The Insurance Challenge: Managing Complexity
Complexity has grown for insurance companies amid acquisitions and product proliferation. Now to stay in the game, insurers—life and pension firms in particular—need more transparent, straightforward operations. This means complexity must be addressed.
When the financial crisis hit three years ago, its impact on banks received the most attention as maintaining short-term liquidity required substantial government intervention. The insurance industry, by contrast, appeared to be far less affected, aside from the toxic assets on balance sheets. It is clear now, however, that the crisis has had a far greater impact on the insurance business—especially life and pension insurance—than first thought. Indeed, the unstable global economy spurred a cascade of effects that are now reshaping the industry in a number of negative ways. New capital requirements and risk management constraints are reducing financial returns; costs are rising as consumer groups demand more transparency; government austerity programs are reducing fiscal advantages; and new regulations are changing traditional distribution channels (see sidebar: The "New" Insurance Industry).
As these trends change the industry, insurance companies must change to address these trends. First on the agenda: Managing complexity. The insurance industry is awash in complexity, both external toward customers (above the skin) and internal in processes (below the skin).
Insurers that manage this complexity—and do it soon—will have a strategic advantage. There will be more time to focus on growth areas, build sustainable market positions, react to marketplace developments and improve the customer experience. A streamlined back office will result in sharper, more transparent products and services. Less ambiguity in organizational structure and processes means more effective risk management and less effort in complying with ever-increasing regulatory demands. And the cost savings—as much as 40 percent—will serve as a strong foundation for future growth of the business.
The Culprit: Complexity
Complexity is often justified by market demand and the strategic value generated by a large product portfolio, which is to say that complexity is not necessarily bad as long as it provides value that more than compensates for the additional costs. However, from our work and research in this area, we know that what drives complexity does not necessarily drive additional value, for the following reasons:
- Closed book portfolios are administered using inefficient processes which are often supported by old, costly systems and organized in separate back offices
- Low-volume products are expensive to administer
- Investments required for regulatory changes are on the rise
- Certain brands and distribution channels may require specific administration and work-arounds to maintain
- Fixed costs are high, especially those required to run and maintain multiple information and communications technologies (ICT) systems
- Silo organizations limit the ability to cross-sell or develop and sell packaged products
Moreover, complexity reduces internal transparency and makes it difficult for management to steer the organization and the strategy. As a result, a typical insurer's commercial business portfolio—products, customer segments and distribution channels served, or a combination of these—does not focus on areas that allow for profitable growth. Figure 1 illustrates this.
A large part of volume in the insurance business is generated by activities that fail to contribute sufficiently to either customer value or profitability. Investing heavily in creating new products supported by a new system may offer more value to the customer, but it does not necessarily generate sufficient returns. Why? Because the old back-office complexity usually remains in place. Generally speaking, building a new system will be successful only when it totally replaces the existing one.
Legacy portfolios require particular attention, especially with life and pension insurance contracts that must be administered for 30 years or more. The cost dynamics of these systems are often misunderstood and the fixed costs for maintaining them underestimated. These costs drive up the per-policy contract-administration costs significantly—45 percent after five years—as the portfolio that is run on these systems depletes (see figure 2).
Insurers that successfully eliminate or manage sources of complexity are able to provide products with essentially the same market value, but at substantially lower costs (see figure 3). Managing complexity begins with thoroughly reviewing the business and product portfolio and taking action along the following three fronts:
Streamlining the business and product portfolio. The first lesson in complexity management is to streamline business areas that generate profitable growth and abandon businesses, products and services that neither offer sufficient value to customers nor contribute enough to profits. (Business areas include products, channels, labels and other relevant areas.) This streamlining must take into account internal capabilities for optimal results.
Bundling portfolios. After having reduced personnel-related costs—that is, making administrative systems and processes more efficient—bundling portfolios onto less systems (ideally one) is now the way forward for insurance companies to further reduce costs and build scale. Bundling leads to fewer systems in operations. This is a two-step process:
Combine all new production into one low-cost system. Here, choices must be made regarding product or customer portfolios, as it may be impossible to serve all existing products or customer segments through the preferred system.
Reduce the number of legacy systems. This is done by migrating portfolios from one or more systems to a "target" system. The key to success is in the choice of target system. While the most efficient system is the obvious choice, operating costs are not the only criterion. The investment required to migrate the portfolio—building equivalent products into the system, building the migration tunnel, changes in reserves to consider—also should be taken into account. Ironically, there are cases in which a portfolio migration to a less efficient system turns out to be the best overall solution.
External solutions for bundling portfolios, such as outsourcing back-office operations, can be a valid option, but this should only be done if customer-service quality can be maintained.
Optimizing remaining processes. Increasing the size of back-office operations will allow for further automation to increase efficiency. With a less complex back office, the management structure can also be simplified and more effort can be devoted to growth and creating value.
The Road Map
Successful complexity management touches on every aspect of the business, so the solution must take into account the prerequisites of every link and relationship in the value chain (see figure 4). It requires a deep understanding of the complexity drivers and accurate measurement of the potential impact of complexity-reduction levers. These should be as follows:
- Assess all product, process and systems characteristics, as well as areas of overlap
- Perform detailed cost modeling (multi-cube), going beyond cost analysis offered in normal management reporting to identify the impact of complexity on costs
- Run scenarios to gauge the potential impact of different strategies; do this before moving to solutions based on increasing revenues and profitability, determining investments needed or risks to be managed
Meeting the Challenge
Clearly the challenges to managing complexity in insurance are significant, but the benefits that await are well worth the effort and investment required to meet these challenges. The issue for insurers is not whether to implement a complexity-management program, but how quickly to do it.