The economic net benefits of loss prevention technologies in the context of risk management and insurance

Both Danish and building owners worldwide spend billions of Danish kroner annually on mitigatingthe risk of building damage. It is reasonable to consider investments that directly limit risk offinancial loss from building damage. At the same time, investments can have indirect impactsthrough insurance pricing and contracts. Whether such investment can and do return a positive netbenefit when the interactions between insurers and policyholders are considered is the overarchingquestion of this thesis.

Building owners face a dilemma where they can choose to invest in adjusting the risk of building damage, choose to transfer—some or all—risk to a third party or choose to do both with the
expectation of increasing their own net benefit through a combination of lower damage and insurance costs. Unfortunately, existing research provides little understanding of the effect property loss prevention technologies have on building damage and how they possibly influence property insurance pricing under risk transfer. To address the overarching question, this thesis aims to quantify the effect of property loss prevention technologies on building damages, and how investment in property loss prevention technologies may affect property insurance pricing. Finally, the thesis explores how property owners should prioritise investment in loss prevention ex-ante risk transfer.

The thesis consists of four scientific articles. Together, the four articles provide an understanding of the economic net benefit of investing in property loss preventive technologies for both building owners and policyholders. The first article guides the reader through the known academic literature on property loss prevention technologies’ effect on property risk. The review identifies significant gaps in knowledge about the effects of the most widely used loss prevention technologies on property risk. In particular, significant heterogeneity in underlying factors influencing the risks, including neighbourhood and scale effects, makes establishing causality difficult. Furthermore, very few studies attempt to quantify impacts in monetary terms, especially with regard to changes in insurance costs relating to investments. This has resulted in net benefits of investments having rarely
been calculated and when they have them not including insurance market impacts.

The second article begins to address these gaps through an empirical analysis of the relationship between property loss prevention technology and property damage for a broad set of Danish municipal properties. The article parses the damages of the municipalities’ properties as a function of most commonly used technologies: automatic fire protection systems, sprinkler systems, burglar alarms, access control systems, video surveillance systems and automatic water stop protection. The
data come from approximately 5,000 buildings owned by Danish municipalities from 2014 – 2018.

The analysis finds significantly lower damage costs in the presence of loss prevention technology, ceteris paribus. It also finds that despite an effective reduction in costs, the direct financial gain from investing in loss prevention may be low. This is in large part because of the low probability of damage events occurring. The limited estimated savings may thus only partially co-finance the loss prevention technologies’ operating costs.

It may be that lower premiums can sufficiently compensate for the remaining uncovered investment costs. The third article investigates how the use of loss prevention technologies affects insurance premiums. The data used in the empirical analysis come from Danish municipal properties. The 40 municipality owners of the buildings held 72 insurance contracts from 2008-2019. Each contract agreement is matched with the data on historical claims, insurance pricing and building characteristics during the period. Despite the earlier analysis in the second article confirming that property loss prevention technologies are associated with lower risk for the risk carrier, the analysis finds that the insurance companies' premium determination is instead primarily affected by the policyholder's historical claims cost. Furthermore, damage costs’ influence on the premium decreases as damage costs become greater. Only increased use of technologies that often limit smaller damages are shown to have some influence on the insurance premium.

In the fourth and final article, a game-theoretical model of the interplay between the policyholder and insurer is formulated. The model simplifies a continuous choice for pricing to the two possible extremes that an insurance company may take in response to the policyholder’s use of loss prevention and increase in deductibles. On the one hand, the insurer may be optimally responsive to the policyholder’s investments in setting the price. The policyholder then benefits from an insurer’s response to an increase in the use of property loss prevention and deductibles with lower insurance prices. Alternatively, the insurer is non-responsive; thus, the policyholder does not benefit. The combined data from the two prior empirical articles are used to understand the industry’s actions. The data show that the insurance industry can be considered non-responsive to policyholders’ use of loss prevention technologies. The data confirm that the use of loss prevention reduces the cost of claims; however, the savings are not passed on to the policyholder but instead found to increase the insurer’s contribution margin. The article makes clear that the policyholder will gain the most by being reluctant with investments in loss prevention if a third party carries the risk.

The overall thesis contributes to the economic literature and makes significant empirical contribution to the understanding of how loss prevention technologies affect property risks and the
insurance companies' pricing of property insurance premiums. It also makes a significant theoretical contribution with a better understanding of how the policyholder should prioritise the choice of investing in loss prevention and setting the level of deductible to increase own net benefit.