, in future, it will not

• Medical advances– use of mechanical heart, liver– use of potato for skin

Genetic research

• Human genome project: There are 100,000 genes and 3 billion pairs of ATCG DNA codes

• Genome needed two ingredients: gene mapping technology and advances in computer technology

• Cure for potential diseases that arise out of faulty genes

Potential candidates

• Most genetically linked diseases

• Down’s syndrome

• Alzheimer’s disease

• muscular dystrophy

• genetically linked cancer (breast)

• cure for baldness

• screening fertilized eggs

Potential problems

• Identifying problem gene does not mean identifying cure

• so far, 4,000 dieases have been linked to specific sites on specific chromosomes

• Potential to identify disease long before it manifests itself

• Identified genetic risk factor may lead to loss of health insurance, workers’ compensation or life insurance

Examples

• California man was denied health insurance when he changed job because he had the gene for neurofibromatosis

• Missouri woman had a blood test showing that her unborn child may have abnormally formed spinal cord

• Texas woman denied life and disability insurance because her mother might have died due to Hintington’s disease

The issue

• Rights of insurance company versus the rights of the individual

• Insurer: use genetic information to underwrite risk for a homogeneous group

• Discrimination: when it is not justified by facts

• Justification: insurance company’s view-statistical justification

Ultimate implication

• Insurance is only available for individuals who are free from genetic diseases

• Each group with sufficiently identifiable genetic disease potential can be insured

• Many types of discriminations are not allowed by law: based on skin color

• Can an employer make hiring or insurance decisions based on genetic tests for cancer?

Hazards of technology

• Industrial waste is a hazard to humans

• cyanide is a poison used in many chemical processes

• radioactive material is a by-product of nuclear energy

• many industrial by-products are known carcinogens

• some harmful effects are known later: DDT

Example

• Environmental cleanup in the US would cost $500b-$1trillion

• Surplus in property casualty in the US is $200b

• If insurance industry cannot offer insurance for the “general” market, government will have to step in and eventually the taxpayers will foot the bill

Technological advances in the financial markets

• Financial and risk management are converging

• Insurer can hedge risks of interest sensitive assets and liabilities with currency futures and other derivatives

• Securitization: derivative financial instrument, act-of-God bonds, Catastrophic Re Options...

Potential problems

• Many in the corporations do not understand the new instruments

• Hence, they do not understand the potential abuse

• Barings problem: one person’s misuse brought down a company

• If some complex derivatives are intentionally or deliberately mispriced, it could be a potential problem