In today's dynamic market, with traditional and nontraditional competitors becoming more aggressive and financial-service deregulation a reality, effective performance management has become critical to securing an insurer's future viability. Increasingly, innovative insurers are utilizing more-sophisticated performance-benchmarking tools to measure and manage value creation.
Because property/casualty insurance remains an inherently volatile business, it demands cutting-edge risk management tools that optimize the trade-off between risk and return. Best-of-breed insurers will have to employ effective risk-management strategies and performance-benchmarking techniques to consistently meet or exceed stakeholder expectations. In today's tight labor market, such value-added organizations will better attract and retain top talent. In turn, that will foster innovation and help execute strategic objectives.
Creating or Destroying Value?
To succeed, insurers will have to adopt a flexible strategic plan that leverages their organization's core competencies. They will also embrace a forward-looking business model that measures the effectiveness of an insurer's core activities. That in turn will involve increased business partnering.
Central to value creation will be an insurer's ability to respond quickly and effectively to customers' increasing demands for convenience, service, low-cost, customized-risk solutions and financial security. Customers are becoming more discerning and empowered in their insurance buying decisions. That's a result of increased price transparency in commodity lines brought by the Internet, and integrated-risk solutions required by risk managers of large and mid-sized commercial businesses.
From a financial perspective, value creation is evidenced by sustained results that exceed a company's cost of capital, or in meeting stakeholder expectations. Regardless of ownership structure, all insurers have stakeholders with identifiable performance expectations.
More insurers--even beyond the ranks of publicly traded insurers--are embracing the concepts of value-creation and performance benchmarking. Performance benchmarks vary by insurer. They can be based on income levels, operating returns, risk-adjusted returns or shareholder value. Typically, the goal of mutual insurers is to increase surplus levels and enhance policyholder security. That becomes the means to build capital bases to offset claims inflation, absorb unexpected losses and support future growth.
Ownership structure and operating environment can affect the choice of performance objectives. For example, in its rating evaluation, A.M. Best acknowledges that mutual companies and subsidiaries of European-based stock insurers have a lower cost of capital. As a result, those companies can assume a longer-term strategic view that emphasizes balance-sheet strength over maximizing near-term earnings.
Two leading mutual insurers, Nationwide and Liberty Mutual, exhibit superior balance-sheet strength and sustainable competitive advantages but also target operating returns lower than their stock counterparts' goals. However, their target returns comfortably exceed their inherently lower cost-of-capital requirements. Their objectives remain competitive enough to instill a performance mindset and focus on improved efficiency within their respective organizations.
Too often, publicly traded U.S.-based insurers can focus too intently on generating top-line growth and meeting high standards for return on equity, shortchanging their operating fundamentals and loss reserves in the process. That tendency was evidenced by sizable reserve additions announced by Reliance, Frontier, Fremont and Acceptance in 1999.
Leveraging Performance Drivers
Enhancing performance and creating value come through leveraging core competencies and are achieved by adjusting the operational and financial "dials" that have the most impact for a given organization. Performance levers typically relate to managing risks, loss reserves, claims, expenses and investments.
The manner in which incentives are used to help management achieve those results have a direct bearing on the execution. Through the use of clear benchmarks, it is possible to instill a greater performance ethic in the organization and attract and retain innovative employees able to support strategic objectives.
To date, insurers have been reluctant to adopt models that have been employed by manufacturing and service-based industries, such as Economic- or Marketbased Value Analysis. Instead, many have begun focusing on risk-adjusted measures that emphasize return on equity or return on allocated capital. Stock companies have led the way with a focus on measuring return on equity, although innovative mutual insurers have been willing to consider those forms of bench- marking. Ultimately, both groups must consider whether profits cover the cost of capital, plus provide additional margins to achieve other goals. Those goals could be to support further growth or return funds to stakeholders. The cost of capital may be higher for stock companies, based on the need to pay dividends and service debt.
A combination of better technology and a willingness to measure strategic goals and capital-allocation decisions across the board has spurred companies to find new ways to measure results. Tools include dynamic financial analysis, enterprise-resource technology-based reporting systems and greater sharing of financial information.
By determining the drivers of value--both financial and operational--companies will better be able to develop corporate strategy, manage risk and return, and measure performance. More importantly, execution will drive success. In today's business model, operational drivers must support financial objectives. Revenue growth needs to be supported by distribution, market positioning and technology. However, growth objectives and deployment of capital must be calibrated with risk-adjusted returns and supported by conservative underwriting and reserving standards. In addition, a company's cost of capital and expense structure must be considered in making decisions affecting pricing, claims handling and obtaining reinsurance.
The Two Sides to Diversification
Historically, diversified revenue streams have led to greater earnings stability because profitable businesses compensate for under-performing units. Some of the largest, most broadly diversified insurers--organizations such as American International Group, Travelers, and Hartford--have helped achieve performance stability based on a broad mix of property/casualty, life/health and financial-service products and services. These multiline units have also maintained a tight focus on measuring profit centers through performance-based accountability. At a corporate level, management limits the downside of nonperforming units through controls and early warning systems.
Detecting problems early is important, given today's softmarket conditions. A growing number of companies have reported that 10% to 20% of their business has shown poor results and weak fundamentals, which in turn has imperiled the "acceptable" performance of their remaining books of business.
Discrete business units may complement one another, but insurers are finding that each unit must be able to stand on its own for the enterprise to benefit. Although integration between ACE Group and Cigna's former commercial units is still in its early stages, ACE was willing to trade outstanding returns on its more-volatile excess-casualty business for lower but more-stable diversified commercial-lines earnings. On the other hand, other traditionally multiline insurers such as CNA, St. Paul and Allstate have recently shed business units that weren't deemed strategic or that didn't generate returns that covered their respective costs of capital.
For specialty insurers, managing performance is a greater challenge because they lack the diversity of earnings available to multilines. Specialty insurers can experience more volatile and cyclical results than their multi-line counterparts or when compared to insurers with greater diversity in products. As a result, focusing on fundamentals becomes even more important. California's workers' compensation market is a prime example of a specialty segment now in the throes of extremely poor market conditions, exacerbated by the controversies surrounding the Unicover pool and similar arrangements. Rates may rise in that market, but some insurers have risked their autonomy--if not their solvency--by pursuing market share through aggressive pricing, then passing underpriced business to reinsurers. They now face the prospect that those obligations may be returned following the possible rescission of Unicover-related and other low-level-retention reinsurance agreements.
The Appetite for Risk
The essence of insurance is found in identifying, quantifying and managing risk within defined parameters. Without these fundamental skills, insurers are vulnerable to unexpected earnings volatility, and negative market reactions.
Today, A.M. Best is encouraged that most companies prudently use sophisticated risk-management tools to quantify their exposures to catastrophes and to manage property concentrations. While not precise, catastrophe modeling represents the best technological tool available to quantify an insurer's potential loss exposure to natural perils. Models continue to be refined. Catastrophe modeling plays a vital role in identifying, monitoring and managing a company's exposure and protecting its financial strength.
Based on proprietary information shared in the rating process, A.M. Best believes most insurers have established prudent catastrophe risk levels when calculating the impact of severe single-occurrence losses (for example, losses from a 100-year hurricane or a 250-year earthquake) on their capital base or earnings. However, few insurers, share their catastrophe risk parameters with the marketplace. One exception is Allstate, which has consistently identified a $1 billion ceiling for a single, severe catastrophe. Articulating a company's risk appetite--the impact on capital of a severe single occurrence and on earnings for expected annual aggregate losses--will allow the marketplace to better respond to an insurer's "unexpected" shock losses. Over time, articulating these parameters can help temper negative reactions from investors, managers, regulators and rating agencies.
Maintaining Safety Margins in Reserves
This is the 12th year of "soft" commercial market conditions. A.M. Best remains concerned that many companies have been writing business at prices well below expected loss costs.
Too frequently, insurers--virtually all of them stock companies--have "shorted" the current accident year. That is being done by reporting combined ratios that are unrealistically low or by reporting an artificially low loss ratio on a particular line of business based on allocating reserves that have been set aside for prior years. Writers of personal auto and workers' compensation coverage have benefited from prior-year reserve redundancies. With the exception of several auto writers, those cushions have vanished. The "pain phase" is well under way and A.M. Best expects a significant number of insurers to report loss reserve shortfall surprises throughout the coming year. These announcements will compromisc insurers' balance sheets, wipe out prior profits--proving they were illusory--and in many instances cost overly aggressive insurers their independence.
Not surprisingly, mutual insurers have reported few material reserve adjustments in recent years, since they are less inclined than their stock counterparts to prop up reported results.
Reduced Expense Ratios--Finally?
Admittedly, the expense ratio is a crude measure of efficiency. Nevertheless, the disparity in expense ratios, or level of relative efficiency, across much of the property/casualty industry is glaring. It is particularly acute within the personal lines and standard commercial lines segments where critical mass, scale and efficiency are keys to survival in today's consolidating marketplace. At the same time, many smaller and regional companies are seeing their historic advantage of more-favorable loss ratios erode.
These factors are forcing companies to restructure as a means of streamlining back-office operations and reducing overhead. However, constrained premium growth means restructuring may not be enough. Even low-cost providers such as Allstate and Liberty Mutual announced significant restructuring during 1999 to stay ahead of the curve.
Insurers have sought to reduce expense ratios through greater dependence on technology, streamlining the back office, spreading fixed costs over a broader base of business, and cutting facilities and personnel, with mixed results. Many mergers and acquisitions have been announced for the stated reason of gaining economies of scale and reducing expenses; however, few have been well executed or it is too early to validate their success. The industry standard remains the l996 acquisition of Aetna's property/casualty business by Travelers.
More insurers will Likely focus on cutting expenses by building new state-of-the-art agency interfaces and processing systems, replacing fragmented and cumbersome legacy systems. Further, we expect insurers will write a larger share of new business through lower-cost distribution channels, including the Internet. Despite concerns over channel conflict, insurers have little choice but to focus on lowering acquisition costs, which account for roughly two-thirds of the industry's expense ratio.
With financial-service deregulation a reality, strategic alliances should increase dramatically as a means of expanding marketing and distribution beyond insurers' traditional boundaries. For example, in 1999, Hartford announced an agreement to sell insurance to car buyers through Ford dealerships. Well-conceived alliances offer a huge opportunity for insurers to grow their core business and create "virtual critical mass," based on lower fixed costs and shorter lead times. Local and regional insurers, which traditionally enjoy a loss-ratio advantage, may have the most to gain through strategic alliances with local business partners as a means to create virtual critical mass.
Investment management has become increasingly important because of the difficulty in enhancing underwriting profitability. Given lower interest rates, the challenge has increased for insurers to maximize the return on their portfolio without overextending asset risk. However, modest improvements in a property/casualty insurer's investment yield can have a greater, more immediate impact on the bottom line than can an equivalent improvement in the loss or expense ratio. McKinsey & Co. estimates that bottom-line impact of a 10-basis-point increase in investment performance is equivalent to a 25-basis-point decrease in the loss ratio or a 35-basis-point decline in the expense ratio.
Property/casualty insurers traditionally have not maximized their investment returns, often due to self-imposed limitations. Most companies have maintained that they take risk on the liability side of their balance sheet and are therefore adverse to take risk on the asset side. As a result, they have focused on net investment income as a more dependable driver of earnings. Regulatory, tax and asset/liability matching constraints can limit flexibility. As underwriting margins further compress, well-capitalized insurers may run a greater risk--and opportunity cost--by not investing prudently in equities to enhance their total investment return.
Similar to A.M. Best's increased incorporation of total risk-adjusted returns into its rating evaluation, companies such as Fireman's Fund, Winterthur Swiss, Farmers and Swiss Re are factoring some recurring unrealized capital gains into their investment strategies, performance benchmarking and capital-allocation decisions.
The key to maximizing investment performance is establishing appropriate, individualized benchmarks that reflect corporate objectives and constraints. Benchmarks for duration, investment earning targets and strategic asset allocation should consider asset-liability issues, underwriting performance, reserve adequacy, liquidity needs and corporate taxes. Sophisticated companies are more willing to invest in developing the expertise in this area, either through in-house staff or by outsourcing certain asset classes. For competitive reasons, there will likely be more outsourcing of this function to third-party asset managers.
New Tools for New Times
Performance remains an integral component of A.M. Best's rating evaluation. A year ago, we expanded our operating performance tests beyond traditional reported measures and increased our emphasis on prospective, risk-adjusted returns relative to premiums and surplus. Many of our performance measures include three adjustments to "even the playing field" and provide a clearer picture of a company's historic and prospective profitability. Many of Best's measures reflect an insurer's ultimate accident-year underwriting results, including an annual aggregate catastrophe-loss estimate provided by companies, and provides a 7% credit for unrealized stock gains.
We believe these prospective measures, combined with our risk-adjusted approach to historical measures, provide a more accurate gauge of a company's ability to sustain long-term operating performance.
A.M. Best actively discusses with companies their internal performance measurements and capital-allocation methodologies, while sharing our performance benchmarks used in the rating process.
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|Date:||Jan 1, 2000|
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