The Ricardian concept of comparative advantage (now some 200 years old) is a long-standing component of economic models; and supports many elements of public policy, such as the benefits of international trade making all the parties involved ultimately better off.
In contrast, the economists Angus Deaton and Ann Case have begun to articulate what one might be termed (with apologies to them both) a theory of cumulative disadvantage, as the result of which whole segments of a population group are effectively condemned to perpetuate a cycle in which its members are constrained from reaching their potential by a range of cultural, societal, educational and health factors.
Perhaps fancifully, we thought we would consider these two concepts in the context of the (re)insurance industry; and highlight some potential contrasting outcomes. Sentiment as to whether companies should specialize, or seek to provide as broad a range of products as possible tends to go in cycles; but what, in a (re)insurance company is a true comparative advantage? We would argue that it is the ability to write business that consistently generates high quality, risk-adjusted premium income, where losses are carefully controlled and manageable. Sadly, as results over the past few years have shown, as in 2016 when the US industry suffered a cumulative underwriting loss, far too many businesses are unable to differentiate themselves, with the result that a “good outcome” is now being able to keep one’s Combined Ratio below 100%. If one thinks about it, it is rather odd that a business should consider itself lucky to break even in the application of what is supposed to be its core competence. Where is the comparative advantage in that?
And to compound the lack, in most cases, of a comparative advantage, we shall move on the cumulative disadvantages now “enjoyed” by most (re)insurance industry participants. The continuing surfeit of capital seems to compel many to find a use for it, or contort their business model so that they do not “lose out” (think of the asset management industry’s obsession with “Assets Under Management”), which leads to erosion of discipline and being picked off in terms of pricing available in commoditized business lines. Add to this a byzantine and often opaque cost structure, which can consume an inordinate share of the revenue stream; the potential for disruption by actors who have no attachment to received wisdom and are willing to ignore “standard practice; plus uncertainty about the likely loss experience of new business lines, such as “cyber” and one has a reasonable facsimile of cumulative disadvantage.
How then to break the cycle?
Comparative advantage is only relevant if the underlying activity in which one engages is sustainably profitable. Clearly, it makes no sense to be the best there is in a particular industry if the core activity results in value destruction, or fails to earn its true cost of capital . So, the need exists for the P&C (re)insurance industry to consider some deep and fundamental changes to its business model if it is to overcome cumulative disadvantage.
We’d be more than happy to explain our interpretation of comparative advantage!
The Awbury Team