In the second of his articles on captives as a 21st century risk management tool Marcus Schmalbach of the Fachhochschule des Mittelstands examines the effects of megatrends on insurance.
Today’s global companies are forced to deal with a variety of risks. In addition to disaster risks (eg, earthquakes, hurricanes and avian flu), property risks (eg, fire and technical risks, such as the failure of public utilities), liability risks (eg, product recall, environmental and water damage), financial risks (eg, bad debts, financial market risks, currency risks), personnel risks (eg, loss of employees, confidence damage, strike, illness/injury, liability for damage to third parties, individual errors by employees), market risks (eg, steady shortening of product life cycles, entry of new competitors, introduction of substitutes), a stronger emphasis is being placed on newer risks, such as terrorist attacks, and risks that arise due to digitisation (eg, damage to reputation in social networks, data loss, or hacking attacks).
These circumstances require companies to use holistic risk management in order to keep the impact on both the company and the business environment as low as possible in the event that such risks materialise. Since the economy is now globally connected, the total failure of a company may have a ‘butterfly effect’ that results in extensive damage to the overall economy. Accordingly, there are various frameworks that the management boards of companies can use to ensure that management can adequately deal with risk. Empirical values and experience ensure that traditional risks such as fire or business interruption are no longer life-threatening for the company, but the threatening risks are innovating. Correspondingly it is necessary to meet them with innovative solutions such as contemporary legislations and modern hedging tools.
The risk analysis of a company is based on the question of whether risks can, or should, be avoided, reduced, limited, borne, or insured. Whether a company bears the risk itself or transfers it to an insurance company, in particular, depends on the frequency, probability of occurrence, and damage potential, in addition to the risk policy. Not all risks are transferred to an insurer, even if the companies would like them to be. Insurers do not assume all risks, and many are thus uninsurable, or insurable only to a limited extent. An example can be taken from the volcanic eruption in Iceland of 2010: The multi-week closure of European airspace and the losses suffered in the aviation industry were not covered by insurance.
Uninsurable risks can pose a significant threat to the future of a company. Companies face a risk landscape that has in part been reconstituted in recent years. Not only have recent years seen structural changes in the economy, but there have also been notable changes in the legal environment and new forms of risk stemming from both digitisation and globalisation, including global political changes, and technological innovations. The complexity of these changes has led to a permanent extension of the limits of insurability and ultimately the need to design new insurance products.
As the current Allianz Risk Barometer 2016 shows, company risk managers have an increasingly changed perception of existence-threatening company risks. Top risks include business interruption (including supply chain interruption), market developments (market volatility, increased competition and stagnating markets) and cyber incidents took the top positions.
That fears of a disruption of supply chain ranked in first place is in no way surprising. In the prevailing globalised world in which companies have continuously improved their processes and supply chains and just-in-time respectively just-in-sequence production have become commonplace, a business interruption not only impacts the smooth running of a company but also its customers.
“It seems ironic that the risk takers (traditional insurance companies) are not interested in taking risks and subsidising possible innovative products through existing ones.”
Accordingly, risks can no longer be viewed in isolation from each other and a business interruption with no plan B would equally result in reputation damage—which can pose a threat to the existence of the company. In contrast, traditional industrial risks, such as natural disasters (earthquakes, floods, and storms), fire and explosion, and liability losses are no longer the worry drivers of industrial enterprises.
The ‘soft market’ remains stable and the turnover generated in the sector is falling continuously. Companies are afraid more of the unknown, of risks that they do not know, or cannot calculate. Strategic changes in the market also matter, as well as the prevailing hype about startups that will damage the business models of established businesses, or at least, put them into question. The ‘old economy’ feared an increasing attrition of its shares as a result of digitisation and innovative technologies and derived business models.
Megatrends, such as digital and physical technologies (eg, additive manufacturing), nanotechnology, driverless vehicles, and smart cities and factories create a new standard, bring positive aspects and boost the economy, but this is accompanied by a great deal of uncertainty and the risk that the company’s business model is in question or even rationalised.
New business models
Especially in the automotive sector an unprecedented change is taking place. Electric cars of the future will be self-driving, and an important aspect for successful sales is interpreted as the entertainment system of the vehicle. This goes hand in hand with production becoming increasingly more digital (the internet of things) and suppliers of the required parts will change as a whole.
At the same time Amazon represents the supermarket of the future as it exits from the digital world into the stationary. The fashion industry is equally undergoing a transformation and is continuously individualised and greener. Fair trade is increasingly becoming the focus of the buyer—Adidas has had an initial success with collections made from ocean garbage, which is processed by means of additive manufacturing for individualised and ecologically acceptable garments to suit the lifestyle of health and sustainability (LOHAS) community. Companies are responding to the growing trend of greening and are expanding their product portfolios towards vegan and vegetarian, so as not to leave this market completely to new entrants.
Figure 1: Influences of megatrends on existing business models
Consequences for the insurance industry
Megatrends have arrived in the industry. In particular, the business to consumer industry is responding to the new demands of the market and consequently existing business models are questioned or even discarded and must be remodelled. At the same time, the demand for traditional risk coverage (liability, fire, accident, etc) is accompanied by a decreased willingness for insurance coverage in this area to pay for it at the respective companies, as these risks are no longer classified as a threat to their existence.
Corporations with private risk management have already responded to this development and have increasingly opted for alternative solutions and have turned towards the alternative risk transfer (ART) market. Medium-sized companies mostly lack the internal know-how for such steps, or the insurance protection can be purchased so cheaply that the effort does not relate to the benefits. Equally, however, it can also be seen that there are ‘true’ company risks for which no traditional insurance protection exists.
Due to moral hazard, it is not possible for the insurance industry to assure customers against market trends or innovation failures—at least, if one uses a classic calculation basis and the principle of insurance does not want to replace it with a gamble. What happens, however, if the demand of the customers of traditional insurance continues to decline and the insurance industry does not make product innovations and is also not responsive to the prevailing megatrends and business model insurance, or the product portfolio in the industrial insurance sector is put into question?
The ART market is a continuous growth market and in many domiciles the attractiveness of the captive solution is continually being honed. These have the advantage that they are not a rigid construct and can be better understood as a piggy bank, which the customer can access when needed and also secure damages that he could not cover with a more classical insurance market (eg, costs as a result of innovation failures, reputation, etc).
The insurance industry has reacted to the development of digitisation and now offers cyber risk solutions to its customers, but the concepts are not yet mature in their entirety and the true value may be in question. Hacker attacks are accompanied by reputation damage that cannot be calculated and can cause an irreversible damage to the company.
In the November 2016 attack on the German telecom Telekom 900,000 customers were off the network for several hours. Even if Telekom had taken out insurance against this claim, the question of data safety remains with the customer. Can Telekom protect my data sufficiently? Is Telekom the right provider for my company? In the worst case, such a hacker attack brings a wave of consequences with it and the long-term reputational damage is significantly higher than the costs incurred due to the cyber attack itself. Pile up those headlines, and the business model, or at least the line of business of Telekom, may be in question.
Accordingly, Telekom is looking for solutions in order not to prevent hacker attacks, but to offer solutions for its customers, should an attack happen. Accordingly, the megatrend of digitisation—and the associated risk of cyber attack—is not only a risk to Telekom, but equally the chance to expand the product portfolio to new businesses, and to pull the insurance industry out of its core business (insurance).
This example can be adapted easily to other industries. Large OEMs such as Daimler and BMW have in-house captive solutions for their insurance portfolio. Returning to the fear of supply chain disruptions, risk managers at Daimler Captive offer their own insurance solutions to their customers and thereby strengthen their standing in the company, at the same time strengthening the profitability of their own business unit and reducing the risks along the supply chain. This leads to a lasting contribution to the company’s success—digitisation and the consequent approach of blockchain.
Possible scenarios and outlook
Based on Michael Porter’s five forces analysis, five different competitors affect the insurance sector: other insurers (competitors); suppliers (brokers, general agencies); new competitors (Google, fintech companies, and captives owners); customers (captives establishment or use of ART solutions); and substitutes (ART market, non-traditional insurance solutions, and risk security in the collective without the insurer). How realistic and dangerous are these competitive forces and which scenarios are conceivable?
- Competitors (other insurance companies)
The industrial insurance market is a mature market and there is competition among insurance companies. A unique selling point (USP) is difficult to generate. The result was and is a price war, which led to a consolidation of the market in the past few decades. Since businesses with a high insurance demand—especially in sectors that are very susceptible to damage such as the automotive industry—are running up deficits, more merger and acquisition activity can be expected in the future.
- Suppliers (brokers, general agents)
Even with the brokers, there is a steady number of mergers in the market. It is becoming more difficult to generate value for the customer, as the internet increasingly exposes the risk landscape and, due to the limited number of industrial insurers on the market, the provision of insurance solutions no longer presents the industrial companies with huge challenges. Forecasts suggest that the market position and the need for brokers in the coming years will decrease continuously.
- New competitors
Google is feared by many industries, as the company has two of the most important commodities of the 21st century: data and information. This is ultimately an important part of the USP of an insurance company—advanced knowledge compared to its customers. The other half is the risk balance over the law of large numbers.
Google was able to implement this component relatively quickly. Through a ‘blitzkrieg’-type market penetration, which is realistic in the digital age, the company was able to save market share using competitive prices. Insurance is a non-haptic and emotionally uncharged product. It sells only through trust. Insurance customers can get trust also from Alphabet—mother of the Google Group based in California—because the company has billions in reserves and virtually inexhaustible monetary resources.
More danger comes from captive owners who belong to a megacorporation—eg, the captives of BMW or Daimler. They could take a progressive approach and bundle the risks of their suppliers in their captive insurance, in order to better control and manage the risk of supply chain interruption. Also possible is the successful market penetration by fintech companies, which take advantage of the blockchain approach and gain price-sensitive customers through lean administration.
A market penetration by a fintech company, however, would probably take too long, as it has no brand awareness and a long timeframe for the roll-out is required. It would be more likely to buy the corresponding technology of an established, high net worth company, which would guarantee fast scaling (eg, Alphabet).
The larger the company, the greater the likelihood that there is onsite risk management, which deals intensively with the optimisation of the risk portfolio. The more accurately the company knows its risks and can calculate them, the less likely is a covering of risks through a traditional insurance solution. In particular, the captive solution has been successful in the large corporate world and immense annual premiums are missing from the insurance company’s balance sheets. Captive startups are not to be described as hype, but it is a steadily growing market, which is becoming more attractive.
The aforementioned ART market does not offer traditional safeguards for industrial companies. The market is relatively small, complex and opaque. In particular for small and medium businesses it is not attractive, because the contact person is missing and the risk portfolio is too small. However, digitisation is a driver for the market to become better known and more attractive—also and especially for the medium-sized segment.
Figure 2: Megatrends and their influence on the risk and insurance market participants
In summary it can be said that the risk and insurance industry, like other industries, has to innovative and must launch new, marketable products. The industry has repeatedly placed products over decades and has already developed an innovative product with the cyber attack solution. However, one product in 10 years will not suffice to maintain the insurance business model. The USP is crumbling and the known enemies (other insurers) have been expanded by numerous potential competitors, which have become large and powerful in the context of digitisation.
A reactionary action is no longer sufficient. Solutions for existential risks (eg, innovation failures, reputation damage) must be offered to the customer to protect its existing portfolio. It seems ironic that the risk takers (traditional insurance companies) are not interested in taking risks and subsidising possible innovative products through existing ones.
Enough examples from other industries show that the era of process optimisation has been replaced by the era of disruptive innovation. The market is in harmony and the clients put their insurance portfolio on the test bench. It is an interesting time for company risk managers to rethink the use of captives, because whoever wants tomorrow, to be who he is today, must be willing to change.
Marcus Schmalbach is a lecturer in business administration in Fachhochschule des Mittelstands (FHM) University of Applied Sciences in Germany. He can be contacted at: firstname.lastname@example.org
Fachhochschule des Mittelstands, Europe, Marcus Schmalbach, Insurance, Captive, Risk management, Data loss, Analysis, Legislation, Auto, Cyber