The value chain approach to insurance
The insurance business model categorises risks into three major categories: predictable losses that occur frequently that are not severe; improbable losses that are infrequent but severe; and catastrophic losses that occur very rarely but are extremely severe.
Traditional insurance providers handle predictable and some improbable losses well, but invariably find it harder to efficiently spread some improbable and most catastrophic losses, particularly when their occurrence is widespread. This is the area where captives provide the highest value.
“Profitability, asset efficiency, revenue growth and diversification of risks would dominate the strategic choices of this value chain.”
The basis of my argument focuses on the supply chain and value chain approach, and extends the traditional insurance model far beyond merely considering the financial loss to a client in the event of a claim. Assuming a company is a suitable candidate for a captive insurance arrangement, the traditional insurance model cannot compete with additional considerations, including the supply chain/value chain approach.
The traditional supply chain
Typical insurance products and services are usually designed and marketed to downstream customers by a ‘supply chain’ of carefully crafted insurance products. The business model uses actuarial language to estimate and quantify a ‘fortuitous’ risk, along with the ability of the insurers (brokers, underwriters and reinsurers) to efficiently transfer and distribute some (or all) of the risks away from the client downstream towards reinsurers upstream.
Insurance companies accordingly operate on a 50 percent loss ratio (give or take), based on the expectation that 50 cents of every dollar in premium payments is expected to be paid out in claims. The remaining 50 percent covers overheads and provides the insurer with a profit and, presumably, a healthy return on investment.
The insurance industry value chain
The premium itself is finite. That creates a zero-sum game between supposedly collaborating insurers operating on a supply chain. Every insurance provider providing a product or service along the supply chain seeks to gain ‘competitive’ advantage with the end customer.
The value chain, or Porter’s value chain, captures the share value activities of the underwriter and the broker as a case in point. The goal is to obtain competitive advantage based on four elements: operational efficiency; product leadership; customer intimacy; and, if possible, system lock-in of the customer.
Fundamentally the broker (and the underwriter) would identify those primary activities and supporting actuarial activities that would be much appreciated by the client customer (competitive advantage). It also identifies added-value activities such as marketing and claims services which would be assembled around expertise, infrastructure and other resources provided by themselves, or their supply chain.
Value chains tend to be customised and involve sub-activities and processes that are specific to a particular customer’s needs. Activities such as actuarial analysis/policy creation and claims processing are key value chain drivers. Each actor on the value chain (reinsurer, underwriter and broker) charges a fee mark-up for its services which, in the insurance industry, means a share of premium.
The client customers, on the other hand, are not part of this supply-value chain and have no say in how these value activities are created or shared.
The downside of this traditional approach is:
- Many clients with good business safety practices in place end up paying high premiums that are set by actuaries across the insurance supply chain based on industry benchmarks and standards that have little relevance to the actual operations of the client;
- The problem is exacerbated for ‘improbable’ and ‘catastrophic’ risks where insurance premiums are prohibitive (often unattainable), or come with exclusions. Conversely clients with good practices are punished twice as they rarely generate claims against these risks; and
- Clients have little or no say on whether to claim, or to settle a claim, or the type of representation they will receive, or even on how to structure risks in a way that benefits themselves and not the insurance industry.
The captive insurance business model
Owning a captive subsidiary changes the traditional insurance product-service dynamic dramatically. The traditional supply-value chain construct no longer applies. The client customer becomes a member of the value chain and takes over the key activities of the broker and underwriter, effectively making itself into an insurance company in its own right.
The supply chain begins at the customer end and moves upstream towards the reinsurer. The customer takes over the silos and duties of the broker/underwriter. Risks and premiums are based on actual statistics rather than actuarial averages obtained from distribution pools in the market place.
Competitive advantage is based on ‘customer intimacy’, and ‘system lock-in’ is a given. ‘Product leadership’ and ‘operational efficiency’ are decided by the customer selecting the right insurance policy and the right actuarial support providers, who are intimate with the business risks and inner workings of their company.
The value chain would be no different from the value chain the customers would have for any of their products and services. The focus is not just on risk mitigation but on how this new insurance company of theirs should maximise shareholder wealth. Finding the right actuarial support and locking them into long-term contracts to ensure that there is no loss of intellectual property is essential.
Profitability, asset efficiency, revenue growth and diversification of risks would dominate the strategic choices of this value chain. Perhaps the most important attribute of a captive that is often missed is that captives convert insurance and risk management from ‘a major cost centre’ into a ‘major profit centre and wealth generator’ for the parent company.
Benefits of owning and operating a captive
A number of strategic and tactical benefits are provided by captive subsidiaries. They can efficiently design difficult-to-obtain coverages and insure prohibitive risks, and have direct access to reinsurers. They can retain premiums to create a giant war chest for the company, and can stabilise premiums and future-proof them from market fluctuations.
They allow businesses to separate improbable and catastrophic risks and share them between the captive and commercial providers for optimum cover. They can structure family trusts, rewarding key employees (and even family members of a trust) with shares of the captive, among many other advantages.
Captive insurances in customer-centric business models will likely evolve over time in New Zealand and Australia. In this competitive furnace there are likely to be two or three classes of dominant players who will emerge in the marketplace.
There is a unique opportunity for the insurance industry to build a nodal position for itself. How these customers and insurance industry supply-value chains compete and interact at their interfaces should be of interest to all stakeholders in the marketplace at large.
When a customer is allowed to enter the insurance industry value chain, the interface between value-creation and value-sharing will create winners and losers at both ends of the interface. This then leads to an intriguing prospect that needs discussion at the next level of a captive’s creation.
Allan Rodrigues is director at Captive Insurance Solutions NZ. He can be contacted at: dean@captiveinsurance.co.nz
