Efficient or effective?
The ineffable question of the “effs”. What should a business aim for – and more specifically, for us, the underwriting function in an insurance business – efficient operations or effective decision making?
We need to specify what we mean first. In certain industries with great standardisation in a mass market, efficiency is, in effect, effectiveness. The efficacy of McDonalds’ business model is its very efficiency, and this is what makes them so effective. It isn’t effortless: they work effing hard at keeping costs low in delivering N burgers per M employees per hour.
But this isn’t the case for insurance. While it varies by line of business, a typical model breaking down 100% of the total premium (i.e. decomposing the combined ratio) would look something like this:
· 5% profit margin
· 15% expenses
· 20% acquisition costs
· 60% claims costs
Our focus area for seeking efficiency improvements is just 15% of total revenues. If we work really hard and get our expenses down by 5%, then we have improved combined ratio by 0.75%.
We could do better looking at those acquisition costs (usually broker commissions). It’s a truism in the industry that brokers’ margins are both more certain than insurers’, and larger. This is a negotiation challenge, and worth pursuing: but to a degree this depends on the power dynamics of insurers vs brokers, and often the “rain makers” that the brokers are hold the upper hand.
But look at the 60% loss ratio. It’s too often reckoned this is a given: the market (and market cycle) permits a loss ratio of a certain level in a given year. Well, this is plain wrong. Even if you’re really big, there are always opportunities if you make the effort to find improvements in loss ratio. This is portfolio management, and it is what we do at Calibrant and Sybil. For smaller players, or those with a niche, the benefits of portfolio management are even higher. The improvements from strong portfolio management discipline are enduring, and typically range between 1 - 5 points of loss ratio.
Suppose it’s possible to take just 1.5 percentage-points off the loss ratio. This delivers twice as much benefit as a hard-fought 5% reduction in cost base. And in my experience it is far, far easier, far less traumatic, and better for the culture of the firm.
What does this have to do with effectiveness? Well, underwriting is about decision-making, and effective underwriting is effective decision-making. I can’t imagine a better or clearer measure of effectiveness in underwriting than in the loss ratio. And so effective underwriting represents far more fertile land to plough than the barren wastes of efficient operations.
Why is there so much noise on expenses in insurance, then? There may be an element of Finance and Operations holding more sway than Underwriting. But I think it’s probably just a question of awareness. Expenses are there, in your face: that person sitting opposite you costs £X per year. Those business trips cost £Y. But a loss ratio is more abstract, and improving it yet more so.
An insurer needs to conceive of the benefits of portfolio management, and believe they will deliver enduring loss ratio improvements. If this is something they can get behind, then portfolio management is an inexpensive and highly attractive way to deliver improved performance. Underwriters need to be bold and stand their ground, arguing for example that projects should be funded based on loss ratio improvements and not just dry financial cost-benefit analysis.
Underwriting is the most important function in most insurers, and its influence should be paramount in driving corporate focus. Specifically, remember that readily-accessible improvements in underwriting effectiveness are worth at least double what traumatic and hard-fought improvements in efficiency can deliver.
Effectiveness trumps efficiency. Focus on being good, not lean.
