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The Actuary The magazine of the Institute & Faculty of Actuaries

Balancing the books

Many people have speculated on the shape of the insurance financial services industry in the future. However, one scenario that most people agree on is that there will be what we can call specialist manufacturers.
Small and medium-sized (non-niche) insurance service providers will segregate into manufacturing and distribution. The drivers that will shape this change will be the increased use and sophistication of B2B (business to business) extranets and the increasing strength of the large household brands and their large, strong customer base.

These financial services companies will start to specialise in their core competencies, such as manufacturing, and will outsource to other companies their non-core competencies, such as distribution. Distribution will be undertaken by independent specialists, many of them non-financial sector companies, such as supermarkets. These will sell their own-brand financial service products to their own customer base. These outsourced competencies will have to be managed, and it is the management of this value chain that will tax the minds of the business managers within the manufacturing companies on what should or should not be outsourced in addition to distribution.
The insurance providers which become specialist manufacturers will concentrate on underwriting, administration, and product design. These manufacturers will be able to supply a number of specialist distributors with a standard product, modified to take account of the different marketing segments in which the distributors are marketed. Insurance manufacturers will need complex IT infrastructures that will include, for example, the front and back office administration application, CRM (customer relationship management), and workflow applications to support these specialist distributors.

Technology is expensive and complex and needs to be funded. The way it is funded depends to some degree on the size and type of insurance provider.
The large providers which operate across continents and benefit from economies of scale find that their premium income is such that they have a large enough IT budget to be able to purchase new applications outright (the IT budget is on the average about 3% of gross written premiums). It is worth noting that software is generally not classified as an asset and therefore has to be written off immediately. Companies will differ on whether they allocate the cost of software to their acquisition costs or to their ongoing running costs.
New companies to the market also have to purchase applications software, and they would obtain this money as part of the capital required for starting the business.
It is the new manufacturers with small IT budgets which can ill afford the cost of buying complex applications software, and they may struggle to obtain the finance for these applications. Finance can be obtained from a number of sources, for example:
– from their shareholders;
– through financial reinsurance;
– securitisation;
– sub-loan debt;
– increasing their equity.
We need to concentrate on how they can afford the latest technology and remain strong players in the financial services market.
Another way of achieving this is to outsource the IT function to a specialised third party, and the methods of doing this are considered below.

Matching cost with activity
If we can outsource the IT function, are there any other core competencies that can be outsourced? The fund management, administration, and underwriting functions are other areas that could fall into this category. Whatever we outsource, the key message must always be that the cost must be controlled, reduced, transparent, and matched against business activities.
So, if there is an opportunity for manufacturers to reduce cost in a controlled manner and remain competitive by outsourcing some of their core competencies and the IT infrastructure underpinning these business functions, are there any downsides?

The risks
When these functions are outsourced to a third party you get into what is called supply chain management. The definition of a supply chain is anything that has to be managed outside the company.
A significant risk in outsourcing is the risk of damaging the customer relationship. Costs might be reduced to their lowest level but at the same time customer relations might be put at risk. There is always a trade-off between cost and risk, and the different methods of outsourcing address this issue.
What we get back to is what can be managed outside the financial services company and what is core to the company. Taken to its logical conclusion, a financial services company could become a virtual company and only be known by its brand name and also only have responsibility for the distribution of the products.
Currently there are three main types of outsourcing that address the issues of cost control and reduction of cost in the areas of IT infrastructure and administration: managed services, business process outsourcing, and application service provision (ASP).

Managed services
Managed services have the potential to provide services to clients on their site or remotely using the client’s software application infrastructure.
Services offered can embrace the whole of the client’s organisation and can include not only its insurance administration application but also other applications, such as payroll, general ledger and human resources software. Non-computer services, such as cleaning and postage, can also be managed as a service.
In all cases the service runs and maintains the applications and the operations.
This is good for companies that do not require wholesale change in the short term. It could also be used when companies are migrating from legacy applications to new applications, and the new applications can be run in parallel.

Business process outsourcing
Business process outsourcing is where a third party processes and administers a portfolio, using its own infrastructure. This can be the complete end-to-end processing or as much of the processing as the client requires to be outsourced.
The client can expect to be using modern applications, to have the unlimited use of skilled staff, and to benefit from shared experiences that the third party has with other clients. In-house operations cannot normally compete in terms of flexibility, experience, and economies of scale.
This type of service is very attractive to companies which are making a major strategic shift, for example into a new market, and also while the company may be implementing a new IT strategy.
Administration costs can be charged either on a per-policy basis or on a transaction basis, which varies by volumes. Some products, however, have much higher transaction costs than others, because of the complexities of new business and servicing. The question arises, should we charge by product or take an average across the whole portfolio? In practice, where a company has a wide portfolio of business, it is simpler to charge an average cost per policy or transaction.

Application service provision
This is the delivery of applications to the desktop over a wide area network to multiple financial companies and to consumer-owned Internet access devices over the World Wide Web from a data centre. Again, this is very much a ‘pay-as-you-go’ basis, with costs normally charged on a per-transaction basis. The costs cover use of the application and the cost of processing the transaction. The costs can vary, depending upon the volumes of business transactions and the cost of the IT infrastructure used.
This is advantageous to new entrants into the market, which can adopt the newest technologies, and also for existing financial services companies which wish to enter the market with a new product line.
The customer keeps control of the application through using its own staff, and uses some of its own assets, such as the general ledger application. The customer is in fact maximising its existing assets. Advantages to the customer can be summarised as cost reduction, wider distribution, security, and improved customer service.

Contracts normally last for a period of three years. Transaction costs can be high, because of infrastructure and support costs. Taken to the extreme, there is a finite economic point beyond which the ASP cannot be financially viable when measured against the costs the customer is paying for the ASP.
By using an ASP, financial services companies can concentrate on some of the other major drivers in the financial services market, including:
– New market entrants, such as retail banks, fund management companies, and shop retailers with strong brands moving into their market space.
– Entering other markets, such as the retail banking market.
– Non-traditional direct selling via such media as iDTV and WAP.
– The EU single insurance market is becoming more of a practical reality.
– Insurance markets are opening up to international competition.
– Government imposing caps on expenses, eg the 1% cap on expenses within stakeholder pensions.
– The drive for more consumer legislation.

Financial service providers will also have some concerns over the service they will receive from the ASP. These concerns cover such items as the retention and control of the customer contact, the speed to market of new products, existing assets, flexibility, costs, and existing skills. These can, however, all be alleviated by building in end-to-end service standards with penalty clauses into the contract
Application service provisions do have other advantages. In particular, when it comes to smaller software applications, such as warehousing software, these can be integrated into a division of that company within its own budget, without having to go through the normal cycle of division/head office/parent company for approval.
Outsourcing is no longer seen as a domain just for the large multinational financial players, but for any size of company to use to gain a competitive advantage. The one overriding advantage of outsourcing is that it allows for costs to be matched more closely to the activities of the administration centre than ever before.