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CAV
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Why expense focus is the most valid route to short‐term value creation for
Swedish non‐life insurers
CAVEN
DI M
ANAGEM
ENT IN
SIGHT
“Never confuse motion with action” Benjamin Franklin
“Beware of little expenses. A small leak will sink a great ship” Benjamin Franklin
Why expense focus is the most valid route to short-term value creation for Swedish non-life insurers
Setting the scene The fundamentals of the non-life insurance industry make it significantly more stable compared to the life insurance industry, which is illustrated by relatively stable earnings from year to year. As one would expect from a mature industry, non-life profitability, in terms of return on equity, typically fluctuates around cost of capital, i.e. non-life insurance must be treated as a long-term value case and not a short-term growth case.
Nevertheless, profitability in non-life insurance is very reliant on the capital market environment, as investment income makes up a much larger portion of the pre-tax profit than the technical result in mature insurance markets.
Figure 1: Profitability pressure here to stay
The underwriting operations are, besides being the other fundamental value driver of non-life insurance profitability, the cushion that dampens insurers losses during bust cycles.
The current market fundamentals are characterized by a toxic mix of a low interest rates, higher price consciousness fueled by transparency and increasing complexity driven by regulation, together with a simultaneous need to deal with aging IT infrastructure and a structural lack of growth perspectives – all of which makes keeping the underwriting result high challenging, to say the least.
To conclude, having sound, balanced and profitable underwriting operations is, besides being the fundamental enabler in acquiring investable assets in the first place, paramount in terms of parry poor investment cycles, hence protecting the equity in the balance sheet.
Figure 1: Profitability pressure here to stay
1
Profitability of P&C market particpants is not significant higher than Cost of Equity
Return of Equity composition heavily skewed towards net investment income
-10
-5
0
5
10
15
20
2006 2008 2010 2012 2014
CoE2
RoE1
-3 -4 -3 -5 -3
14
6
12 1115
4
4
4 4
211
2012
12
2011
5
Other
14Technicalresult
Netinvestmentincome
201420132010
14
RoE composition, PercentFigures might not end up due to rounding
1 RoE: Swedish market excluding non-competitive market participants (AFA Sjuk & AFA Trygg)2 CoE: Data represents Western Europe general insuranceSource: Swedish insurance association, Stern Business school, Cavendi analysis
Percent Average industry return: 11%Average cost of equity: 10%
1
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Figure 2: Poor profitability development in Sweden
2
Sweden behind in terms of profitability…Combined ratio, Percent
…driven by poor profitability in mutualsCombined ratio, Percent
79 75 70 71 7018
2012
8717
2011
9318
2010
97
2014
8818
2013
8918
Loss ratioExpense ratio
Den
Nor
SweS
wed
ish
non-
mut
uals
Sw
edis
h m
utua
l76 78 75 74 74
2014
9420
2013
9319
2012
9520
2011
9719
2010
9519
71 72 69 69 6518
2011
9219
2010
9221
2014
8418
2013
8617
2012
87
73 77 75 71 8018
2011
9417
2010
9017
2014
9818
2013
8918
2012
93Ø 93
81 82 77 78 72
2011
10321
2010
10221
2014
9221
2013
9820
2012
9821 Ø 99
Source: National insurance associations, Cavendi analysis
2
The starting point in Sweden Even if the Scandinavian non-life markets are often referred to as some of the most cost efficient in the world in terms of operations, the Swedish market participants’ performance is relatively polarized due to the high proportion of mutuals in the market, in which the demand for bottom line result and expected return on capital is lower.
Figure 2: Poor profitability development in Sweden
Historically, value adding insurers in Sweden have generally needed at least 15% RoE to honor their capital obligations to investors. This tends to translate into about 85-95% in combined ratio depending on balance sheet characteristics (investment return expectations) where a higher share of risk-carrying assets would increase the expected return and vice versa.
Since indemnity costs are, by definition, volatile and the fact that loss ratios got stuck at 70-75% levels somewhere in the mid 2000’s, structural improvements in this direction have proven to be challenging – expense actions increasingly clearly emerge as the remaining natural source of improvement.
Limited impact so far – IT & other support costs rapidly increasing at the expense of the core business and customer interaction Swedish non-life insurers, like their international counterparts, are in a transformation mode and are trying to future proof their business and operating models. To fund this, most insurers are therefore actively promoting some kind of efficiency agenda, and have done so for years.
Unfortunately, looking at the Swedish industry’s expense ratio as a whole, these savings are not being materialized through an improved bottom line1, on the contrary, since new expenses seem to be constantly emerging and offsetting old cost savings. Two things in particular are driving this phenomenon:
IT infrastructure investments not delivering on business case, i.e. process efficiency is much harder to obtain than expected
Increased level of complexity driven by legislation ramp-up
The fact that many insurers are failing to materialize stated business case efficiency gains on their huge IT investments is worrying in the first place. Furthermore, Cavendi has analyzed detailed expense data for a large number of insurers and outcomes suggest that insurers tend to be ramping up costs as well as staff in support functions at the expense of the core business – a development for the customer value that could be called to question.
This development can be seen when analyzing the relative trend in cost associated to customer facing units, such as sales- or claims-focused call centers, and comparing this to the more administrative OH units.
In the customer facing units, the expense ratios have, over the last five-year period decreased by one to five percentage points, while the OH costs have escalated by over ten percentage points over the same time period.
Figure 3: OH cost up 2-3x more than costs associated with customer interaction
Sourcing efficiency gains from the core business units that maintain the primary link to customers is of course not ideal from a customer or management standpoint. An adaptation to online self-service solutions fronting the customer is just part of the solution. Additional reasons as to why this is happening on a broader scale varies of course from company to company, but observations of a wide range of insurers suggest three major drivers:
The core business units have significantly more efficiency knowledge and experience of how to execute savings than the rest of the organization, hence they finance the growth of general overhead costs
Cost cutting is easier at ‘the organizational base’ where managers with budget responsibility and affected staff have limited interactions, i.e. the situation in parts of the organization characterized by multiple layers of staff such as large call centers etc
IT expenditure outside core investments is being allowed to grow disproportionately, hence offsetting by far any smaller efficiency initiatives that do exist within OH functions2
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Figure 3: OH costs up 2-3x more than costs associated with customer interaction
3
9493959795
20141312112010
Combined ratio
Expense ratio
Acquisition ratio
Administrative ratio
Claims handling ratio
Claims ratio
Loss ratio ratio
2019201919
20141312112010
7474757876
1312112010 2014
12-5%
201413
12
12
13
11
12
2010
12
87787
20141312112010+11%
88878
2014-1%
1312112010
6566677168
122010 11 13 2014
Source: Swedish insurance association, Cavendi analysis
+3xdifference
External
Internal
+2xdifference
3
The starting point in Sweden Even if the Scandinavian non-life markets are often referred to as some of the most cost efficient in the world in terms of operations, the Swedish market participants’ performance is relatively polarized due to the high proportion of mutuals in the market, in which the demand for bottom line result and expected return on capital is lower.
Figure 2: Poor profitability development in Sweden
Historically, value adding insurers in Sweden have generally needed at least 15% RoE to honor their capital obligations to investors. This tends to translate into about 85-95% in combined ratio depending on balance sheet characteristics (investment return expectations) where a higher share of risk-carrying assets would increase the expected return and vice versa.
Since indemnity costs are, by definition, volatile and the fact that loss ratios got stuck at 70-75% levels somewhere in the mid 2000’s, structural improvements in this direction have proven to be challenging – expense actions increasingly clearly emerge as the remaining natural source of improvement.
Limited impact so far – IT & other support costs rapidly increasing at the expense of the core business and customer interaction Swedish non-life insurers, like their international counterparts, are in a transformation mode and are trying to future proof their business and operating models. To fund this, most insurers are therefore actively promoting some kind of efficiency agenda, and have done so for years.
Unfortunately, looking at the Swedish industry’s expense ratio as a whole, these savings are not being materialized through an improved bottom line1, on the contrary, since new expenses seem to be constantly emerging and offsetting old cost savings. Two things in particular are driving this phenomenon:
IT infrastructure investments not delivering on business case, i.e. process efficiency is much harder to obtain than expected
Increased level of complexity driven by legislation ramp-up
The fact that many insurers are failing to materialize stated business case efficiency gains on their huge IT investments is worrying in the first place. Furthermore, Cavendi has analyzed detailed expense data for a large number of insurers and outcomes suggest that insurers tend to be ramping up costs as well as staff in support functions at the expense of the core business – a development for the customer value that could be called to question.
This development can be seen when analyzing the relative trend in cost associated to customer facing units, such as sales- or claims-focused call centers, and comparing this to the more administrative OH units.
In the customer facing units, the expense ratios have, over the last five-year period decreased by one to five percentage points, while the OH costs have escalated by over ten percentage points over the same time period.
Figure 3: OH cost up 2-3x more than costs associated with customer interaction
Sourcing efficiency gains from the core business units that maintain the primary link to customers is of course not ideal from a customer or management standpoint. An adaptation to online self-service solutions fronting the customer is just part of the solution. Additional reasons as to why this is happening on a broader scale varies of course from company to company, but observations of a wide range of insurers suggest three major drivers:
The core business units have significantly more efficiency knowledge and experience of how to execute savings than the rest of the organization, hence they finance the growth of general overhead costs
Cost cutting is easier at ‘the organizational base’ where managers with budget responsibility and affected staff have limited interactions, i.e. the situation in parts of the organization characterized by multiple layers of staff such as large call centers etc
IT expenditure outside core investments is being allowed to grow disproportionately, hence offsetting by far any smaller efficiency initiatives that do exist within OH functions2
Similar A closer dthe two lacustomer
In Motorthan the
In Houseperformi
Figure 4: O
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3 Share of in
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ssumed to mdown in plasts between wide cost ra
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ual insurers
xpense base foio ove 0.5 milliontion model an
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asses are vermity of bothbelieve that than traditio
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ational costs
- and worst
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ry diversifieh size4 and the absolutonal
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ouse & Conten core entry
For
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3,259Mutuals
TotalSwedishmarket
~2.3x
Non-mutuals 4,488
4,488TotalSwedishmarket
2,856
Mutuals
~1.6x
Non-mutuals
2,272
2,856
Figure 4: Operational cost difference of 60-130% between low- and high mark market participants for key products
4
MotorOperational cost per policy1, SEK
House and ContentOperational cost per policy1, SEK
3,809
2,922
1,971
2,320
2,882
1,971
2,819
2,777
1,759
1,932
2,267
1,759
1 Total costs (Claims payout + Claims handling expenses + Administrative expenses + Acquisition expenses) divided by number of policies by product and by insurance player
Source: Swedish insurance association, Swedish FSA, Cavendi analysis
4
Similar players operating similar products with huge cost differences A closer drill down at two isolated classes of business in the market suggests a wide span of costs. For the two largest retail product classes, Motor and House & Content, both serving as the main customer entry product for many insurers the cost situation for the insurers varies considerably.
In Motor, the high mark market participant has more than double the associated operational costs than the best performing market participant.
In House & Content the span is less, however there is still a factor 1.6 between the best- and worst performing market participants.
Figure 4: Operational cost difference of 60-130% between low- and high mark market participants for key products
The chosen customer segments and distribution setup is often assumed to make up for the majority or, at least, a large portion of any profitability difference. A drill down in player’s profit and loss accounting does however not reveal significant differences in costs between the dominant channels, hence it does not constitute a fully explanatory power for such a wide cost range.3
Also, bearing in mind the fact that the underlying risks for these product classes are very diversified and assumed to be evenly spread across the sample, and the relative uniformity of both size4 and business models5 of the players in the sample, there is a reason to strongly believe that the absolute cost structure directly controlled by management is much more important than traditional explanatory factors, e.g. distribution models or economies of scale.
This holds true also when benchmarking demutualized and mutual insurers separate.
What does it take to get oneself out of a profitability mismatch? An insurer has in principle four levers to pull to improve the operational combined ratio over an foreseeable time period:
Organic growth: Growth in exposure with same or very similar business mix6 Rates: Price increases on renewed business Net incurred claims costs: Reduction in net incurred claims across all classes of claims Expense reduction: Reduction of all expenses impacting the result – directly owned &
allocations
Cavendi has scrutinized the effort needed to reach a three (3) percentage point improvement in the combined ratio for three types of hypothetical players in the Swedish non-life industry:
The average insurer The average demutualized insurer The average mutual insurer
The takeaway is clear – rate actions and efficiency measures are superior to organic growth for all company types, with a factor five to seven, which implies five to seven (5-7) units (SEK) of growth are needed to offset one (1) unit of efficiency. This holds true for all company types even if it is tougher for public players to reach the target relative mutual ones, which suggests that public players are leaner from the start.
Figure 5: Levers to be pulled to different degrees to improve the combined ratio by three (3) percentage points
The fact that organic growth, hence size, is of limited importance for short/mid term profitability for a non-life player also holds true when analyzing other simpler ratios, e.g. costs per GWP through a scale curve7. On drilling deeper into this matter, initial findings suggest that classic economics of scale thinking is only valid in a few areas, e.g. policy issuance and asset management etc. but seems to be absent in most areas. The likely explanation lies in the high share of variable costs insurers carry thus making organic growth expensive, aside of the fact that it is hard to obtain.
Rates on the other hand, cost nothing and improve the top line and make a contribution to covering fixed expenses. Obviously, the problematic flipside of rate indexation is the increasing level of transparency fueled by digitalization and the fact that this weapon can only be used once a year.
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Figure 5: Levers to be pulled to different degrees to improve the combined ratio by three (3) ppt
5
Lever
Total SwedishMarketPercent
Non-mutualsPercent
MutualsPercent
Organic growthGrowth in exposure with current business mix
RatesIncrease on all renewed business, no change to mix
Net incurred claims costsReduction in NIC across all classes of claim
ExpensesReduction in all expenses impacting the result –directly owned and allocated
3
-16
-5
19
3
-18
-4
21
3
-4
-15
17
Source: Swedish insurance association, Cavendi analysis
5
Similar players operating similar products with huge cost differences A closer drill down at two isolated classes of business in the market suggests a wide span of costs. For the two largest retail product classes, Motor and House & Content, both serving as the main customer entry product for many insurers the cost situation for the insurers varies considerably.
In Motor, the high mark market participant has more than double the associated operational costs than the best performing market participant.
In House & Content the span is less, however there is still a factor 1.6 between the best- and worst performing market participants.
Figure 4: Operational cost difference of 60-130% between low- and high mark market participants for key products
The chosen customer segments and distribution setup is often assumed to make up for the majority or, at least, a large portion of any profitability difference. A drill down in player’s profit and loss accounting does however not reveal significant differences in costs between the dominant channels, hence it does not constitute a fully explanatory power for such a wide cost range.3
Also, bearing in mind the fact that the underlying risks for these product classes are very diversified and assumed to be evenly spread across the sample, and the relative uniformity of both size4 and business models5 of the players in the sample, there is a reason to strongly believe that the absolute cost structure directly controlled by management is much more important than traditional explanatory factors, e.g. distribution models or economies of scale.
This holds true also when benchmarking demutualized and mutual insurers separate.
What does it take to get oneself out of a profitability mismatch? An insurer has in principle four levers to pull to improve the operational combined ratio over an foreseeable time period:
Organic growth: Growth in exposure with same or very similar business mix6 Rates: Price increases on renewed business Net incurred claims costs: Reduction in net incurred claims across all classes of claims Expense reduction: Reduction of all expenses impacting the result – directly owned &
allocations
Cavendi has scrutinized the effort needed to reach a three (3) percentage point improvement in the combined ratio for three types of hypothetical players in the Swedish non-life industry:
The average insurer The average demutualized insurer The average mutual insurer
The takeaway is clear – rate actions and efficiency measures are superior to organic growth for all company types, with a factor five to seven, which implies five to seven (5-7) units (SEK) of growth are needed to offset one (1) unit of efficiency. This holds true for all company types even if it is tougher for public players to reach the target relative mutual ones, which suggests that public players are leaner from the start.
Figure 5: Levers to be pulled to different degrees to improve the combined ratio by three (3) percentage points
The fact that organic growth, hence size, is of limited importance for short/mid term profitability for a non-life player also holds true when analyzing other simpler ratios, e.g. costs per GWP through a scale curve7. On drilling deeper into this matter, initial findings suggest that classic economics of scale thinking is only valid in a few areas, e.g. policy issuance and asset management etc. but seems to be absent in most areas. The likely explanation lies in the high share of variable costs insurers carry thus making organic growth expensive, aside of the fact that it is hard to obtain.
Rates on the other hand, cost nothing and improve the top line and make a contribution to covering fixed expenses. Obviously, the problematic flipside of rate indexation is the increasing level of transparency fueled by digitalization and the fact that this weapon can only be used once a year.
Reducing net incurred claims costs normally means paying claims suppliers less (successfully fighting claims inflation) or customers less (adjusting terms and conditions). Ideally this can be done by being better at technical risk selection, hence better tariffs and underwriting processes. The ‘Big Data’ evolution will potentially improve this over time, but this lever is unarguably dependent on the historic customer base and significant up front investments in data analytics and IT software.
What remains is the only fully controllable lever – expenses. This lever holds all costs linked to both personnel and non-personnel and is the action with the most reliable result.
Where lies the opportunity for expense reduction? A non-life insurer has an expense base usually consisting of five major buckets
Wages and other compensation to employees (50-70%) IT expenses (incl. depreciation and IT consultancy costs) (10-30%) Marketing expenditure (including advertising consultancy) (5-10%) Premises & Facility Management (~5%) Other items (~10%)
By targeting one or several of the cost buckets above to different extents, there are obviously numerous possibilities to improve profitability. The various approaches all have different means, convey different levels of impact (in both time and money) and cause different levels of distortion to the organization, hence also to the business.
Figure 6: Different efficiency levers
We consistently see that the biggest expense reduction opportunity is to reduce complexity in operations, and that preferably this should be assessed prior to any other expense actions, such as distribution model improvement or performance management etc. Reduction of complexity means getting the basics right and discontinuing activities that do not drive value, all under limited business disruption. For optimal effect, this should principally be executed simultaneously within two dimensions:
1. Organizational effectiveness (personnel costs) 2. Operational effectiveness (non-personnel costs and processes)
For both the organizational and the operational processes and their (in)effectiveness, i.e. their corresponding (often too high) costs, there seldom tends to be one or a few explanatory factors that drive costs out of the budget comfort zone.
Figure 6: Different efficiency levers
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Business unit efficiency
How to operate
How to succeed
Corporate-portfolio strategyIdentify areas where the fundamentals are suitable for play
Bus. complexity reduction
Get the basics right and discontinue activities that
do not drive value
Sales & Marketing Scrutinize products, brands and channels. Discontinue or rebuild where relevant
OperationsScrutinize and optimize processes of policy administration and claims
IT and technical infrastructureFight fragmentation of legacy systems by securing transparency in functions and costs towards the business. Secure a relevant funding proportion of AM and AE relative AD
Support functionsScrutinize among activities - prioritize business value rather than SLA
Organizational efficiency enablersOrganize for efficiency – start at the top
Operating model modernization
Modernize amongIT systems
Get performance management right
Overhaul distribution, claims and support models to improve economics of scale
Clean-up, Sunset and Modernize. After that –automatize/digitalize
Make all decisions with P&L owners in mind. Incentivize
the workforce by embedding efficiency targets
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Instead, inefficiencies tend to start in a series of minor errors in various unprioritized processes, solved by simple manual overriding. However, when smaller errors bulk up over time, this tends to create an increasingly greater burden for the organization. A common short-term solution for such problems is to extend the organization or construct temporary workaround processes rather than deal with the core issue. The problematic consequence of not addressing the core issue is therefore swelling organizations and inefficient ways of working within units and departments.
Hence, there is almost never a silver bullet to fire to improve effectiveness, i.e. it is almost impossible for management to execute a few smaller targeted changes and simultaneously reach big profitability impact. Instead, and to reach sustainable impact, a substantial amount of smaller improvements is usually needed through a structured program.
This is particularly relevant in support functions (service level agreement adaption) and IT (infrastructure modernization or sunsetting of legacy systems), where an adaption to a lower service level agreement often implies a savings potential that exceeds 15% with limited impact on the business lines.
What is important to consider during execution Regardless of the desire to drive expense reduction, i.e. price your products or services more competitively, improve financial performance or better serve your customer (stop processes that drive complexity), it is not only important to attack the problem in a structured manner but even more important is to do so with an objective mindset.
What tends to work:
Critically assess the entire cost mass and understand which parts that generate value and focus on the parts that do not (i.e. ‘good costs’ vs ‘bad costs’)
Concentrate on areas where there is significant potential – take on the big ticket items first (‘quick wins’ seldom create material impact)
View all departments objectively – scrutinize top and middle management ‘I just need… - requests’ and ‘business threats’ carefully
Swift execution all the way through – plan sufficiently, communicate clearly and execute swiftly
Ideally, make cuts when you can, not when you have to!
What tends to fail:
Reducing costs without understanding the big picture and how cost cutting can impact employee and/or customer satisfaction as well as loyalty (i.e. unable to see the difference between ‘good costs’ and ‘bad costs’)
Executing non sustainable cost reductions – if costs are easy to get rid of, they tend to be back sooner rather than later
Giving all departments an ‘equal’ target of e.g. 10% is a very imprecise way of execution and tends to miss the mark
Leaving too large unallocated gaps in plan – things seldom end up exactly as planned, hence planning for the exact target or slightly below target is often unsuccessful
Underestimating the need for honest communication – not revealing or smoothing over the original intentions often tends to backfire
Underestimating the understanding for tough business decisions at stakeholder level
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Contact information For any queries regarding this publication or Cavendi’s strategy service offering, please contact the author or any member of Cavdendi’s Strategy Practice.
For other inquiries regarding Cavendi’s service offerings please contact Cavendi’s CEO.
Mats Skogström (author)
Senior Manager, Stockholm
Phone: +46 70 958 80 98
Email: [email protected]
Experience
Mats has more than 9 years of experience of strategy and corporate development.
He has extensive proficiency in managing projects within strategic, corporate finance and organizational related consulting assignments for multinational clients predominantly in the insurance & banking industries. The profitability dimension has been a recurring theme in projects in which Mats has been involvement.
Prior to working at Cavendi, Mats worked at a first tier global consultancy firm and as head of strategy for one of the core countries in a global P&C insurance group.
Jan Bäckman
Partner & CEO, Stockholm
Phone: +46 70 718 25 99
Email: [email protected]
Experience
Jan has more than 20 years of consulting experience and heads Cavendi Management Consulting since 2016.
While focusing on operational excellence and performance management, Jan’s specialty lies within the transformation of finance functions. His project leadership and advisory experience comes from multiple industries.
Prior to working at Cavendi, Jan worked at one of the Big 4 companies where he was the lead partner for the Swedish CFO program and the shared services & outsourcing advisory practice.
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Phone: +46 8 410 829 50 [email protected] www.cavendi.se
Visiting address: Birger Jarlsgatan 32b, 114 29 Stockholm