TI: A basis for survival
AU: Newberry-Patrick; Bacon-Mark
SO: Accountancy-. Oct 1994; v114n1214, pp. 48-50 [3 pages]
IS: 0001-4664
PY: 1994
AV: Fulltext online. Photocopy available from ABI/INFORM 2162.00
RN: B-ACE-34-15
AB: A whole series of events has significantly changed the traditional picture of the insurance industry, and whether companies offer life and pension products and household and motor insurance or insure major commercial risks, there are recurring themes that are changing the framework within which the industry operates. Faced with new challenges, the industry needs to focus on the overall costs of doing business and, in particular, on the relative profitability of different products and different customer segments. Historical financial information and budgeting are inadequate to support the difficult decisions that need to be made. Activity-based budgeting and costing and activity-based management have been used with success in other industries. These techniques are well suited to address the problems facing the insurance industry.
SF: Graphs
CC: Western-Europe,-includes-UK (9175); Insurance-industry (8200); Accounting-policies-and-procedures (4120)
DE: Insurance-industry; Activity-based-costing; Product-costing; Profitability-
GE: UK
PN: Accountancy
CD: ACTYAD
PC: ACE
NW: 2534
TX:
Once upon a time the insurance industry was stable, profitable land secure. untroubled by the pressures that have affected so much of corporate life in the latter part of this century, or so the story goes. A whole series of events has significantly changed that traditional picture, and whether companies are offering life and pensions products, household and motor insurance or insuring major commercial risks, there are recurring themes that are changing the framework within which the industry operates:
*The 1980s shake-up in the financial services markets has brought new entrants, particularly banks, into the life and pensions market, adding to the excess capacity that already exists.
*The telephone-based direct writers in the motor and household sector have dramatically changed traditional distribution relationships.
*Tighter regulation to protect consumers' interests has increased many insurers' cost base, particularly in the life and pensions markets.
*A growing (albeit slowly) consumer sophistication has raised awareness of what insurance products cost the consumer -- a trend that is likely to be increased by the forthcoming hard disclosure of commissions for life and pensions products.
*Corporate policyholders' increasing awareness of risk management and financing techniques is significantly changing the way in which commercial insurance is offered, and the types of product involved.
In the life and pensions segment, cost overruns (excess of costs over allowances in product pricing) cannot continue at their historical levels. As illustrated in Figure 1, the costs of traditional distribution channels are not competitive with those of the new entrant bancassurers. (Figure 1 omitted) In the motor sector, traditional insurers expense ratios (expenses as a percentage of premium income) around 25% -- are not competitive with the direct motor insurers, which are operating with expense ratios around 11%. Despite these pressures, as Figure 2 shows, staffing levels in the industry have not been cut back as sharply as in other industries. (Figure 2 omitted)
Faced with these challenges. the industry needs to focus on the overall costs of doing business and, in particular, on the relative profitability of different products and different customer segments. Historical financial information and budgeting are inadequate to support the difficult decisions that need to be taken. Activity-based budgeting and costing and activity-based management (ABM) have been used with some success in other industries (see 'Out with the old, in with the new', ACCOUNTANCY, July, p 49) and, as some companies now appreciate, these techniques are well-suited to addressing the problems the insurance industry is facing.
TRADITIONAL TECHNIQUES
Although it might be expected that an industry with a long tradition of managing in a complex financial environment would be a repository of sophisticated financial management techniques, the insurance industry has actually lagged behind. Typically. within insurance companies, financial information is generated with a strong orientation towards regulatory considerations and less emphasis on the information needed to manage. Consequently, many insurance companies do not have adequate financial information to provide an effective basis of management. It is not unusual in an insurance company to be confronted by an immense amount of data. However, seldom is that data presented in a way that signals clearly to management what action needs to be taken.
To compound the problem, many insurance companies have elaborate bases of cost apportionment, apportioning costs to products, distribution channels or customers. Unfortunately, these apportionments are usually made on arbitrary bases that do not reflect the underlying nature of the business or the needs of management, and consequently the resulting product or channel costs cannot be used meaningfully to make decisions.
The key questions that management in the industry needs to be able to answer are:
*How can costs be brought down to a competitive level while still providing the required levels of service?
*Can the insurer offer a product or service at a market competitive price and still generate a profit?
*What are the most effective forms of distribution. and where should effort be invested for the future?
These questions are typical of those that activity-based management and costing techniques were developed to address in other industries.
THE ACTIVITY-BASED APPROACH
The application of activity-based management techniques to the insurance industry is broadly similar for all sectors -- there are nuances in the life and pensions. household and motor and commercial sectors that need to be considered, but the underlying philosophy is equally applicable. The starting point for implementing ABM, for any insurer, is to understand the critical activities of the business. To many businesses. this is now well-trodden ground. At a high level, the insurer's major processes need to be understood; typically, five or six key processes will be the core of the business. In a household insurer, for example, these may be securing new customer relationships, underwriting the risk, servicing and paying claims, securing renewal of the business and developing new products. Below these high level processes there will be a series of activities. and below these a series of tasks. Common high-level processes may have different underlying activities for different business segments. For example, in a life and pensions company, acquisition of business may be identified as a core process. but different distribution channels -- (direct sales force, tied agents or independent financial advisors) -- may involve very different activities.
Once the key processes in the business have been identified, the inputs to and resources consumed by each activity underlying those processes need to be identified and costed, the outputs from each process specified and the drivers of activities understood, ie, the factors that determine the volume of work performed and the cost incurred. This part of the process is the most fundamental, since it enables management to understand the core of the business and, in some cases, to rediscover what determines the underlying cost base and profitability.
In a household insurer, key drivers of activity may relate to the additional product features offered (eg, number of approved garages for motor repairs, or instant replacement of windscreens) or to controls applied by the business (eg, the levels at which surveys are to be carried out for underwriting purposes or claims inspections for claims settlement). In the life and pensions sector, with increasing pressure from tougher regulation, increased commission disclosure and the entry of bancassurers to the market, most traditional insurers have had to reconsider their operations and assess ways of reducing their cost base. Cost overruns of 70% to 30 have not been unusual -- and must be eliminated.
Typical causes of overruns include the hangover effect of staffing up for the surge in business in the late 1980s and increasing costs arising from additional regulatory requirements. In many instances. the cost savings achieved have been in the form of staff reductions, or by changing processes and developing more efficient ways of carrying out the business.
Often technology is used as the enabling force for change. There is a widespread recognition that it is not enough to have a one-off reduction in the cost base or a one-off business process re-engineering exercise, and ABM enables these benefits to be lucked in and creates a basis for ongoing improvement.
Many of the long-established life and pensions companies and household insurers have, historically, offered a very wide range of products, which is now believed to be no longer desirable in many cases. Using an activity-based costing and management system to determine product profitability gives a much more reliable picture of product profitability and enables management to establish a direct link between the choice of certain products, the cost base and ultimate profitability.
Life and pensions companies have also traditionally looked at sales distribution channel profitability using poor cost apportionments. Understanding distribution activity and consequential cost through activity-based costing enables management to focus on how to improve the channel's effectiveness and the delivery of the necessary training.
The industry is also paying close attention to customer profitability. Measuring individual customer profitability is unlikely to be either of interest or feasible. However, activity-based costing is a very useful tool for considering profitability by major customer segment, analysing the differential activities that are necessary to service different customer segments and providing a financial evaluation of those activities.
For major commercial insurers, profitability by product line is of interest, necessitating an understanding of cost by line of business as well as underwriting result --although for those insurers that are providing major corporate clients with multi-line programmes, there may be greater emphasis on customer profitability. In the light of the developments in risk management and risk financing, major commercial insurers are having to reconsider and reposition their products and services. This may mean extending their services into active risk management and changing the insurance cover provided in the light of the emergence of other risk financing techniques.
Historical financial management tools typically do not provide an informed basis for the insurer to price its new products or service offerings. Using activity-based costing and management, it is possible to construct a model of the resources that would be needed to provide a given service or product and then to cost those resources, determining, by reference to a market-derived price, the profitability of a particular service or product, and allowing the company's resources to be properly focused.
IMPLEMENTING ABM
Although the practical problems of implementing ABM in insurance companies are very similar to those experienced in other organisations, there are some specific areas in which the insurance industry's particular features make for additional complications.
As was noted in 'Out with old, in with the new', ABM works particularly well where a company's management is moving towards a process-based approach. Where it is not, there is a need to overcome the traditional barriers of the past. Historically, many insurance companies have exhibited some of the worst behaviour in terms of strong departmental fiefdoms within the organisation, with budgeting and management focused on functions rather than process.
The activity analysis, which is a necessary starting point for an activity-based approach, will throw into sharp perspective the contribution the different parts of the company have made to the process of establishing and maintaining customer relationships. In an aggressive direct salesforce life company, it is all too easy to develop a mentality that accepts domination by the salesforce and sees other functions as second class citizens. A rigorous analysis of activities will show that the company's administration functions have a vital role to play in maintaining relationships with customers, who will receive regular communications over the life of a product in the form of unit allocation notices, bonus notices or details of policy amendment.
Correspondingly, in a commercial insurer, the relative roles of the branch and the interface with brokers, compared with those of the underwriter and policy administration functions, will become apparent, demonstrating that only a team approach will successfully win clients and service them properly.
Insurance companies are complex, and an important part of moving to ABM in this environment is to pitch the starting level of detail correctly. The approach must go into sufficient detail to be credible and produce meaningful results, particularly where management behaviour is expected to change. However, if the exercise is too detailed it will take too long, will not gain support, and the results -- the product of a myriad of assumptions -- may lose the intuitive sense of being reasonably founded. Adopting the philosophy of 'think big, start small', perhaps supported by pilot applications, is a sound starting point for most insurers moving to ABM.
The introduction of a new basis of costing products may encounter resistance. Traditionally, products have been built up on the basis of actuarial allowances for costs of acquisition and maintenance of business. Often, these allowances are very generic in nature and are typically not well-rooted in a robust costing system, although, in life and pensions companies, the appointed actuary will carry out an annual investigation of expenses and consider some of the issues relevant to the determination of cost. It is very important to overcome this resistance, because actuarial allowances for costs in product design are commonly based on broad apportionments of costs, and are not susceptible to comparison in a meaningful way with costs on an activity basis.
If resistance in this area can be overcome, the combination of the actuary's traditional knowledge in building up product design and a robust activity-based costing system is very powerful. Many life and pensions companies compare allowances in the products with actual costs and, rightly, conclude that they are running with too high a cost base. Using an activity-based costing system and ABM links the traditional basis of product design and measurement to a powerful tool that enables management to take decisive action.
There will be a particular focus in many companies on analysing distribution activity and improving effective use of resources in this area. In a life and pensions company with a direct salesforce, the activities of managers and branch support, as well as the activity of the frontline sales staff, are attracting particular attention at present. Activity analysis and ABM can be particularly rewarding in this area, where a more effective targeting of resources can be achieved. However, culturally, people involved in these front-end activities are often resistant to completing the necessary analysis and to the introduction of any system with overtones of centralist control. Similar problems can manifest themselves with account executives managing major accounts within commercial insurers. Once again, an effective way of overcoming resistance of this sort is to 'think big and start small'. A successful pilot in a particular area, which delivers significant benefits to management in that area, will soon attract attention in a competitive front-end sales environment.
Software to support activity-based costing systems is developing, and there are now a number of packages that will provide the necessary support to activity-based budgeting, costing and, in turn, activity-based management. However, the complex nature of insurance companies often has a consequential effect on financial systems. Not all companies have resolved these complications, and they are struggling with their existing financial systems. While there is no reason why conventional activity-based costing packages should not be applied in insurers, existing complications or inadequacies in financial systems do not make implementation any easier. In particular, linking systems to existing core administration and workflow management systems can be complex.
Almost all sectors of the insurance industry recognise the need for significant change in the way that core products and services are provided. Activity-based management is not a panacea for all ills, but many of the problems it was designed to address are manifested within the insurance industry at present. Many of the traditional bases of managing an insurance business and designing and costing products are compatible with activity-based techniques.
Although many companies have considered the application of activity-based techniques and some have made significant advances, many insurers have only partially embraced the concept. For these insurers there are significant gains to be made and, for some, in the light of the magnitude of problems facing parts of the industry, activity-based management may be a lifebelt that needs to be grasped quickly if they hope to survive.
Patrick Newberry is a partner in Coopers & Lybrand's insurance practice, and is chairman of the firm's life insurance market group. Mark Bacon is a consultant in Coopers' insurance financial management group.
CR: Copyright Institute of Chartered Accountants in England & Wales 1994
AN: 933338