The financial crisis has triggered a recession of frightening potential and unknown duration, leading to dramatic declines in consumption and capital investment across the economy. For many cash-strapped businesses, this is either rational or mandatory. But should the insurance industry react similarly? Specifically, does it make sense for carriers to refrain from making strategic IT investments in these economically challenging times?
I argue that the industry's unique characteristics, as well as a sensible contrarian investment theory, suggest that strategic IT investments have never been as vital and as potentially rewarding as they are today.
As the causes of the credit crisis have come to light, so have the sources of resilience within the insurance industry. Carriers are held to high standards of transparency, hold their assets primarily in low-volatility, fixed-income assets and employ virtually no leverage. Notably, carriers also act as principals for most risks they underwrite, as opposed to merely business originators. Consequently, with a few exceptions, the industry as a whole has avoided the reckless practices and "toxic" assets that have destabilized the financial system.
Moreover, because insurance is generally a non-discretionary purchase, and the majority of premium revenue comes from renewals, carriers endure less volatility in demand than other industries. This has put most carriers in an enviable position - flat or declining premiums, yes - but also in possession of the secure capital foundation to take a calm, long-term perspective.
That perspective recognizes that the insurance business can be modeled as a flow of capital into one of four destinations. First, surplus can be allocated as underwriting capacity to write new business or bolster existing reserves. Second, surplus can be invested into capital markets. Third, it can be returned to shareholders and policyholders. And fourth, it can be invested into infrastructure to enhance the insurance "machine."
The relative attractiveness of these "destinations" fluctuates with market conditions. In hard markets with insurance demand outpacing supply, and carriers retaining strong pricing power, maximizing underwriting capacity makes sense. Alternatively, in a soft market, particularly when equity markets are yielding high risk-adjusted returns, allocating surplus toward investment income or returning surplus to shareholders may be more efficient uses of capital.
Opinions differ as to whether the insurance market is softening or hardening, but the historically low ratio of premium-to-surplus, as well as common sense, suggest that premiums have been declining because of the macroeconomic slowdown, not for a want of capacity. The direction of the equity market is impossible to know, but the huge spike in volatility in recent months certainly argues against any increase in market exposure beyond the industry's traditionally conservative allocation.
BAD ECONOMY, BIG INVESTMENT
If neither the insurance nor capital markets are appealing destinations for a carrier's surplus, this leaves the fourth option: internal investments in the efficiency and effectiveness of core operations. Adverse market conditions make increased internal capital investments more attractive than usual, because the alternate uses of capital are much less appealing. This may seem counter-intuitive at a time when every expenditure is being carefully scrutinized, but it answers the only question that matters for choosing where to invest: Where can we achieve the highest rate of risk-adjusted return?
Ask any adjuster, underwriter, policy service specialist or product manager, and they can readily identify improvement opportunities for a more efficient, accurate and customer-responsive operation. Yet, blocking virtually all of these ideas is a hulking obstacle: the legacy core system. Typically 15 to 30 years in age, running on legacy technology platforms, and designed purely for financial processing, legacy core systems fundamentally constrain virtually every aspect of the insurance "machine." Inflexible product definitions and business logic, limited structured data, difficult user interfaces, lack of workflow, and arduous integrations to internal and external sources of data are among the structural issues that inhibit operational best practice.
Consequently, there is no higher-yielding, long-term investment today than in replacing legacy core systems. Moreover, there is no better time to invest.
The "risk-averse" approach of withholding strategic IT investment because of the recession may, in fact, be risk-seeking.
Far-sighted carriers recognize that an adverse market puts them in the enviable position of having the means to invest in its most strategic needs while costs are the lowest. Those that execute can achieve sustained advantage over competitors who hoard their capital, investing it in poor insurance and capital markets.
Marcus Ryu is VP, strategy and new products at San Mateo, Calif.-based Guidewire Software Inc.
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