Most insurance companies aren’t bold enough in their strategies to boost profits, according to a recent report from McKinsey & Company, which also says that industry CEOs must lead the way to successful transformations that generate profits.
Purposeful, bold moves include shifting resources between businesses, boosting underwriting margins, improving productivity, and pursuing “thematic and programmatic” M&A deals, according to the McKinsey Insurance Practice analysts who authored a June 2019 report titled ““How to win in insurance: Climbing the power curve.”
While McKinsey analysts agree that all that sounds “instinctive” rather than bold, they say many insurers are failing to follow these steps rigorously. In fact, their analysis of the economic profits of 209 insurers around the world (property/casualty and life) reveals that 20 percent of the insurers created 90 percent of the overall industry profit.
(Editor’s Note: The metric used for the analysis, economic profit is defined as “the total profit after the cost of capital is subtracted.” The insurance industry analysis using economic profit draws on the work McKinsey colleagues Chris Bradley, Martin Hirt and Sven Smit presented in the book, “Strategy Beyond the Hockey Stick: People, Probabilities, and Big Moves to Beat the Odds.”
The cost of capital is the cost of raising additional capital—the interest rate a company pats to raise debt, or from an equity perspective, the return investors demand to compensate for the risk of owning a company’s shares.)
The report illustrates the discrepancy in average economic profit for the best and worst insurers graphically on a curve that the authors refer to as a “power curve.” The graph of average economic profits for 2013-2017 starts off on the far left with large negative values that increase to zero (moving left to right) in a section of the curve devoted to the worst performers (the bottom quintile). Moving further right, the upsloping curve becomes a fairly straight line hovering near the zer0 level across the second, third and fourth quintiles. On the far right, a gently upward sloping curve reveals that the top quintile created economic value in excess of their cost of capital over time.
Putting dollars to the illustration, the researchers found that the top 20 percent of insurers created an annual average of $764 million in economic profit during the 2013-2017 period, the middle 60 percent produced an average of only $26 million, and the bottom 20 percent lost an average of $976 million per company per year.
How to Be Bold
Moving up the power curve isn’t easy, McKinsey’s researchers say, noting that the odds of jumping from the bottom to top quintile in a decade were 17 percent (for companies on the bottom from 2003-2007).
While the authors outline a handful of bold moves for increasing mobility on the power curve, they also stress that there is no magic strategy. “Strategy is probabilistic, not deterministic.” The goal is to work to beat the odds—and the real success stories come from insurers that combine the strategy moves they outline in the report, the authors suggest.
Discussing the idea on a video on McKinsey’s website, Kurt Strovink, a senior partner and one of the authors, said that companies in the middle quintiles—those just making their cost of capital—have about a 8 percent chance of moving up to the top. The 8 percent becomes 50 percent when bold moves are used in combination.
What are the bold moves?
Examining more than 40 potential levers, the researchers report that just five explain power curve mobility.
For each move, the authors give examples of unnamed companies that successfully implemented the strategies and indicate the thresholds of performance needed to move up the curve.
Explaining the first (resource-shifting) move, for example, the authors note that some carriers offer too many legacy products that don’t produce meaningful profit. That was the situation for a Europe-centric life insurer that reallocated capital to high-return segments in Asia and the U.S., jumping to the top of the curve.
How much capital do movers reallocate?
The “threshold for outperformance is the reallocation of 60 percent of surplus generated over a decade.”
High thresholds are common to all the moves. “Even if a company is doing something in each of these dimensions, how much it is doing often makes a difference. In other words, strategy is not only about the directionality of moves but also their materiality,” the authors explain.
Highlighting the laser focus needed for moves like resource reallocation and reinvesting in already profitable businesses, Strovink delivered advice to chief executive officers on his video analysis. “Sometimes it feels more comfortable to do many things because you’re hedging your bets. But the cost of ‘peanut-buttering’ investments and resources—capital and people—across a number of opportunities [is high] in terms of your strategic success,” he said. Providing some quantification, he said that the difference in total return to shareholder between companies that move resources around and those that don’t is roughly four points every year.
“You can double a company’s size inside of 10 years from changes like that,” which add up over time, he said.
“The role of the CEO is critical,” Strovink continued. The CEO is ideally positioned to calibrate materiality—”to judge whether the organization is doing enough—if what people think is being done is bold enough. [This is] why successful transformations are increasingly CEO-led,” he said.
As for the M&A move, the report says that a “programmatic approach” means focus too—focus on executing a series of deals, no single one of which exceeds 30 percent of market capitalization. But overall, across a 10-year span, the total deal value should be greater than 30 percent. Such deals are simpler to integrate and avoid competitive bidding issues. They can be “thematic” also—along themes like building technology or extending into new lines or geographies.
Turning to the underwriting improvement move, accomplished by one P/C insurer described in the report that adopted machine learning for risk selection and pricing, McKinsey said that insurers need to be in the top 30 percent of the industry by gross underwriting margin to scale the curve. Similarly, companies need to aim for cost improvement in the top 30 percent of the industry for the productivity move to be a difference-maker.
McKinsey addressed the last move in more detail in a separate related report published earlier this month, “The productivity imperative in insurance.” That report delivers some good news, noting that P/C carriers have increased productivity in all areas of the value chain (using measures like gross premiums per full-time employee, claims per claims management FTE, new policies per policy issuance FTE, etc.) The gains came from investments in automation and improved sourcing, the report says.
Other conclusions presented in the “Productivity imperative” report include these:
Like the “Power curve” report, which outlines the “bold moves” for success, the “Productivity” report describes four sets of levers for insurers to pull to boost productivity: functional excellence; restructuring to simplify; business transformation (going digital, selling closed books, etc.); sustaining momentum with enterprise agility.
In addition to introducing the “bold moves” for success, the earlier “Power curve” report also distinguishes such moves—strategic ones made with conviction—from reckless moves. In addition, it outlines two factors that can work for or against leaders seeking to move up the curve: endowment (an insurer’s starting point in terms of size, financial flexibility, product and IT experience and investment) and trends (market, economic changes in industry or geography).