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Creating Breakthrough
Value in Life Insurance
To Virtual Integration
Creating Breakthrough Value in Life Insurance
:
a . r. x i a i xi \
ax i xnusrns uxnrn si ror
No wonder the life insurance industry is under siege (see figure 1). Deregulation has opened the flood-
gates to new entrants including banks and investment firms. Demutualization is forcing performance
improvements in an effort to meet the expectations of cautious investors. The Internet has transformed
the industry by offering new channels, new opportunities to leverage customer information and new
ways to deliver on consumers growing expectations of customer service. (Despite this pressure to offer
strong Internet capabilities, insurers must be frugal with their e-business expenditures.) Estate tax
reform is promising to hamper sales of certain tax-advantaged insurance products, while the fickle
stock market is continuing to do its best to dissuade investors and destabilize investment income.
Looking ahead, insurers can count on asset retention and management challenges as aging baby
boomers stop accumulating wealth and instead aspire to longer periods of retirement and asset
distributionultimately transferring their wealth to a new, more sophisticated and service-conscience
generation of investors.
Beyond the external forces, an assortment of internal dynamics is eroding life insurers ability to
increase profitability. Pure management of insurance risk, for example, prevents insurers from differ-
entiating and earning large profits. Hefty amounts of capital and resources tied up in servicing old,
in-force blocks of business is preventing large insurers from moving into new markets, creating new
products and streamlining expenses. It is often these aging servicing and technology environments
that thwart insurers attempts to offer more innovative (and more profitable) products. Similarly,
insurers are unable to use their superior investment skills to increase profits due to constraints by
regulators both in the amount of reserves to be held and in the nature of investments made. And with
more sophisticated customers purchasing new types of products preferring annuity products to
whole life policiesas well as demands for 24/7 customer service, insurers are left with even fewer
opportunities to boost margins.
The result? Over the past five years, the performance of public life insurers has lagged signifi-
cantly behind other financial service sectors, and the gap is widening. In a recent study comparing life
Introduction
Market pressures faced by major players in the insurance industry call into question the viability of
the traditional vertically integrated approach to the life insurance business. Customers and capital
markets no longer value many of the traditional functions that insurance companies perform and
are looking for increased return from the remaining activities. Successfully addressing these pressures
requires a new vision and a bold approachin essence, a disaggregation of the existing business
model and a fundamental refocusing on the core components of the business. The linchpin of this
effort is the transformation of mundane processing and servicing functions into new strategic
capabilities. Together, these capabilities are the catalyst to unlocking value in the industry.
Creating Breakthrough Value in Life Insurance
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:
insurers to all others (including the S&P 500, diversified financials and the financial sector), the returns
of life insurers have risen only slightly while the returns of others are as much as five times higher than
the original investment. In fact, the economic returns of life insurance companies would have to
increase by almost five percentage points to match the average performance of leading financial
services institutions.
Some analysts assert that a wave of consolidation is the only way to close the earnings gap in the
insurance industryciting as proof the more than 175 life and health insurance deals valued at
more than US$80 billion that have been signed since 1998. This includes the purchase of American
General by AIG. In fact, many analysts believe that intra-industry consolidation will accelerate as
global players with global brands, technology and distribution resources gain economies of scale
and build sustainable customer franchises. Other analysts, including those at ING and Citibank,
support another viewpoint, saying that it is only a matter of time before life insurers become divisions
of much larger financial-services firms.
Which of these competing groups of analysts is right? They are both right. The reality is that the
two trends will persist concurrently in the coming years.
In this paper, we offer insurance executives a way to capture a competitive advantage during this
period of change. Our remedy resides in A.T. Kearneys virtual integration strategya proprietary
approach to reworking the business model that helps life insurers bridge performance gaps by focusing
on core, value-creating activities. Central to the strategy is an unbundling of the existing business
model that allows an insurer to focus on specific activities that will generate the highest possible
value for the company. In essence, what we propose for the insurance industry is a movement from
vertical integration to virtual integration.
uxioci xo vaiur i x rnr i xsunaxcr nusi xrss xonri
Virtual integration is an emerging approach to business system transformation and optimization. By its
simplest definition, virtual integration is the unbundling of the insurance industrys existing business
model enabling an insurer to individually manage specific activities that will generate the highest
possible value for the company.
Briefly, instead of thinking of insurance as a single business, in a virtually integrated company
insurance becomes three unique businesses: processing and servicing (operations), product creation
(design and underwriting) and sales (distribution). Whether the company is actually broken up
into three distinct entities, or a major function is outsourced, the aim is to think of the company as
a portfolio of distinct businesses in which each component is focused on value creation (see figure 2).
Clearly, this trend of individually managingand thus unbundlingthe value chain is fairly
well developed. The financial services industry, especially the mortgage and credit card sectors, is
well versed in the concept (see sidebar: Unbundling the Value Chain). Players in these sectors have
demonstrated how quickly this concept can be adopted and integrated, as well as how profitable the
processing and servicing business can be.
Creating Breakthrough Value in Life Insurance
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,
Nonetheless, life insurers have been hesitant to fully embrace the concept due, in part, to the unique
nature of their business and to significant, inherent barriers to change. For example, the complexity of
products and slowing industry growth have led to a dependence on expensive face-to-face producers
such as agents and brokers. The insurance industry also suffers from a lack of homogeneity and data
standards for sharing information as well as a vast number of proprietary, inflexible IT systems
(a wide range of systems can exist within a single institution). Furthermore industry governance
under a mutual structure has delayed both innovation and decision-making.
These challenges, coupled with policies that stay on the books for decades, have prevented the
insurance industry from taking advantage of the significant economic benefits that can be derived
from virtual integration.
Until now.
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Today, several A.T. Kearney clients are exploring virtual integration strategies. Our work focuses
primarily on evaluating ways to unbundle traditional functions and create new businesses with
a basis for long-term competitive advantage. In our experience, processing and servicingtraditionally
viewed and managed as an unfortunate cost black holeis the key anchor of this transformation
approach (see sidebar on page 11: A Shift in Focus). Indeed, based on our own estimates, the impact of
outsourcing just the processing of in-force policies can be impressive. For example, in analyzing the
impact such a move would have on the 10 largest individual life insurance providers, our estimates
reveal the potential for an average increase in market capitalization in the range of 2 to 6 percent.
Consequently, while value increases in the sales and product-creation areas, the real breakthrough from
virtual integration comes from transforming the processing and servicing area into a value generator.
Of course, the ideal configuration of a virtual organizationand the role of processing and
servicingwill differ according to an insurers size, focus and core competencies. For example,
a regional insurer may decide to outsource its policy servicing and processing in an effort to focus
on specific product and segment niches. By comparison, an international diversified financial services
company would likely partner with a third-party administrator (TPA) to create an enterprisewide
process and servicing shared-services utility, which would free the business segments to focus on
their core operations. Finally, a large traditional insurer might decide to partner with a TPA to
create an industry-wide utility to process and service policies. This move would not only create new
revenue sources but also allow the company to redeploy resources to pursue alternative distribution
models for its products. The result is a virtually integrated insurance company with processing and
service, sales and distribution, and product creation and underwriting utilities that can be owned
and managed solely by the insurer or with a strategic partner.
Essentially, this discussion is about addressing processing and servicing capabilities to create new
strategic options for insurers. It begins with variations on two themes: fix the old and create
the new.
Creating Breakthrough Value in Life Insurance
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group want insurance or increased coverage terms but have limited or no access to sales and distribution
(agents, for example). This represents an overall market opportunity estimated to be several billions
in premiums.
To tap into this market, many insurers are pursuing a variety of different product and channel
strategies. Most have created online distribution offerings to match all types of customer needs and
to provide high quality, reliable and personable customer service. Insurance companies are aligning
with independent brokers, employers, banks and, of course, using the Internet as a distribution
channel. The key challenge is to become the easiest to do business with. To do so, requires an open,
effective and integrated processing and servicing capabilityeither owned or through a partner.
Without such a capability, all the investments in distribution are nothing more than facades on
a movie set they look nice from the outside but who would want to live there?
Underwriting and product creation
Suppose an insurance providers core competence is design and underwriting. To bolster creativity
and innovation, the company decides to diversify and is now creating products for other companies,
even private labeling its own products, and devising new products to address the needs of the
upcoming retirement bubble to manage distribution of assets in the golden years.
Now that U.S. regulatory conditions have legalized convergence, insurance companies are free
to sell their product to banks that are looking to enter the insurance business. Few banks have
endeavored to go it alone, however. Instead, banks and insurers are creating partnerships at an
unprecedented rate, and bancassurance has become an accepted part of the financial services spectrum.
A survey by the Association of Banks-In-Insurance estimates that 22 percent of banks are selling
group life and health insurance, and another 23 percent plan to do so within two years. Yet, while
banks are keen on enhancing their role as insurance distributors they are in no hurry to assume
underwriting risk, choosing instead to form alliances with insurers. In fact, only 7 percent of banks
say they are likely or very likely to assume underwriting risk within the next three years and, as
an alternative, plan to form alliances with insurance agencies and insurance carriers. An insurance
company with the wherewithal to produce a specific product can offer it to all types of financial
services companies to sell under their own labels.
In the future, product profitability will rest on an insurers ability to design products that will
not only sell but also be efficiently underwritten and servicednecessitating a processing and servicing
capability that supports product innovation. Insurers that focus on underwriting and product creation
have an opportunity to broaden their role: providing customers with greater financial security as their
needs progress from asset protection to asset accumulation and ultimately to asset distribution.
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Critical to the success of virtual integration is leadership that emanates from the top of the organization.
The changes that are required are fundamental, and the level of partnerships forged requires strong
Creating Breakthrough Value in Life Insurance
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Conclusion
The insurance landscape has forever changed. Virtual integration represents a bold approach for life
insurance companies that compete in the new environment to work outside the industry to transform
traditional servicing and processing functions to create new sources of advantage. By disaggregating
the existing business model and focusing on core, value-creating functions, players in the insurance
industry can achieve:
Improved efficiency
A predictable cost structure
New initiatives pursued through redeployment of resources
A strong profit and growth message
Improved capture and use of customer data
Potential long-term capital relief
,
direction and organizational commitment. Before embarking on virtual integration, the insurer
must know that its management team is comitted to change.
In addition, virtual integration requires a sound structuring of cross- and intra-industry strategic
partnerships. Insurers must focus on selecting partners with care and building new business
structures with creativity. Each strategic partnership should begin by defining common goals and
objectives, and formulating a way to measure progress against the goals. It is also critical to have
a comprehensive view of the value creationparticularly in terms of cost transparency and value
sharing. The economic attractiveness of the alliance will rest on the insurers cost structure and the
opportunities for cost displacement. Therefore, before making any decisions with long-term implica-
tions, it is important to consider all costs that will be incurredincluding conversion costs and the
cost of an internal restructuringand then determine how best to share the displaced operating costs
with a partner.
Also, all partnerships must be based on a good cultural fit. This is particularly important when
alliance partners make up what was previously a core part of the insurers organization.
Finally, insurers will need to make a commitment to fundamentally changing and
challenging their business. This involves a careful consideration of the potential risks that surround
the organizational changes and the strategic implications of new approaches and relationships. For
example, the following questions should be answered: Is it possible to disengage from the alliance
if the relationship sours? Are there switching costs? Are there barriers to exit? Will business be
disrupted if the relationship ends? What are the financial and strategic risks of an unsuccessful
operating model? Answering these questions and persevering through transformation challenges
will separate winners from the rest of industry.
Creating Breakthrough Value in Life Insurance
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: c
Unbundling the Value Chain
Virtual integration is not a new concept. Years ago, the financial services industry reacted to many of the same mar-
ket pressures that are now hammering the insurance industry in much the same way. Financial services organizations
began by using their technological know-how to improve simple transactions, which eventually led to an industry trans-
formation.
The mortgage industry epitomizes the unbundling concept. More than a decade ago, pressure from shareholders
for higher financial returns as well as increasing competition from new entrants drove the industry to rethink its busi-
ness model. Profit margins were a factor in the decision, or rather a lack of profit margins in loan origination (credit
risk management, for example). The entire experience culminated in credit-mortgage securitization, and the stan-
dardization and simplification of products. Today, loan origination in the mortgage industry is separate from process-
ing, which is dominated by a handful of large traditional players that have established industry-wide processing utilities.
Case in point: Homeside Lending, a Bank of Boston creation. In a radical departure from traditional mortgage
banking, Homeside was launched in 1995 to sell and service mortgages of new banking partners. Shortly thereafter,
Homeside exited the retail side of the business to focus exclusively on servicing. By originating loans largely as a whole-
sale lender, Homeside keeps loan acquisition costs low and does not need to support a brick-and-mortar franchise.
Homeside built its servicing portfolio by forming strategic alliances with preferred partners that originate the loans
including Barnett Bank, Cendant, Bank One, Peoples Bank and Merrill Lynchand offers co-branding servicing
to its partners. Today, Homeside ranks sixth in the United States for residential mortgages with approximately 2 mil-
lion loans and US$150 billion in servicing volume.
Credit cards evolved along a similar path. Today the processing and servicing of credit cards has consolidated around
a handful of firms that, like mortgage firms, benefit from economies of scale. One leader is First Data Resources (FDR)
whose sole focus on processing makes it among the largest third-party processors of credit cards. FDR handles all card-
transaction processing and card-portfolio management for credit, debit, stored-value, commercial, private label and
oil-card issuers. The company now boasts a client base of nearly 1,500 card issuers and processes more than one million
transactions an hour, settling, on average, more than US$3 billion daily. For the most recent two-year period, the stock
price of FDRs parent company (FDC) outperformed the S&P, Dow Jones and NASDAQ indices.
Insurers that embrace these strategies will have an opportunity to reposition their companies and
become effective competitors in the new financial services marketplace.
A Shift in Focus
Creating Breakthrough Value in Life Insurance
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Figure 1: Insurance industry pressures
Source: A.T. Kearney
Increasing competition
Decreasing margins and profitability
Search for economies of scale
Focus on distribution productivity and
reduced dependence on agents
Decreasing customer loyalty
Focus on customer preferences
and product innovation
Changing customer
preferences and needs
Financial market scrutiny
Privatization and declining
regulatory barriers
Market entry of
new competitors
Increasing product
commoditization
Technological/e-business
innovation
: :
Many insurers have already begun separating and consolidating servicing and processing operations, where more
than 35 percent of the industrys controllable expenses are generated (see figure A). The results have been less than
optimal. For example, in some cases, insurers gain volume but not real scale to drive down costs. Some insurers are
hindered by so-called archeological layers of processes and systems that affect service performance. Still others inad-
vertently create loosely connected information islands that cannot support customer transactions nor relationships.
In almost all cases, insurers that attempt an unbundling fail to live up to the new strategic options outlined by their
leadership teams.
While technology will take care of many of these industry-specific issues, the larger challenge lies in convincing
companies to shift their traditional focus from products and distribution to processing and servicing. To date, the
industrys main focus has been on the product offering and distribution channels, while neglecting the potential in
the processing and servicing function. This lack of attention has led to cumbersome, outdated processes and systems,
and inhibited value creation in distribution and manufacturing.
Leaders in the insurance industry are exploring new approaches to their processing and servicing capability
recognizing it as a significant new source of untapped value and acknowledging its critical role in supporting their
virtual insurance strategies.
a . r. x i a i xi \
Source: A.T. Kearney
Advisory and program oversight of
in-force processing and servicing utility
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administrative and servicing partner
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capital deployment partner
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Transfer of responsibility for in-force servicing and processing
Lower fixed costs per policy
Reduction of risk-based capital requirements
Improved surplus position
Reinsurance of in-force liabilities
Figure 3: Proposed structure for the in-force business
Source: A.T. Kearney
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Vertically integrated
business system
Deconstructed
business system
Processing
and servicing
Selling
Product
creation
Processing
and servicing
Selling
Product
creation
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Reconstructed
business system
Deconstruction Reconstruction
Processing
and servicing
Selling
Product
creation
Virtual integration
Figure 2: Disintegration of the traditional life insurance business model
a . r. x i a i xi \
Source: A.T. Kearney
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cavirai-nrviosxrxr vanrxrn nrxrvirs
100%
80%
Long-term
return on
capital to capital
deployment
partner
Controllable
operating costs
NPV of
business
purchased
Amount of capital
transferred to
ceding insurance
company
Before After
Policy management costs
New business related costs
Overhead costs
100%
Y%
X%
Z%
75%
Y%
X%
Z%
Insurance company general expense base analysis
voiics xaxaorxrxr vanrxrn nrxrvirs
Cost per
policy
Number of policies processed
Initial average cost per policy (including
conversion and initial investment costs)
may be higher than servicing charge to carrier
Having achieved scale and
efficiency improvements,
cost per policy becomes much
lower over time
Initial servicing
charge to carrier
Figure 4: Benefits of in-force business partnerships
a . r. x i a i xi \
Source: A.T. Kearney
Generate and
qualify leads
Communicate
benefits and
features of
products
Collect client
information
Provide quotes/
illustrations
Primary functions
Key activities
Percentage of total
operating expenses
Gather under-
writing information
Review application
and make risk
assessment
Issue policy and
complete with the
insured and agent/
sales entity
Set up policy on
the administrative
platform
Manage the policy,
billing and state-
ments
Respond to queries
Complete all
policy-related
transactions/
changes
Develop the
product strategy
Design product
features and pricing
Manage the over-
all book of business
Manage regulatory
and reserving
requirements
Overhead costs
shared by the entire
organization (e.g.,
real estate, legal
fees, directors fees)
Marketing
and sales
46%
Processing
14%
37%
Servicing
23%
Product
development
2%
Support
15%
Figure A: Breakdown of operating expenses by function
1101/15M/543
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Atlanta
Boston
Buenos Aires
Caracas
Chicago
Cleveland
Dallas
Detroit
Los Angeles
Mexico City
Miami
Minneapolis
New York
Plano
San Diego
San Francisco
So Paulo
Silicon Valley
Stamford
Toronto
Washington, D.C.
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Bangkok
Beijing
Hong Kong
Jakarta
Kuala Lumpur
Melbourne
New Delhi
Seoul
Shanghai
Singapore
Sydney
Tokyo
iuioii
Amsterdam
Athens
Barcelona
Berlin
Brussels
Budapest
Copenhagen
Dsseldorf
Frankfurt
Geneva
Helsinki
Istanbul
Lisbon
London
Madrid
Milan
Moscow
Munich
Oslo
Paris
Prague
Rome
Stockholm
Stuttgart
Vienna
Warsaw
Zurich
For more information or additional copies, contact Marketing & Communications at:
A.T. Kearney, Inc.
222 West Adams Street
Chicago, Illinois 60606 U.S.A.
1 312 648 0111
fax 1 312 223 6200
email: insight@atkearney.com
www.atkearney.com
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