Creating IT Advantage in the Insurance Industry

Creating IT Advantage in the Insurance Industry BCG s Benchmarking Initiative BCG REPORT

Creating IT Advantage in the Insurance Industry BCG s Benchmarking Initiative STEPHAN HEYDORN RAINER MINZ GUNTHER SCHWARZ THOMAS ACHHORNER BOYD PEDERSON MARTIN SEIBOLD HAUKE KRÜMPELMANN APRIL 2005 www.bcg.com

Table of Contents Note to the Reader 4 Acknowledgments 5 Preface 6 Executive Summary 7 IT in Insurance: Key Findings from BCG s Benchmarking Initiative 8 IT Costs Continue to Rise but at a Slower Rate 8 Investment-Cycle Position Determines Total IT Costs 8 Higher Spending Doesn t Mean Greater Efficiency 10 IT Cost Ratio and IT Unit Cost Are Key Performance Indicators 11 IT Cost Ratio Varies Widely Among Business Lines and Countries 11 Cost Benchmarking Is Most Meaningful with Local Peer Groups 14 Clear Scale Effects Exist in IT Unit Costs 14 Application Development and Maintenance Dominate IT Spending 16 Architecture Complexity Increases IT Costs 17 Outsourcing Is Not Being Aggressively Pursued 19 Four Levers for Improving IT Performance and Cost Position 20 Improve Business and IT Strategy Alignment 21 Reduce Complexity 22 Optimize Management of the IT Project Portfolio 24 Evaluate and Pursue Sourcing Options 24 Methodology 26 Creating IT Advantage in the Insurance Industry 3

Note to the Reader If you would like to discuss your insurance business with The Boston Consulting Group, please contact one of the following leaders of our global Financial Services and Information Technology practices: The Americas Monish Kumar BCG New York +1 212 446 2800 kumar.monish@bcg.com Boyd Pederson BCG Toronto +1 416 955 4200 pederson.boyd@bcg.com Europe Stephan Heydorn BCG Düsseldorf +49 2 11 30 11 30 heydorn.stephan@bcg.com Rainer Minz BCG Cologne +49 221 55 00 50 minz.rainer@bcg.com Gunther Schwarz BCG Cologne +49 221 55 00 50 schwarz.gunther@bcg.com Martin Seibold BCG Stuttgart +49 711 20 20 70 seibold.martin@bcg.com Frans Blom BCG Amsterdam +31 35 548 6800 blom.frans@bcg.com Christophe Duthoit BCG Paris +33 1 40 17 10 10 duthoit.christophe@bcg.com Ralf Dreischmeier BCG London +44 207 753 5353 dreischmeier.ralf@bcg.com Thomas Luippold BCG Zürich +41 1 388 86 86 luippold.thomas@bcg.com Ignazio Rocco BCG Milan +39 0 2 65 59 91 rocco.ignazio@bcg.com Dieter Tschach BCG Vienna +43 1 537 56 80 tschach.dieter@bcg.com Asia-Pacific Thomas Achhorner BCG Hong Kong +852 2506 2111 achhorner.thomas@bcg.com Giles Brennand BCG Hong Kong +852 2506 2111 brennand.giles@bcg.com Thomas Reichert BCG Sydney +61 2 9323 5600 reichert.thomas@bcg.com 4 BCG REPORT

Preface The current rules for success and profitability in the insurance industry are far different than they were five or ten years ago. Insurance companies today, no longer able to count on extraordinary investment returns, focus on identifying attractive markets and market segments, trying to achieve local leadership positions, and improving overall competitiveness. They must therefore concentrate on their core skills, reduce complexity, and systematically evaluate options to improve value creation within their companies. Achieving operational excellence has become an increasingly common strategic goal, one that requires superior management of IT resources. With IT costs comprising up to 30 percent of total operational expenses at insurance companies, optimizing IT spending to achieve enhanced efficiency and effectiveness is climbing higher and higher on both CEO and CIO agendas. Yet despite the growing importance of the IT function, only a few major insurance companies have gained a complete understanding of their competitive IT positions. For most institutions, the performance level and cost of IT remain well hidden. As a consequence, many levers that could help sharpen IT efficiency and effectiveness are not being put to good use. The aim of the BCG IT-Benchmarking in Insurance initiative is to help CEOs and CIOs of major insurance companies obtain a better perspective on their competitive positions with respect to information technology. Accordingly, we seek to help top management answer four key questions: How much does our company spend on IT compared with our peer group? What is the business value generated by our IT investments? What are the main business and IT drivers of our company s IT costs? How can our company manage its IT resources more efficiently and more effectively? Given that any insurer s business characteristics (such as size, nature of sales channels, and product mix) and IT characteristics (such as type of infrastructure and complexity of architecture) act as IT cost drivers, a central focus of our study is to look holistically at business and IT performance, and to identify the drivers and metrics that top managers can use to improve their IT cost positions. The ultimate goal is to transform IT from a mere tool for enabling products and processes into a source of true competitive advantage. This report, which addresses the key findings of our ongoing IT-benchmarking initiative, is based on data gathered from more than 80 insurance companies in six major insurance markets between 1998 and 2004. We plan to continue conducting annual surveys in order to further monitor and evaluate the long-term effects of different IT strategies and market trends. We hope the report will be thought provoking and serve as a source of useful information for both CEOs and CIOs in these extremely challenging times for the global insurance industry. 6 BCG REPORT

Executive Summary Information technology is a major driver of cost and value, and therefore a critical strategic issue for insurance companies. IT costs continue to rise for insurers, although the rate of increase has slowed since the late 1990s. IT costs can be separated into two general types: those for supporting ongoing IT operations and maintenance (run-the-company costs) and those for innovating and developing new functionalities (change-the-company costs). Relatively high IT innovation budgets do not automatically bring added value to the insurer, since new functionalities must be aligned with strategic objectives. In order to accurately measure and reduce IT costs on an ongoing basis, insurers must take steps to make IT costs more transparent. A majority of insurers find it difficult to determine their total IT costs and even more challenging to assess those of separate business lines. This condition reflects a general lack of rigor in both identifying different types of IT costs and tracking how IT costs are allocated. To accurately gauge the competitive IT position of an individual insurance company, a benchmarking comparison with local competitors is necessary. The two most important IT performance indicators for insurers are IT cost ratio (total IT costs as a percentage of gross premiums) and IT unit cost (the IT cost per policy or per insured risk in the portfolio). Both figures should be carefully monitored for each business line in order to improve cost and performance transparency and to permit the setting of competitive target IT costs. IT costs can be effectively and strategically managed if insurers give IT issues the high priority they deserve. Business characteristics such as the company s size, the depth and complexity of the product portfolio, and the number and nature of sales channels are principal drivers of IT costs. Consequently, CIOs should identify these cost drivers and clearly track the ways in which they affect IT budgets. CIOs can directly manage key IT cost drivers, such as the IT project portfolio, the nature and complexity of IT architecture, the efficiency of IT processes, and the approach to IT sourcing. Insurers should aim to increase the change-thecompany share of the IT budget and commit to managing new IT investments rigorously. This includes gauging the optimal moment to introduce new technologies. IT can become a true source of competitive advantage only if an insurer s IT strategy is well aligned with its overall business strategy. If IT and business strategies diverge, IT investments cannot possibly achieve maximum value. Proper alignment can be brought about only through integrated planning, supported by organizational and governance structures aimed at maximizing the business value of IT investments and reducing total IT costs. Part of this process involves forming a clear understanding of the IT implications of specific business decisions such as merger activities, the extension of sales channels, and the redesign of business models or processes. IT project portfolios should be managed centrally and vigilantly, including regularly reviewing each project s progress, budget status, and realized benefits. In parallel, insurers should aim to trim their run-the-company IT costs by reducing IT complexity, consolidating data centers, and leveraging outsourcing options. Creating IT Advantage in the Insurance Industry 7

IT in Insurance: Key Findings from BCG s Benchmarking Initiative Our benchmarking studies in a variety of markets have provided fundamental insights about the evolving role and impact of information technology in the insurance industry, and have revealed the most important drivers of IT costs on both the business and IT sides. Understanding these aspects and trends is a critical prerequisite for insurers that hope to improve their overall performance through more efficient and more effective use of IT. Following are the primary insights of the studies. IT Costs Continue to Rise but at a Slower Rate IT spending by insurance companies has increased significantly over the past decade. The increase was most pronounced in the late 1990s, when many insurers spent heavily to resolve Y2K issues, manage the introduction of the euro, stay abreast of the e- commerce boom, and execute large-scale expansion strategies. In Germany, for example, IT costs for leading insurers grew by 12 percent annually between 1996 and 2001 but slowed to an annual increase of 2 percent between 2001 and 2004. During the same respective time spans, premiums grew by 5 percent and 4 percent annually. (See Exhibit 1.) The reasons for the decline in IT cost growth were largely that Y2K and other projects had run their course and that the growth of IT costs lost momentum following the negative capital-market trend that began in 2000 leading to a new focus on cost efficiency and reduced IT budgets. We have observed a similar IT cost pattern across all business lines. Moreover, when comparing the rise of IT costs with that of premiums, the majority of companies in our survey managed to achieve a higher rate of premium growth, at least in some years, although there was wide variation among players. EXHIBIT 1 IT COSTS ARE RISING AT A SLOWER RATE Example: Leading German Insurers, 1996 2004 Growth index IT costs Gross premiums +12% 1996 2001 +5% 1996 2001 IT cost increase SOURCES: BCG IT-benchmarking initiative; BCG analysis. NOTE: Percentage increases are annual averages. +2% 2001 2004 +4% 2001 2004 1996 2001 2004 Yet in contradiction to the long-term trend, some insurance companies have actually reduced their overall IT costs over the past few years. One subsidiary of a major European insurance group, for example, has managed to steadily slash its IT costs by pursuing five major initiatives: implementing strategic IT portfolio management, standardizing its IT infrastructure, pooling its applicationdevelopment resources, applying rigid processes, and launching a rigorous performance culture featuring frequent benchmarking of its IT cost position. (See the sidebar IT Cost Structure Is Usually Not Transparent. ) Investment-Cycle Position Determines Total IT Costs One way of separating IT costs is to distinguish between costs for ongoing operation and maintenance of the IT landscape (run-the-company costs) and costs for innovating and developing new functionalities in IT systems (change-the-company costs). From 1999 to 2003, the average share of change-the-company costs for the insurers in our study decreased from 30 percent to 25 percent of the total IT budget. Potential reasons for the decline were twofold. First, growing cost pressure in the industry has resulted in a reduction of can do projects. Second, the size of the change-the-company budget is closely linked to each 8 BCG REPORT

individual company s position in the investment cycle. Insurers in our benchmarking studies demonstrated four typical investment patterns. (See Exhibit 2.) IT savers, which spend only what is absolutely necessary on IT, with minimal change-thecompany costs. IT consolidators, whose growing IT costs reflect investments in the harmonization of their application landscape (such as during or after a merger). When consolidation efforts are intense, change-thecompany costs are generally small. IT investors, which spend increasing amounts on new functionalities (such as technologies for optimal business-process support), IT infrastructure, and the enhancement of employees IT skills. Change-the-company costs are usually higher for investors than they are for consolidators, reflecting the larger IT project portfolio. EXHIBIT 2 INSURERS DEMONSTRATE FOUR TYPICAL INVESTMENT PATTERNS Low IT cost ratio, 2004 High Low IT saver IT consolidator SOURCES: BCG IT-benchmarking initiative; BCG analysis. IT optimizer IT investor Change in IT capabilities, 2002 2004 High IT optimizers, which display just slightly growing or even decreasing IT costs but still manage to build new capabilities. Optimizers rely on a cost-efficient and flexible IT architecture that can be enhanced without significant cost increases. Their change-the-company ratio (as a percentage of total IT costs) is usually above average. The minimized cost strategy of IT savers usually cannot be maintained. Overly restricted IT investment hinders the competitiveness of most companies in the long term because new products, the demand for higher back-office productivity, fluctuating market conditions, and changes in stateof-the-art technologies require additional IT investments. A simplified IT-improvement process would be to start, for example, as an IT consolidator with a welldefined target IT landscape based on strategic business and IT objectives. During the consolidation process, benefits could be reaped as redundant and noncritical applications were retired, shifting budgets from consolidation to innovation. Next, as an IT investor, the company could optimize top-priority systems in order to support potentially new and innovative business processes, leading to efficiency IT COST STRUCTURE IS USUALLY NOT TRANSPARENT Although IT performance and cost-efficient IT management are key success factors for every insurance company, full transparency of IT costs is relatively rare. Most of the insurers that participated in our studies found it challenging to determine total IT costs both for their companies as a whole and for specific business lines. The underlying reasons for this difficulty include the following: Some business-unit IT costs, such as those for equipment that is not deployed centrally, are often not recognized The various types of IT costs have never been accurately broken down or properly allocated to lines of business No internal service-charge mechanisms exist for allocating secondary IT costs such as those for rent, electricity, IT procurement, IT controlling, and human resources functions This lack of transparency hinders CIOs in managing their available resources. Creating IT cost transparency as an initial step therefore generates value in itself. Creating IT Advantage in the Insurance Industry 9

gains in back-office departments. Then, as an IT optimizer, the company could reduce total IT costs (compared with the original starting position) and gain benefits from a flexible IT architecture. It should be noted, however, that a high change-thecompany budget, in itself, does not guarantee added value for the institution. New developments and functionalities must be tightly aligned with strategic business and IT requirements in order for the company to reap benefits. Higher Spending Doesn t Mean Greater Efficiency Back-office productivity, defined as the number of back-office full-time employees (FTEs) per thousand policies, is a scaledriven function in insurance companies. (See Exhibit 3.) As with IT unit costs, the deviation in scale curves among countries owes mainly to differences in specific market characteristics, such as the prevalence of bundled products or group policies, EXHIBIT 3 SCALE EFFECTS EXIST IN BACK-OFFICE PRODUCTIVITY Number of back-office FTEs per thousand policies 1.5 Back-office productivity in life insurance, 2003 A high change-the-company budget, in itself, does not guarantee added value for an institution. varying business models, the average premium per policy, and the degree of automation in business processes. These back-office scale effects have been confirmed by a detailed analysis of policy-administration and claims-management transactions. One major insurance group showed, for example, that by doubling the number of policies it administered in motor insurance, it would be able to reduce IT unit costs by 14 percent. The savings could reach 21 percent if the number of policies were tripled. Such scale effects are key elements of third-party policyadministration business models currently being pursued by several international players. (See Exhibit 4.) Analyzing these results alongside scale effects in IT unit costs, BCG explored the possibility of a direct correlation between back-office productivity and IT unit costs. The hypothesis was that insurers that spent more on IT (as demonstrated by a position above the IT unit-cost scale curve in their respective markets) would have higher back-office productivity owing to increased levels of automation and IT support. Surprisingly, we found no empirical evidence for this hypothesis on a company level. For the sample of companies in our survey, higher IT unit costs were not associated with a corresponding increase in back-office productivity. Among the reasons for this lack of correlation, which has been verified by additional analyses, are the following: 1.0 0.5 0 Germany France United States Netherlands 3 6 9 12 Policies (millions) A lack of alignment between IT investments and strategic business targets, and therefore no prioritization of investments according to strategic requirements. (For example, one major insurance group s IT function invested significantly in a new application for industrial business that the corporate side had already decided to divest.) Nonexistent or underdeveloped business cases for IT investments and no clear implementation concept to realize savings on the business side. Unrealized potential benefits in the short term, especially insufficient FTE reduction. SOURCES: BCG IT-benchmarking initiative; BCG analysis; TCi Consulting & Research. Poor delivery and fulfillment of project goals by the IT function. 10 BCG REPORT