P&C Cost Containment and Efficiencies- It ain’t working…

Note content with pointing out (“How to win in insurance: Climbing the power curve”) that most of the economic benefits in (re)insurance accrue to a relatively small percentage of the industry, McKinsey has now published a follow-up article, which provides evidence to support the anecdotal view that the industry’s efforts on managing and reducing its often bloated and inefficient cost structures are so far not working in many cases.

In fact, the industry continues to face a structural problem in addressing its operating costs; with McKinsey estimating that, for the top 10 largest composite groups, efficiency has actually deteriorated by some 40% since 2009 in terms of “SG&A” as a percentage of revenues. Of course, this has not been helped by stagnant or declining premiums in many key, but commoditized product lines.

This is not to say that there have not been improvements in certain components such as labour productivity. However, these have been offset by increases in areas such as IT and the increasing burden of regulation. In fact, the gap between the top and bottom quartiles has widened over the past 5 years, such that the operating costs of the former (at 15.3% of GPW) are 44% better than those of the latter (at 22.1%). In an era of lower investment returns, this simply exacerbates the problems facing P&C businesses in terms of earning their cost of capital.

Interestingly, while one would have thought that scale would be beneficial in terms of the ability to drive down costs, the reality is more nuanced, with McKinsey pointing out that “the higher cost players tend to be multiline incumbents with a complex portfolio” that find themselves subject to continuous cost creep. Trying to manage multiple legal entities, brands, legacy systems, product lines, regulatory and capital regimes in the face of static or falling premiums, and the increasing commoditization of hitherto core businesses represents a significant challenge, and one which it seems overtaxes many industry participants, as evidenced by the lack of meaningful cost reductions, as well as existential angst expressed by entities such as Lloyd’s, which recognize that their cost structures are unsustainable.

Naturally, there is no panacea that can magically reduce costs. In reality, success results from something that in many ways represents the Japanese concept of kaizen, continuous improvement, made famous by Toyota. McKinsey suggests a combination of “functional excellence” (e.g., optimizing processes of specific functions); “structural simplification” (self -evident); “business transformation” (such as radical steps to amend operating models, or business portfolio composition); and “enterprise agility” (e.g., ensuring the availability of the requisite talent, communication channels, management focus.) Of course, a business consultancy would make such points. However, they are an amplification of the kaizen approach.

One thing is clear: any (re)insurance executive serious about the long term viability of his or her business model, needs to examine all of its components, rank order them in terms of their impact on its cost base vs. their contribution to generating sustainable revenues, and be prepared to contemplate and then execute upon steps which may appear threatening to vested interests, but which are essential to the business having any chance of becoming part of the top quartile or better in terms of costs, which provides some hope of better returns on capital. The lower and more flexible one’s cost base is, the greater one’s resilience in the face of a competitive market in which the “winners” increasingly dominate.

For Awbury, our focus has always been, and will remain on underwriting bespoke credit, economic and financial risks; maintaining a focused “fit for purpose” organizational structure; and making sure that, as our business scales, our costs do not.

The Awbury Team

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