The Value of Scale: A Closer Look for Insurance

265 The Value of Scale: A Closer Look for InsuranceNFT 3/2005 Scale economies While scale economies are evident across various industries, they are difficult to ob- serve in the insurance industry. Scale econo- mies drive value through two primary mech- anisms. First, larger insurers are able to amor- tize fixed costs across greater premium vol- ume. For the majority of life and non-life carriers, this represents 10% to 15% of total expenses. Second, as insurers gain more ex- perience, they are able to improve operational efficiency and reduce marginal costs through learning curve effects. Numerous studies, across a wide range of industries, indicate that operational costs typically decline by 10% to 30% with each doubling of cumulated output. Applied to the insurance industry, these gen- eral observations would mistakenly suggest that insurers with the greatest number of pol- icies, time in business or cumulated premium can become the low-cost, high-growth carriers. Scale economies are often cited by many insurers as a strategic rationale for mergers and acquisitions. A recent IBM study ana- by David Sterner and Kathy-Ann Hutson The Value of Scale: A Closer Look for Insurance Scale economies are well observed in many indus- tries and are touted by many insurers as a strategic and tactical aspiration. However, thoughtful analy- sis of the insurance industry indicates that scale advantages are elusive and create minimal value. Structural and cultural particularities appear to exist which limit the importance of scale. These include significant regulations; low entry barriers; reliance on investment income; irrational pricing; low fixed costs; and, most importantly, the limited leverage of accumulated experience to improve operations. Nonetheless, a limited number of carriers have leveraged scale economies for competitive advantage and value creation by controlling expenses, focusing investment and management resources to mitigate key centralization risks and developing specific capabilities to achieve scale benefits. David Sterner is a Global Insurance Segment Manager with IBM, USA, and Kathy-Ann Hutson is an Insurance Strategic Researcher with IBM, USA. David Sterner sternerd@us.ibm.com Kathy-Ann Hutson 266 The Value of Scale: A Closer Look for Insurance lyzed the 80 largest life insurance transactions over the past eight years. Nearly half of ac- quiring companies cited scale and scope econ- omies as the primary driver behind the trans- action. However, an analysis of shareholder returns illustrates that these same insurers suffered the poorest short- and long- term results (see figure 1). In contrast, those insur- ers who achieved the highest shareholder re- turns indicated that the primary purpose of the transaction was to acquire additional capabil- ities. A subsequent review of the value de- stroying M&A transactions indicates that ac- quiring companies often failed to fully under- stand the effort required to successfully inte- grate the two organizations. Many of these transactions led to a more complex and less efficient operating structure. (See Figure 1.) Evidence of scale economies in the non-life insurance segment is equally elusive. An IBM study of the 75 largest U.S. property/casualty carriers over the past 15 years strongly sug- gests that there is no correlation between size and performance. The study, which focused on shareholder value creation, included an analysis of insurer size measured against sev- eral performance metrics. In all cases, larger carriers failed to exhibit superior results over smaller carriers. IBM’s Global Study on Scale in Insurance This seemingly lack of evidence supporting the existence of scale economies in the global insurance industry provided the rationale for a separate IBM study which covered more than 10,000 non-life and life insurers across 30 countries over the past 5 years. The study focused on evaluating 18 distinct perform- ance metrics relative to scale as measured by premium income. Figure 2 illustrates the typ- ical pattern the study observed across the metrics. For non-life carriers, selected operational metrics examined included incurred losses and underwriting expenses as a percentage of premiums, while for life carriers operating expense and return on surplus were analyzed. For the non-life insurers the study found no impact from scale on loss results or underwrit- ing effectiveness. Superior claims results were not necessarily linked to scale economies. Large and small insurers performed around the sample average, but small insurers had a greater degree of variance. For life insurers, there was no impact on operating efficiency or ROE that resulted from scale. The study also looked at selected non-oper- ational metrics including growth, shareholder returns and cost of capital. Most insurers regardless of their size hovered around the mean of the sample for growth. However, the Average % Return % of Average 10 TTD Indexed Deals Price/Book Day CAGR CAGR* Economies of Scales and Scope 43.8 2.0 -0.8 -6.3 -3.1 Core Expansion 40.0 1.8 2.0 1.0 0.4 Capability Acquisition 8.8 3.3 6.6 22.0 2.9 Diversification 7.5 4.6 -0.5 -4.2 -3.8 TTD = Total to Date * Indexed to S&P from date of acquisition to TTD 1/2/04 Source: Mergerstat and IBM analysis, 2005 Figure 1 267 The Value of Scale: A Closer Look for Insurance study did illustrate that smaller insurers had significantly greater shareholder returns rela- tive to larger insurers. The results were mixed on the analysis of cost of capital. Large insurers had a lower cost of debt compared to smaller insurers. Howev- er, they had a higher cost of equity and higher cost of capital overall. Larger insurers in the sample tended to be more diverse geographi- cally, which may lend to greater risk exposure across multiple markets. Finally, large insurers in the study seemed to do well in attracting highly skilled manage- ment to their organizations. Large insurers in the sample demonstrated effective use of com- pensation to attract the best and the brightest management teams to their organizations. The study also examined external capabili- ties such as reinsurance, advertising expense and technology spend. It was unclear whether larger insurers used reinsurance vehicles bet- ter or worse than smaller insurers. Insurers seemed to retain around the same percentage of premiums regardless of size. With respect to technology spend, the study did not uncov- er any correlations to spending patterns based on size. More detailed analysis of individual companies found that technology spend was often driven by strategic intent, capability and vision, rather than scale efficiency. In addi- tion, the level of spending on technology was influenced by non-scale factors such as geog- raphy, products, distribution, regulation and customer segments. Finally, while the level of advertising spend between large and small insurers was approximately equal relative to the size of each company, the higher dollar volume of the large carriers afforded them greater reach in advertising. Global versus Regional IBM’s study of scale in insurance also suggests that multinational carriers may be at a disad- vantage with respect to achieving scale econ- omies. The study categorized carriers as ei- ther global or regional and analyzed share- holder returns between the two groups. Figure 3 illustrates that regional carriers achieved significantly higher returns and had a signifi- cantly lower cost of capital. Ideally, global insurers should be able to Measure of Scale Efficiency of Effectiveness Measure Figure 2 268 The Value of Scale: A Closer Look for Insurance apply their knowledge and resource advantage more efficiently and effectively across coun- tries. However, a myriad of challenges makes knowledge and resource transfers difficult. Additionally, the greater the spread geograph- ically, the more complex a company’s opera- tions become, which makes any advantage of scale elusive and difficult to maintain. A more detailed analysis of individual com- panies in the study highlighted several factors impacting the results in figure 3. First, global insurers face business complexities that vary by country. Customer needs may vary dra- matically making it difficult to import prod- ucts from one country to the next. The com- petitive structure in each country will also vary significantly, creating the need for global insurers to adopt different strategies for each market. Finally, regulatory requirements are typically unique to each country, necessitat- ing separate products, processes and report- ing structures in order to adhere to differing sets of regulatory requirements. All of these factors require significant resources and com- plex operations, which, when not managed correctly, can lead to diseconomies of scale rather than gains in efficiency. Additional factors outside the direct control of company management may also explain the lower shareholder returns of global insur- ers, including a higher degree of geopolitical risk embedded in the stock price. In addition, global companies are exposed to a larger number of natural and man-made catastro- phes since they operate in a larger number of countries. Finally, investor confidence in multinational insurers may be negatively im- pacted as financial transparency rules evolve at different rates around the world. Overall, scale did not lead to measurable improvement in financial or operating per- formance. Large insurers did not appear to use scale to their advantage but were able to limit any downside risks. These carriers overall failed to reduce redundancy in operations and capitalize on reuse and had underdeveloped metrics and methodologies that failed to im- prove performance, planning and execution. In addition, the large scale and complex na- ture of their operations limited the speed of innovation and the level of coordination among business units. Small carriers exhibited a much higher de- gree of volatility in their results with some companies achieving superior returns and oth- ers suffering dismal performance. Those that underperformed failed to focus on distinct customer segments to achieve benefits from information economies of scale and scope. These carriers had difficulty in attracting and Figure 3: Global versus Regional: Return and Cost of Capital 2003 Premium USD Billions (%) TSR WACC Study Life 1,542 (57) 2.8 5.6 (10,112) Non-life 1,163 (43) 4.3 5.2 Total 2,704 Global Life 431 (56) -4.2 6.6 (24) Non-life 338 (44) -5.7 5.9 Total 769 Regional Life 1,111 (57) 5.1 5.1 (10,088) Non-life 825 (43) 5.7 5.1 Total 1,985 Source: IBM analyses, 2005 269 The Value of Scale: A Closer Look for Insurance retaining high skill individuals across the or- ganization. Finally, small carriers had high fixed costs and a limited amount of discretion- ary spend to support renewal and innovation within their business. Winning Strategies From the analysis, the study uncovered two key questions. One, what benefits of scale were large insurers not capturing? Second, how can small insurers achieve consistently high performance by adapting select strate- gies and capabilities typical of larger insur- ers? An in-depth review of large carriers that have leveraged scale economies for competi- tive advantage illustrated some common strat- egies employed to increase the level of value creation. • Shifting fixed, nondiscretionary costs to become variable and discretionary across information technology, process and or- ganization by aggressively pursuing sourc- ing alternatives. • Value creation through decreased expenses and reduced cost of capital – IT utilization, informational and skill economies, asset redeployment and lower capital costs. • Investment and management focus to miti- gate key centralization risks – decreased degrees of freedom, inflexibility, central staffing excess, lack of business alignment. • Capability development to achieve scale and scope benefits – asset arbitrage, pro- curement, data and knowledge leverage, portfolio optimization, skills management. In addition to the above strategies, large car- riers leveraged several key capabilities to create value across the value chain. • Marketing: Maximized share-of-voice through uniform branding, customer- product-channel focus, and internal and external consistency in marketing messag- ing. • Product Operations: Developed a disciplined product development process executable across the enterprise and which considers customer, product, and channel lifetime value. • Customer Acquisition: Strengthened cur- rent channels while building option value through investments in consumer educa- tion and operations to increase viability of alternative channels. • Underwriting: Maximized customer and household lifetime value through explicit consideration of product and service port- folio across segments. • Policy Administration: Developed a com- prehensive, value-driven, long term core capability vision in the context of the accu- mulated organizational legacy as well stra- tegic intent. • Claims: Invested in the required processes and information technology to gather, screen, implement and refine claims best practices on an ongoing basis. • Customer and Channel Management: Rec- ognized that the fundamental unit of value is the customer and channel relationship and developed strategies, tactics and capa- bilities to create and capture that value. • Enterprise Management: Considered both strategic and operating importance in the context of ability to execute when develop- ing enterprise sourcing strategies Finally, a number of smaller carriers have developed strategies and tactics to address the threats that larger carriers pose. However, given the apparent limited benefits that carri- ers have been historically able to achieve from scale economies, carriers of all sizes should thoughtfully consider the implications and re- examine their strategies and capabilities.