Power Laws and Probabilistic Strategy…

It is well understood that some relationships in terms of how one factor affects another are linear, while others are non-linear (so-called power laws). As Albert Bartlett said:

“The greatest shortcoming of the human race is our inability to understand the exponential function”.

In business, many managerial approaches are based on an incremental, essentially linear approach, aiming for a gradual increase in revenues accompanied by a similar growth in profits. This is a symptom of strategic inertia; of accepting mediocrity. In some areas, such an approach may enable a business to survive for a long time, although its end may come swiftly if its environment changes.

McKinsey recently published an article (How to win in insurance: Climbing the power curve) which should give the incrementalists serious pause for thought. In studying the economic profit (total profit less cost of capital) of 209 insurers (being all insurers with revenues above USD 1BN in 2017) from 2013 to 2017 McKinsey identified what amounts to a “power curve”:

– The top 20% generated an annual average economic profit of USD 764MM equivalent
– The middle 60% produced an average economic profit of USD 26MM (i.e., they just about broke even in nominal terms)
– The bottom 20% suffered an economic loss of USD 976MM per year (i.e., they rapidly destroyed value)

Visually, the data looks much like a two-ended Allen Key held horizontally- essentially showing that most of the wealth creation and destruction are in the tails.

Of course, when challenged about under-performance (re)insurance company managers (like those in any other industry) will state that they are undertaking a “strategic review” which will transform the fortunes of an underperforming business. Unfortunately, as McKinsey points out, not much changes in reality: the odds of a bottom quintile company moving to the top quintile between 2003 and 2017 were 17%; and those from the middle 3 quintiles into the top no more than 10%, which in some ways reinforces the dangers of complacency exhibited by the “great middle”.

As with many things in life, outcomes are usually probabilistic, not deterministic; and so it is with strategy. There are no certainties of success. However, McKinsey’s research highlighted 5 areas which were the most likely to enhance a company’s positive trajectory and move it up the power curve:

– Dynamically shifting resources between business units
– Reinvesting material amounts of capital in organic growth opportunities
– Pursuing thematic and programmatic M&A
– Enhancing underwriting margins
– Making “game-changing” improvements in productivity.

It would be easy to say that these are “obvious”. Yet, if they are, why do so few (re)insurers seem to make a serious effort to implement one or more of them? As McKinsey points out, what differentiates outcomes is the magnitude and intensity applied to escape from the “usual” approach to change. Materiality matters at least as much as direction.

To comment on an area near and dear to the hearts of the Awbury Team, if the key goal of any (re)insurer is to generate a high risk-adjusted return on capital (and to stop seeking the “safety in numbers” of a Combined Ratio of a little below 100%), enhancing underwriting margins should be an obsession, with an equal focus on more efficient processes, higher margin and non-commoditized product lines, and lower loss ratios. Unfortunately, for many, this often requires going outside their “comfort zone”. Yet the behaviour described is not reckless, but rather involves analyzing where the most value is likely to be created, and refusing to be distracted by the siren call of simply a larger premium flow.

To sum up, management teams need to be bold, focused, and know how to apply “leverage” within their business model in the ways that will truly make a difference. Being “comfortable” is not really a valid option.

The Awbury Team

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