The importance of price as a piece of information

Prices are a powerful signal, but be wary of distortions when acting on them

Quick summary:

• The price of a good or service conveys powerful pieces of information

• Prices are valuable because they are expressed in terms that are easily understood

• A big challenge arises when prices are distorted by outside influences (subsidies)

• When setting prices, consider the signals you are sending to your customers

• When considering prices, ask if the total economic costs are adequately included

• When prices appear to be too low, look for hidden costs in your transactions

The power of the “price signal of risk” in insurance

I spend several years in the mid-2010s as a leader at USAA with a specialty in property underwriting in disaster-prone areas. We worked hard as a team alongside actuaries, product managers, and claims experts to find a balance between making homeowners insurance products that were both available and affordable for customers while remaining profitable for the company. We used sophisticated tools, including catastrophe modeling, aerial imagery, and artificial intelligence, to accurately assess risk probabilities. Due to the uncertainties involved, there was a lot of room for methodological differences and statistical error. Given the need to properly assess over 5 million addresses, we needed to ensure our approach scaled and did not drive up expenses or lead to a poor customer experience.

As part of this process, we had a philosophy of working with our customers to help them understand their risk and identify actions they could take to strengthen their homes and property, seeking to reduce the likelihood of a loss occurring or the severity of the damage should one occur. Unusual among most insurance carriers, we exposed some of the same data we used in our analysis to the public and provided them with a categorical assessment. Homes were rated as low, moderate, high, or very high risk across several perils such as flooding, high winds, and wildfire. Despite this desire to educate homeowners and help them make sound decisions, these descriptors were generally too broad and vague to be meaningful. What is the difference between moderate and high? High and very high? How much time and money should I invest in protecting my property - a known and fixed cost - compared to “rolling the dice” that nothing bad will happen while I live here? Worst case, isn’t that why I purchased insurance in the first place - to compensate me in the event of a loss?

One area where we could gain a lot of traction was in Florida. The state had a program called Florida Building Code (FBC) credits that provided steep discounts on insurance premiums for features such as roof-to-wall connections and openings protection such as hurricane-strength shutters. While homeowners premiums in the state were the highest in the nation on average and could exceed $10,000 annually, these discounts often ranged in the thousands. As a property owner, it was fairly straightforward to do the math: you had a good sense of your premiums and how much you could save by purchasing a home with strong features or retrofitting to harden your home against wind and water damage from hurricanes. In short, there was a price signal of risk: instead of vague terms such as “high risk,” your insurance premiums and discounts communicated your level of risk in precise, easy-to-understand units ($).

Cost considerations: interest rates and profits

The price signal of risk - insurance premiums - are a powerful source of information for economic actors. In addition to helping homeowners fully understand their risk of loss from a hurricane, they can also influence home builders, local zoning officials, state government leaders, and public policy, to name a few stakeholders. Roughly speaking, a home that costs $10,000 to insure annually is 5x more likely to suffer a severe loss than one that costs $2,000 to insure. The math is crude; undoubtedly, this is a gross simplification - but that is precisely the point. Economic actors do not have to be insurance experts: the price signal of risk alone contains enough information to guide their decision-making.

More broadly, we see this same impact on the larger economy when considering macro trends such as the level and changes in interest rates and inflation. Concerns over an economic recession have led to mass layoffs over the past year. Investors are prizing profitability over growth. Ironically, it may prove that we will avoid what felt like an inevitable recession. If so, the reason we avoided one is likely because of the independent decisions and actions that firms took to adjust their businesses. While not formally coordinated, the information signals from economic indicators such as CPI inflation and federal funds rate act as part of the “invisible hand” mechanism oft mentioned as the defining feature of capitalism.

Be aware of hidden costs in your transactions

Unfortunately, we cannot always rely on prices to convey all relevant information. I previously wrote about the end of an era for cheap tech-enabled lives in Forestview. Prices have been rising partly due to supply chain constraints due to COVID-related challenges. Still, many rates have also risen for prices that were artificially low to drive growth for services such as ride-sharing and streaming video that aren’t directly related to the pandemic. Additional price-related adjustments are also being made: tipping is now standard for ride-sharing (and seemingly everything else), and streaming services are raising prices while introducing ads for their cheapest tiers.

Other motivations behind economic transactions can be hidden and are worth considering. For example, the new rival professional golf league LIV Golf has lured several top names from the established PGA Tour over the past year. There has been a fierce debate about the intentions of the Saudi-backed LIV tour and questions about whether it can be self-sustaining from a purely economic standpoint. (It does not appear to be at the moment or for the foreseeable future.) More examples abound: think about climate change and related investments and costs or the rise in polarization following the rise of social media and Big Tech. The point here is that, too often, the costs we need to consider come in the nebulous form of “very high risk” rather than more easily quantifiable forms like the dollars and cents of insurance premiums. Prices are a critical source of information that works exceptionally well in general precisely because they allow us to ignore more details. Too often recently, they fail to tell us a complete story.