Insurers aren’t spending less; they’re spending differently.
- Kate Smith
- October 2018
- Common Theme: Though insurers talk about the need to reduce expenses, expense ratios remain flat.
- Up and Down: Investments in technology could cause expenses to go up before they come down.
- End Game: The call for better expense management is a call for greater efficiency.
Shortly before Brian Duperreault's arrival as chief executive officer, AIG had reduced its expenses by nearly $2 billion.
Kweilin Ellingrud, McKinsey & Co.
I think the expense ratios will go up before they can come down, to make room for investments in digital and analytics. But in the three- to five-year time frame they will come down due to automation and due to the payoff of the investments in digital and analytics.
“That's heavy lifting,” Duperreault said during the company's first-half earnings call in August. “But once that was all done and you take a look at the results, the expense ratios remain high. And so, all it said was more needed to be done.
“That was a beginning but not an end. Expense management needs to be a way of life around here.”
Duperreault's sentiments have been echoed by his peers throughout the industry. Expenses, they say, are too high. Reductions, they say, are needed.
Amidst all the talk of reining in costs, however, lies a stubborn truth: Expenses as a percentage of premium haven't moved in a decade.
The median expense ratio for the property/casualty segment has hovered right around 28% for 10 years, according to A.M. Best figures.
“While dollar values have been consistently increasing, expenses as a percentage of premiums have been essentially flat for close to a decade,” said Jason Hopper, associate director of industry research and analytics for A.M. Best.
It might seem there is a dichotomy between what the industry is saying and what the data is showing. But that isn't exactly the case, experts say.
Cutting costs isn't simply about reducing dollars; it's about freeing them up.
“Insurers are looking to save because they want to reinvest in next-generation levers,” Kweilin Ellingrud, senior partner at McKinsey &Co., said.
Expenses, therefore, aren't decreasing; they are shifting.
The overall dollar spend is on the rise, but how companies are spending is changing. Even in expense areas that have remained flat, such as commissions, there is movement. Contingent commissions, for example, are on the rise. And in areas such as salary, more money is being directed toward two segments—senior executives and new hires.
But the biggest shift has been in IT costs. According to McKinsey, IT costs increased 24% between 2012 and 2017, from about 17% of P/C insurers' operating costs to 21%. On the life side, spending increased 12%, but from a higher base, going from 26% of operating costs to 29%.
“What you're seeing is IT taking up a larger share of the operating costs and other things getting squeezed out to keep costs stable,” Ellingrud said.
While lowering expenses remains the end goal, experts say expense ratios are unlikely to decrease in the short term. They may even increase as companies invest in new technologies. The payoff will come in the midterm.
“I think the expense ratios will go up before they can come down, to make room for investments in digital and analytics,” Ellingrud said. “But in the three- to five-year time frame they will come down due to automation and due to the payoff of the investments in digital and analytics.”
Kenneth Saldanha, Accenture
We’re seeing a massive shift toward the agile technology notion of saying, ‘I don’t want to solve the mothership problem with a massive technology investment. I want to take very clearly defined use cases and find solutions ... that are high variable cost/low fixed cost.
Insurance is not a bloated industry. The life segment, in particular, has run on a 10% expense ratio for the last five years, McKinsey said. Even the P/C industry's 27% to 28% expense ratio isn't that bad.
“Very few people realize the average insurance company is putting roughly 70% of its revenues back into paid claims and another 12% to 15% into agent commissions or direct advertising,” Kenneth Saldanha, managing director in the insurance strategy practice at Accenture, said. “So at the macro level, it's not that this industry is bloated and inefficient. At the micro level, though, of course there are ways to tighten up, get more productive and use more technology.”
Digital attackers are putting pressure on the cost structure and forcing incumbents to reevaluate how they operate.
“Leadership teams of carriers are thinking about: What if we were the attacker? How would we structure ourselves differently? How would that change the percentage of costs that go into legacy systems, both in terms of IT and operations?” Ellingrud said. “That pressure has been quite real and growing.”
New entrants can play the game differently. Incumbents, therefore, must respond.
“Startups and new entrants can cherry-pick what segments of the market they want to enter and what they want to write,” Saldanha said. “That lets them operate in a very different manner. As an incumbent insurance company you have to move the ball so you aren't left with the adverse selection of unprofitable business when new entrants come in and cream from the top.”
Persistently low interest rates also have added to the pressure to reduce costs and become more efficient.
“They're not making as much money from investments, so companies have to make more from an underwriting perspective,” David Blades, senior industry analyst for A.M. Best, said. “So they're trying to hone in on the expense side and pare down a bit.
“To that end, they're making investments in technology and operating systems, policy issuance systems, doing more things online. Those help control expenses operationally and impact companies favorably in terms of underwriting gains because they help with better risk selection. From a competitive standpoint, it's important for companies to invest in systems that allow them to be more efficient and more responsive to customers.”
Those efficiency gains come with a price tag. And that cost can show up in the expense ratio.
“If a company is investing in technology that may help them underwrite more precisely and better, their expense ratio may rise slightly,” Blades said. “But if their loss ratio can come down several points, that's the offset. You might actually see expense ratios go up, but companies are hoping what they're investing in will help with other aspects of their operations.”
Reframing the Conversation
The call for better expense management, experts say, is really a call for greater efficiency.
There are three broad, and shifting, ways insurers are pursuing efficiencies, Saldanha said. Twenty years ago, the goal in 80% to 90% of instances was to gain internal efficiencies—how to underwrite for less or manage a team for less, for example. Now, Saldanha said, that's the focus only a third of the time. In the last five years, insurers have been aggressively pursuing efficiencies in interactions with customers and agents. They also are beginning to look at how they can use efficiencies to change the nature of a risk.
“Most of our clients, to get a holistic answer, will play across all three of those dimensions,” Saldanha said.
Digital and analytics are primary focuses, with carriers looking to redesign the front end for customer experience and the back end for straight-through processes.
Improving the customer and agent experience is a top priority for carriers. A third of respondents to a 2018 A.M. Best survey cited that as the focus of their technology improvements.
There are hardcore economics associated with such changes.
“If I can get customers to stop making status calls for claims, I get 40% of my call center volume back,” Saldanha said. “If they can draw that information on a self-service basis, it's a win-win. If I can track my FedEx package and track my pizza delivery, why can't I track my claim? Digital self-service is an exploding segment.”
Technology investments also have the potential to drive growth and improve profitability.
“If you're setting up systems that allow you to get out your quotes quicker to agents, the agents will keep coming back to you because you're allowing them to get back to their clients faster,” Blades said. “That can impact your profitability not just in terms of the bottom line but also in terms of the business that comes your way.
“If you look at it from an industry perspective, premiums have been going up modestly and overall expenditures have been going up at the same level. What companies are hoping for is that agents and brokers will want to do more business with them and they'll at least get the chance to see more business. The more you write, the more your premiums will go up.”
These efficiency gains don't necessarily require a massive investment.
“There are so many companies in the ecosystem that are putting out very simple interfaces,” Saldanha said. “If you want people to call your claims center less, you don't need to build a massive rules engine. You can access any number of startups out there that can give you SMS or even robotic chat interfaces.
“So we're seeing a massive shift toward the agile technology notion of saying, 'I don't want to solve the mothership problem with a massive technology investment. I want to take very clearly defined use cases and find solutions in the insurtech/fintech ecosystem that are high variable cost/low fixed cost.'”
The efficiency mindset doesn't just apply to IT investments. Experts are seeing it across expense areas.
In the highly competitive personal lines segment, reaching customers efficiently is paramount.
“What we've seen in P/C marketing is a shift away from large brand spend—big endorsements, naming of stadiums, naming of sporting events—to much more nimble campaigns and more integrated use of analytics focused on current customers,” Ellingrud said. “For current customers, how do I use analytics to predict if a customer will lapse? If a premium payment is late by a certain number of days and they have called three times in the last two months, does that customer have a five times higher likelihood to lapse? Should there be an outbound save team who calls the customer and speaks to them? Or, if premiums are going up by 10% for a certain group of customers, should there be a focus team and special communication and a special call that goes out to those customers?
“They're using analytics and designing campaigns at a much more sophisticated level. So it's a different mix of marketing spend, away from big brand advertising.”
Advertising in the insurance industry is top-heavy, with five companies accounting for 61% of total advertising expenditure, according to A.M. Best data and research. State Farm, Allstate, Berkshire Hathaway (Geico), Progressive and Liberty Mutual spent $3.6 billion combined on advertising in 2016. Between 2012 and 2016, advertising expenses constituted 11.6% of their total expenses. During that five-year period, the top five advertisers had an average expense ratio of 26.2%.
“Advertising is a weapon these companies have used, more so in the last 10 years,” Blades said. “A lot of their advertising is pointed at millennials. They want to get the first allegiance of this segment of the population that is growing in terms of decision-making power.”
For direct writers such as Geico, advertising generates the majority of their business. And they can dedicate large portions of their expense budget to it because they don't pay producers.
“Everyone says direct companies have a huge advantage because they don't pay agency commissions,” Saldanha said. “That's true, but they spend billions on advertising. You're going to spend 12 to 15 or so points on acquisition, whether you're doing it through advertising or agent commissions. It's six of one, half a dozen of the other.”
While technology has streamlined the customer acquisition process, it hasn't affected commissions. Commission and brokerage expense levels, as a percentage of net premiums earned, have remained consistent in most business lines, according to A.M. Best research. That includes the top four lines by direct premiums written—private passenger auto liability, homeowners multiperil, private passenger auto physical damage, and workers' compensation.
“Technology has added efficiencies for insurers,” Blades said, “but it hasn't directly dipped into the pocket of the agent.”
Nor is it likely to in the near term.
“If a company reduces commission with the thought of lowering expenses, they're going to lose out on a lot of premium,” Hopper said.
Channel conflict is still a thorny issue. Even as carriers test the waters in direct distribution, they haven't touched commission structures.
“Because of the channel conflict there's a lot of reticence to do anything that would be highly controversial with the agents,” Ellingrud said. “So in the near term, there won't be a lot of movement in commissions.
“But in the medium to long term, the five- to 10-year range, I do think commissions will decrease as a percentage of expenses. Direct distribution and digital innovation will start to pay off and we'll see a shift of many more policies being directly distributed without compensation or with lower compensation to agents for more servicing and relationship ownership.”
Salary expenses for P/C insurers have increased annually for the past 10 years, according to A.M. Best research. The average annual salary per employee increased 33% between 2006 and 2016, climbing from $62,900 to $83,700. As a percentage of premiums earned, however, salaries, wages and commissions have been stagnant at around 20%.
Experts do note one significant salary trend—the spike in salaries for senior management and young talent.
“There's an aging issue in insurance, so salaries for people being hired fresh out of college or one to five years out are going up,” Blades said. “On the other end, senior management salaries are going up.
“Midlevel employees aren't seeing that. In the middle is where you've seen some of the operational efficiencies or, in the case of mergers and acquisitions, where the new amalgamation uncovers redundancies.”
Hopper doesn't see much wiggle room in salary expenses.
“Salaries are roughly half of all general insurance expenses the industry gives up,” Hopper said. “If general expenses in total are about 10%, and salaries are half of that, there's not a lot to shave off. It's hard to move that needle.”
Ellingrud expects technology to nudge it.
“We have seen salaries decrease overall as a percentage of the expenses in P&C,” she said. “A lot of that is due to automation and straight-through processing, things that used to be done by people that are no longer done by people.”
Looking out over the horizon, Ellingrud also predicted decreases in marketing, sales support and operations.
“Carriers will become more tailored in their marketing campaigns and have a higher ROI,” she said. “Sales support and especially operations will come down as a percentage of expense because of automation, more self-service and streamlining.”
Conversely, McKinsey anticipates product development and IT expenses to increase.
“Carriers are starting to get smarter and more agile about product development and innovation,” Ellingrud said, “We think P/C players will be innovating quite a bit, so costs in product development will go up.
“Overall, I would say product development and IT will go up. All other expenses will go down, some by quite a bit, as in operations, and others by just a little bit, as in commissions, sales and marketing.”