Evolution theory: adaptability is the strategic imperative for insurers in the evolving industry ecosystem. (Industry Strategies: Management).

Long-term profitable growth is the challenge that insurance industry executives must continually meet to satisfy stakeholders, regardless of market conditions. Traditionally, insurers met that challenge based on the assumption that the market acts as a machine. Corporate behavior was based on the belief that centrally controlled decisions concerning strategy, budgets and resource allocation would produce a predictable outcome.

It is questionable whether this approach worked, even when the market was relatively stable. Insurance companies are now doing business in an increasingly dynamic, uncontrollable environment where this behavior is a recipe for disaster. Terrorism, the failure of large and well-known companies and rapid advances in technology are shaking up societal values and creating new and unprecedented exposures for insurers.

Customers are using the Internet to learn more about insurance products. This leads to a more efficient and competitive insurance marketplace. Internet-based collaboration is slowly gaining speed, and Web services supporting the sharing of business processes among agents, insurers, reinsurers and regulators are just over the horizon. Deregulation, the rise of credible offshore domiciles, and the introduction of creative new risk-transfer and risk-financing alternatives lower the baniers to entering the risk marketplace and enable new competitors, both traditional and nontraditional, to rapidly gain market share.

Market participants are becoming more interconnected and interdependent. The actions of any one insurer, reinsurer, set of customers, regulators or competitors--existing or new to the scene--can ripple through and reshape the entire marketplace and force other participants to respond quickly or fall behind. Turbulence and interdependencies make the market behave and feel more like a natural ecosystem, where species are locked into long-term competition for survival in a perpetually changing environment.

In this marketplace, strategy needs to be based on the model furnished by nature rather than on the Newtonian cause-and-effect machine model. More than a century ago, Charles Darwin said: "It is not the strongest of the species that survives, nor the most intelligent. It is the one that is most adaptable to change." Adaptability has always been the strategic imperative for biological entities in a natural ecosystem. Now it is the strategic imperative for market participants in the evolving insurance business ecosystem.

Principles of Ecosystems

A natural ecosystem is an environment with interdependent biological participants competing in real-time with their own kind and with predators for resources so they can continue to reproduce and evolve There are three overarching principles that describe both natural and business ecosystems:

* The ecosystem itself continues to change as various forces act on it (e.g., climate, catastrophes, the introduction of new species) and simultaneously within it (e.g., the predator/prey interaction).

* Outcomes are unpredictable in terms of scale and scope.

* The rules of survival and adaptability change as the ecosystem changes. The insurance business ecosystem is affected by these same principles, as demonstrated by the following recent events and trends:

* Enron falls, and the ensuing lack of surety capacity accelerates the collapse of Kmart.

* Terrorism dries up reinsurance capacity and causes significant premiurn increases across all major lines of business.

* Citigroup spins off Travelers Property & Casualty, leading other insurers to question the importance of a financial-services supermarket.

* The federal government begins to introduce federally licensed insurers, and existing players immediately defend the status quo.

* Deregulation opens new markets, but also opens the doors for new competitors.

* Prospects arm themselves with rating and premium information available online for a growing number of insurance products.

* Customers expect to have access to information and service from their insurance companies or agents 24 hours a day.

In addition to the rules that frame this game of evolution, market participants must apply, in some form, four key characteristics that successful entities exhibit in ecosystems:

* Being Aware: Also known as "sense and respond." Market participants in a business ecosystem must understand the pertinent events happening in their environment--introduction of new competitors, technology, regulations, shifting demographics and expectations--develop action plans and implement those actions.

* Self-Organizing: Continual realignment with the changing marketplace. Insurers need to develop an organic process independent of central control that enables the firm to continually question, tune and, at times, significantly alter the current structure, decision-making processes, operational processes and even products and services.

* Creating Perpetual Novelty: Biologists call this characteristic the need for never-ending newness. In the natural ecosystem, prey develops novel capabilities to better fend off predators, while successful predators counter with their own evolutionary innovations. In the business ecosystem, firms must continually experiment with new products, services, distribution channels or process efficiencies and be prepared to implement successful experiments on a transformational scale, even if this means disruption to or extinction of traditional ways of doing business. Perpetual novelty requires an organization that rewards innovation, tolerates honest failure and is resolute and flexible enough to implement even painful changes.

* Learning Under Pressure: In the natural ecosystem, biological species survive by adapting as quickly as the rate of transformation of their predators and the ecosystem. In the business ecosystem, this dynamic plays out for specific companies, rather than for the industry (the man-made equivalent of species). Competitive advantage comes to the insurance company that learns the most quickly. The quick learners are best able to leverage their knowledge into innovative plans, operations and products.

Fitness Landscapes

Biologists and scientists in related areas visualize ecosystems as having "fitness landscapes." Fitness landscapes have mountainous terrains where higher peaks represent the more successful survival strategies. The fitness landscape is smoother, with few peaks if there is less complexity, little differentiation among competitors and less uncertainty of change. Similarly, the fitness landscape is rugged with many peaks and valleys if there is more complexity, greater differentiation among competitive strategies and more uncertainty of change.

Executives, academics and consultants speak of competitive landscapes or marketing terrains. Market participants need to strike a balance between exploiting the fitness landscape they're on and exploring for other fitness landscapes. Insurers can improve their positioning in their current fitness landscape by leveraging core competencies to find higher peaks. These peaks generally represent better solutions to customer needs and expectations.

An example of a company discovering a higher peak on its fitness landscape is Direct Line, which rapidly became the largest personal auto writer in the United Kingdom by exploiting existing technologies to offer a convenient, lower-cost alternative. Insurers also can explore customer solutions that do not exist at all on their current fitness landscape. Progressive's piloting of and probable eventual return to charging for automobile insurance by the minute using global-positioning satellite technology is an example of its finding a new fitness landscape.

While both natural and business ecosystems change, business ecosystems and fitness landscapes transform significantly faster than those found in nature--driven by the introduction of new technologies and new competitors and as regulatory philosophies try to catch up with market demands.

In the insurance ecosystem, a participant like Progressive periodically alters the existing fitness landscape or even forms a new landscape. A company like Citigroup can reshape the entire insurance ecosystem through its opportunistic and innovative actions. Either action causes other firms to quickly react or hope for the best if they decide to continue to conduct business as usual.

Adapt or Perish 

Regardless of the cause of change in the natural or business ecosystem, organisms and organizations must adapt or perish. There are five key questions that a firm must address to determine how prepared it is to adapt in the evolving insurance market:

* How aware is your firm of its competitive environment? How well does it identify the pertinent aspects of the world around it--which are sometimes at the periphery--and how quickly does it process that information?

* How robust are your firm's mechanisms for coping with discontinuous change? How quickly and how effectively does it respond to the introduction of new competitors, new products, new regulations or shifting customer expectations? How rapidly can it respond to events such as the Sept. 11 terrorist attacks or the burgeoning customer fear of losing their retirement from mismanaged 401(k)s?

* Is experimentation encouraged? How comfortable are your firm's executives with failure? Do they battle with the inertia of "not invented here"?

* How frequently does your firm truly innovate? How often does it create products or services to fulfill existing customer needs in new ways or uncover new customer needs and fulfill those in an innovative way? What does your firm do--processes, hiring, training, relearning--to keep itself from settling into a stagnant state of equilibrium?

* How does your firm go about learning and building on that knowledge so that it is better able to continually adapt?

Every insurance executive feels the palpability of market turbulence and is looking for the right strategic framework for success in a competitive landscape that is under constant transformation. The lessons and insights from natural ecosystems offer a fresh and realistic perspective for achieving persistent profitability over the long term in a dynamic environment. One obvious caveat is that companies are social constructs with the ability to respond in ways that purely biological organisms cannot. In nature, it is entire species that evolve, not individual organisms. In the business ecosystem, individual companies can, and must, evolve in response to a changing environment.

Organisms in biological systems operate within a limited environmental context (a specific pond, a specific forest), while participants in a business ecosystem have the ability to grow their environment (through new products, new territories or new customer segments) or at least to be aware of a larger context than the one in which they currently operate.

Scientists working in complexity theory call this having a "God's-eye view." The winners in the insurance business ecosystem will be those who adopt this view to not only continually adapt to market upheavals but, more importantly, create those upheavals and force other market participants to evolve, become a marginal player or go extinct.

Barry Rabkin is president of Bostonbased Market Insight Group Ltd., an insurance analyst firm focusing on the impact of technology on strategy and marketing. David Bradford is executive vice president of Advisen Ltd., New York, which offers customized information and tools to commercial and employee benefits insurance professionals.