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Perspective: Wise pruning will keep last year's growth healthy

Perspective: Wise pruning will keep last year's growth healthy

Property and casualty insurance executives have entered 2007 fresh from a year in which profitability is likely to be among the highest in the past 50 years. The combined ratio for the first nine months of 2006 was 91.9%, according to A.M. Best Co. Inc., with 20 of the largest 25 U.S. insurers having stronger nine-month performance improvements in 2006 than 2005.

The data for the remaining months of 2006 is not yet in, but there have been no shocks that suggest anything but a stellar ending for last year. Reports in this magazine suggest that 2006 will be the best underwriting profit year in the past 50 years—which ironically will put new levels of pressure on margins in 2007 and beyond.

The likelihood that the industry will have similar profitability performance in 2007 as it did in 2006 does not appear strong. Insurers benefited last year from a combination of previous rate increases, abnormally low claims frequency and lighter hurricane incidence. This combination helped mask rising costs of health care, legal fees, auto repairs and increases in the prices of most goods and services purchased by insurers.

Should rates be steady or decline—and there are reports of market softening—and should claim frequency or hurricane severity and incidence increase, insurance executives will likely find it difficult to replicate the performance of 2006 unless they are able to materially increase business without exacerbating price pressures or find ways to decrease their costs.

We believe that the last tactic will be the easiest and quickest one to improve profits. Insurers, relative to noninsurers, have not stressed management of third-party expenses as a strategic discipline.

Missing opportunities

Noninsurers in the past decade have paid much attention to managing the costs of purchased goods and services. Companies such as Merck, American Express and General Electric have built up formal purchasing departments with strong authority to determine and enforce purchasing guidelines. These departments generate tens of millions of dollars in value annually through the savings they achieve from such programs.

In contrast, insurers have not been as aggressive in managing their vendors. As a result, insurers tend to miss opportunities to improve profits in a way that is easier than selling more policies or altering their risk management profile. For larger insurers that have grown by acquisition, the savings opportunity is magnified because their purchasing power is larger and the acquired units are typically still operating in a decentralized manner with limited coordination of buying activities.

Initially, the opportunity for managing vendors tends to be difficult to spot due to the multiple systems in which spending data on purchased goods and services is recorded (e.g. accounts payable, general ledger, claims-related spending systems, e-payment spending systems) and due to an absence of sufficient level of detail in the spending data.

Measures of success

Nevertheless, the opportunity is real. With proper support by executive management, the opportunity yields significant value. Our recent reviews of spending at several insurance firms including a P/C and two life and mutual health insurance companies provide a number of reference points for executive management to consider.

At one P/C insurer with net premiums of about $4.0 billion, we found $1.2 billion in purchased costs. At a mutual health insurance company, we found that a company with $3.7 billion in revenue had at least $300 million in traditional purchased costs (excluding medical and health care services).

In another example, a life and health insurer with more than $10.0 billion in revenue appeared to have at least $500 million in purchased costs. For spending that is not contractually bound and for which there are multiple vendor candidates, we have observed that 15% to 25% savings is possible via vendor sourcing practices.

These programs achieve competitive pricing on goods and services by consolidating purchases to a select set of vendors and conducting detailed, multiround negotiations to reach the most competitive pricing available. These vendors are chosen for future business based on the combination of competitive prices of the goods and services and the quality of the goods and services committed to the purchaser.

By rigorously matching the company's demand to the most appropriate suppliers, a material cost benefit is gained.

The value of these programs is manifold, including, among other advantages:

n Rapid profit improvement without cuts in personnel that could impact revenue generation.

n Higher standardization of services and goods purchased across the organization that allow for consistent internal and external customer services.

n Development of vendor partners motivated to help the purchaser achieve business objectives rather than to think simply in terms of discrete transactions.

Although such an approach is clearly beneficial to corporate profitability, we have found a number of driving factors that we feel contribute to insurers' lag in achieving cost benefits relative to companies in other industries:

n Lack of internal resources for vendor negotiations. Typically, insurers have not (in our opinion) sufficiently invested in experienced people and have focused on transaction processing rather than ensuring that transactions take place at optimal terms.

n Lack of relevant internal or external benchmarks. Many of the products that make up the bulk of an insurer's cost base are reasonably unique (for example, legal defense, medical providers, claims adjusters). Without expending significant resources, it is impossible to compare pricing to the "market"—making negotiations and price determination difficult and often suboptimal.

n Lack of management attention on costs. Most organizations dedicate the bulk of management time to "front office" or revenue-generating activities. Rarely are the very best people dedicated to cost management despite the difference in profitability impact that an incremental dollar of sales has vs. an incremental dollar of cost savings.

Insurers that are able to achieve lower internal costs are likely to realize several advantages. They will be able to reinvest higher retained earnings into initiatives that are designed to generate additional revenue. Alternatively, they can deliver higher dividends to their policyholders. They can also use a low cost structure to offer lower prices that generate more customers and more policy sales.

As insurance executives consider their tactical initiatives for 2007, launching vendor cost management programs may be the easiest to achieve and provide the quickest and greatest impact.

Jim Quallen and Rolf Thrane are partners at New York-based management consulting firm Mitchell Madison Group.