Cutting IT can be costly: reducing the budgets for information technology programs will not save companies money in the long run. (Technology).

In the current difficult market, insurers looking to save money may consider cutting their information technology spending. However, insurers doing this may find a dollar saved is not a dollar earned.

Both property and casualty and life insurers are placing a renewed emphasis on expense reduction in 2003. P/C insurers are facing an accumulated history of underwriting losses, reduced investment returns, and emergence of loss cost issues such as asbestos and mold. Life carriers are facing a significant drop in demand for variable products, acceleration of deferred acquisition costs and increased customer sophistication putting significant pressure on margins. These factors, as well as an uncertain economy, are putting more pressure on management to reduce discretionary spending.

From 1997 though 2001, IT spending for U.S. insurers grew at more than 9% annually. This increase began as a result of Y2K-related issues and continued as insurers dealt with e-business imperatives. Current spending levels are expected to remain elevated due to increased total cost of ownership of legacy core IT assets. Yet, too often, management is focused on reducing IT as well as leveraging IT to reduce total expenses.

While IT managers struggle to find areas in which to cut costs, they also face additional pressures to address core infrastructure issues. Insurers are becoming more aware that the core legacy applications upon which their underwriting, policy administration and claims processes rely will no longer be able to support daily operations. Industry analysts estimate that more than 60% of insurers will embark on large-scale e-business technology and business transformation projects in this area over the next 36 months.

Insurers are facing significant challenges as they attempt to balance cost reduction imperatives in the context of the increasing cost of buying, operating, maintaining and depreciating information technology and the need to retool the legacy infrastructure. Insurers have two key alternatives: Reduce IT spending and defer new development or leverage IT to reduce total expenses and create a self-funding mechanism for continued or increased levels of spending. Winning insurers will need to explore the second option.

Moreover, the emphasis on reduced IT costs would appear misguided, as reduced IT costs have a marginal impact on the bottom line. Given the average level of IT spending for U.S. insurers, a 25% reduction in that spending equates to only an 0.8% reduction of total expenses. This immaterial amount of savings also carries with it several business and IT risks, including limited ability to address emerging customer demands; inadequate capacity for peaks in volume; and insufficient frequency of replacement and maintenance of core IT assets.

Rather than focusing on IT as an expense lever, management should examine a full set of expenses across the business. The simple fact is--IT spending represents a relatively small percentage of total expenses and is a key enabler for reducing total expenses.

Insurers that have reduced total costs without destroying value have thoughtfully aligned their strategic intent with IT spending. The critical question is not how low can spending be driven, but rather what is the appropriate level of IT spending in the context of total expenses. This optimal level of IT and non-IT spending should focus on maximizing cash flow with the best mix of revenue and expenses.

IT leadership teams need to follow a few key processes:

Review strategic intent.

* Develop clear understanding of near and long-term strategic direction.

* Identify strategic imperatives.

* Identify capability implications over time.

Identify shareholder value implications.

* Develop shareholder value model.

* Perform sensitivity analysis to determine relative value of levers.

* Identify preliminary action items and implications *

* Identify target expenses and revenues over near and long-term.

* Establish vision.

* Identify near, medium and longer capability implications.

Assess current and potential initiatives.

* Review current economics and capability models.

* Identify economic value gaps.

Develop implementation plan.

* Outline a plan that details resource requirements, timing and tasks through various implementation phases.

* Develop funding approach.

This process is relatively straightforward but is not necessarily easy to execute well. However, for insurers that want to leverage IT for superior value creation, it is worth the effort.

William N Pieroni, a Best's Review columnist, is general manager IBM Global Insurance Industry. He can be reached at [e-mail].