The case for outsourcing claims: outsourcing can be a wise move, but insurers need to look at their unique circumstances before taking this step.

Key Points

* Outsourcing, while increasingly popular among insurers seeking to cut costs, should be done only after careful consideration of multiple issues.

* Large, in-house claims-management infrastructures can drain resources that are better put toward keeping pace with competitors' products and services.

* Claims management is becoming more specialized by lines of business, and carriers may need to examine both their own operations and existing relationships with third-party administrators.

For decades, insurers relied heavily on investment income to achieve profitability. But in today's volatile economic market, investment gain no longer suffices to sustain profitability. Although the Insurance Services Office and the Property Casualty Insurers Association of America recently reported a sharp increase in net income for property/casualty insurers as a result of stock market gains in 2003, it is unlikely that 2004 will bring a repeat of last year's returns, given the market's performance to date. To decrease reliance on investment gain, increase revenue and reduce costs, some insurers increasingly are relying on outsourcing.

But outsourcing isn't a simple, yes-or-no decision, nor is it the right approach for every organization. It involves a multitude of issues and challenges. Unfortunately, the analysis necessary to validate outsourcing decisions does not always take place. According to a 2003 study written by Knowledge@Wharton, in collaboration with Aon Corp., 15% of prospects reported that outsourcing would generate cost savings, but they did not have a clear strategy for outsourcing or a clear idea of the impact of outsourcing on their current and future costs. To ensure that outsourcing is a viable option for an organization, managers need to do considerable analysis and carefully weigh the advantages and disadvantages.

The Industry's Dilemma

This is not an easy task, as most managers today are focused simply on survival and the need to continuously grow revenue. For example, to remain profitable, many insurance carriers have developed new lines of business and expanded into new territories. These carriers often find their efforts hampered by a number of factors, however. First, their existing infrastructures--such as legacy systems, staff and facilities--must be maintained to service claims. Second, building the expertise to service new products, and specialty lines in particular, is costly and time consuming. This results in business opportunities left on the drawing board or executed too slowly to take full advantage of market timing. Increased competition from e-insurance and virtual insurance firms, and their use of cutting-edge technology and outsourced services, further emphasizes the potential disadvantages of maintaining large, noncore infrastructures that cannot be controlled dynamically--staffing and facilities cannot be increased or reduced quickly, and claim systems are not easily overhauled.

Outsourcing Claims

These challenges highlight why some carriers have decided to outsource the claims-management function. Such an approach does, theoretically, provide several benefits. For example, carriers can eliminate the need to invest in new technology and hire or train new employees. What's more, old technology such as fax machines, copiers and legacy claims-management systems that no longer suffice to provide consistent, high-quality claim administration can be eliminated.

In addition, because the expertise and services required to truly manage the claim function are far more extensive and diverse than just transaction processing, a carrier may need to reexamine not only its internal claim department but also its current relationships with generalist third-party claims administrators. Many TPAs today do not have the resources or expertise to manage the entire claim and therefore may not produce optimal outcomes. Further, the competition for business often is driven exclusively by cost of services, and while a generalist TPA may be less expensive, the carrier is well served to look beyond the 15% of the pie that is loss adjustment expense and consider the effectiveness of the claim administrator in managing the entire claim. Savings in LAE easily are wiped out by ineffective management of loss costs in the remaining 85% of the pie.

Carriers also must be concerned with the claims specialization requirements of today's market. Unlike in the past, when claim adjusters could handle multiple lines of business and all aspects of claims, the claims-management process has evolved into many specialized areas of expertise, allowing carriers to optimize their claim outcomes. Thus, a standard line of business, such as workers' compensation, now is managed most effectively by a team of experts--adjusters, investigators, lawyers, case managers, bill reviewers and subrogation specialists. Carriers seeking to outsource claim functions must manage and coordinate the efforts of multiple vendors or seek out one of the few larger claim administrators that can provide all of the necessary, specialized services.

Challenges to Outsourcing

While there are a number of reasons to consider outsourcing, many carriers still prefer to keep services in-house. Many large carriers have the human and financial resources to build and implement effective in-house programs. Their opinion is that the best way to manage their own claims is with a claim department designed specifically to meet their needs. Creating signature claim service, more efficient integration of the carrier's data, and ease of communication between claims, underwriting and financial disciplines are all excellent reasons for building and maintaining an in-house claim department. Indeed, many insurers have tried outsourcing in the past and met with limited success. They have become gun shy and believe that an internal approach will ultimately produce the best outcomes.

Another factor carriers consider when contemplating outsourcing is cost. Many insurers today believe that outsourcing is more costly than using internal resources. Signing a contract with an outsourcing vendor can be a significant line-item expense. This expense must be analyzed in context with other issues, however. For example, one expense that can have a short-term financial impact is the severance cost of employees. If the new outsourcing company does not absorb the carrier's employees, those expenses could negatively impact the carrier's outsourcing return-on-investment analysis.

What Managers Should Consider

A carrier's current circumstances and future goals will make the case for or against outsourcing. Managers should proceed with an open mind when considering it as an option. The decision to outsource an entire claim operation or a specific business process should be made after an honest and thorough analysis of the organization's goals, its strengths and weaknesses, and its true costs. Additional factors to consider include:

* How are tasks currently performed, and what are the true costs of doing so? How do claim results compare with internal and industry data?

* Is the business currently or in the future likely to expand rapidly or contract so as to strain the efficiencies of current facilities and systems?

* Consider the claims functions separately--is there sufficient expertise to produce optimal outcomes?

* What is the impact of intangibles, such as risk mitigation, employee morale or organizational resistance to change?

* What value will outsourcing bring to the organization? Will it improve efficiencies? Create flexibility for entering new lines of business or territories? Ensure claims are settled more accurately and quickly? Help to reduce litigation? Save money? Improve profitability?

* What will happen to existing resources? Will the outsourcing partner hire employees? Will other jobs be found for those individuals? If not, what are the ramifications?

* How will the relationship with the outsourcing vendor be managed? what pricing arrangements and incentives will best serve your needs? Will the claims administrator stake part of its revenue on the claim outcomes?

The answers to these questions will help to establish a baseline against which any gains from outsourcing can be measured effectively. By drafting a benefit delivery strategy, conducting a thorough financial analysis of the company's current operations, and then comparing proposed budgets and outsourcing proposals, managers can better assess the true cost of outsourcing.

As carriers struggle to improve their underwriting results and rely less on investment income, they will continue to look for more relevant strategies that allow them to take advantage of opportunities and shed unprofitable activities more quickly. Evolving technology, the need for a greater range of expertise, and economic uncertainty are causing insurers to break with tradition and seek creative partnerships with outside experts. Companies that are willing to make an honest assessment of their strengths and capabilities will thrive in this new environment.

Jay Garcia is vice president of Cambridge Recovery Services, a unit of Cambridge Integrated Services Group Inc.