Scale and scope: thoughtful analyses of the industry indicate that the advantages of scale and scope economies are elusive and create minimal value.

A significant number of carriers, analysts and consultants speak broadly about the importance of scale and scope economies in the insurance industry. However, a more detailed, thoughtful analysis indicates that value creation from scale and scope economies is elusive at best.

Scale economies drive value through two primary mechanisms. First, larger insurers are able to amortize fixed costs across greater premium volume. For the majority of life and property/casualty carriers, this represents 10% to 15% of total expenses. Second, as insurers gain more experience, they are able to improve operational efficiency and reduce marginal costs through learning curve effects. Numerous studies indicate that operational costs typically decline by 10% to 30% with each doubling of cumulated output across a wide range of industries. Such a general understanding of scale economies would mistakenly suggest that insurers with the greatest number of policies, time in business or cumulated premium can become the low-cost, high-growth carriers.

Scope economies create value as a result of manufacturing or selling different insurance products through current channels. This implies that insurers manufacturing or distributing a diversified products portfolio through a common channel should have cost advantages.

Scale and scope economies are well observed in many industries and are much touted by many insurers as a strategic and tactical aspiration. However, thoughtful analyses of the industry indicate that these advantages are elusive and create minimal value.

Insurance mergers and acquisitions: We examined the 60 largest life transactions over the past six years. The analysis found that insurers pursuing mergers and acquisitions for the purpose of scale economies achieved the highest immediate share returns within 10 days of the M&A announcement, more than 2% relative to other objectives. However, over the long term, these same insurers destroyed value: -15% relative to the other carriers in the study.

Property/casualty value creators: This research examined the 75 largest U.S. property/casualty carriers over the past 15 years. The analysis strongly suggests that size doesn't lead to superior performance along any metric--total shareholder returns, premium growth or policies-in-force growth, total loss or underwriting expense. Apparently, there is no correlation between size and performance.

Winning strategies and capabilities: This analysis examined more than 10,000 life and property/casualty insurers across 90 countries worldwide. We were able to identify five winning strategies--options manager, segment dominator, price competitor, diversified offerer and scale player. Being a high-performing scale player or diversified offerer (scope player) are the most difficult to execute among the strategies. These two strategies had the least percentage of winning carriers.

Why does the insurance industry not exhibit significant, observable scale or scope economies? There are a number of structural and cultural particularities that appear to limit the importance of scale and scope--significant regulations; low entry barriers; reliance on investment income; irrational pricing; low fixed costs; and, most importantly, the limited leverage of accumulated experience to improve operations.

Nonetheless, there are a limited number of carriers that have leveraged scale and scope economies for competitive advantage and value creation in the following ways:

* Shifting fixed, nondiscretionary costs to become variable and discretionary across information technology, process and organization by aggressively pursuing sourcing alternatives;

* Value creation through decreased expenses and reduced cost of capital--IT utilization, informational and skill economies, asset redeployment and lower capital costs;

* Investment and management focus to mitigate key centralization risks--decreased degrees of freedom, inflexibility, central staffing excess, lack of business alignment; and

* Capability development to achieve scale and scope benefits--asset arbitrage, procurement, data and knowledge leverage, portfolio optimization, skills management.

There are also a number of smaller carriers developing strategies and tactics to address the threats that larger carriers pose. However, given the apparent limited benefits that carriers have been historically able to achieve from scale and scope economies, carriers of all sizes should thoughtfully consider the implications and re-examine their strategies and capabilities.

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