Invest to impress

The global recession has predictably led to reductions in spending and capital investment across the board - and the insurance industry is far from immune. It now faces difficult decisions on investment to create a strong but efficient infrastructure. But, due to the industry's unique operating characteristics - combined with its contrarian investment theory - it could be argued that the present economic climate is an ideal time for strategic IT investment.

General insurers have, in the main, managed to avoid the careless and risky practices and shaky assets that have destabilised the financial system. This has been as a result of operating in a strict regulatory environment with the highest standards of accountability, low volatility, low risk and fixed-income assets as well as a healthy risk-averse nature. While bank failures captured the headlines, for the most part insurers have been able to maintain stability and continue to weather the storm.

With the majority of premium revenue coming from renewals, insurers experience less demand volatility than other industries, which places them in an enviable position - the possession of a secure capital foundation allowing them to employ a rational, long-term strategy.

Surplus capital

With the 'luxury' of surplus capital, general insurers have a range of capital investment options. They can increase underwriting bandwidth, secure new business or strengthen existing reserves. They could invest into capital markets, provide dividends, reduce premiums, or invest in their infrastructure to refine the insurance operation and support core processes - such as underwriting or renewing business, collecting premiums, paying losses and, hopefully, returning underwriting profit.

Of course, the appeal of each of these options depends upon a number of factors - not least current market conditions. In the hardening market, with demand for insurance in excess of supply and insurers leveraging their pricing power, maximising underwriting bandwidth may be the most attractive option. Alternatively, in a soft market, particularly when equity markets are yielding high risk-adjusted returns, allocating surplus capital for investment income or sharing the surplus with shareholders may be a better option. Clearly, that is not a choice the industry is likely to face for some time to come.

Expert opinions vary as to whether the insurance market is softening or hardening. But the historically low ratio of premium-to-surplus, as well as basic business sense, suggest the decline in premiums is due to the macroeconomic slowdown rather than a need or desire for increased capacity.

The impact of adverse global market conditions does not lead many insurers to consider an increase in underwriting capacity or capital market investment, so they are left with investment in core operations. It may seem counter-intuitive at a time when cash is scarce and every element of expenditure requires a closer look than usual. Yet it does, however, answer the most important question when choosing where to allocate the investment - namely, what will help achieve the highest rate of risk-adjusted return?

Capitalising on the present

If you polled representatives from various parts of an insurer as well as their suppliers, they would suggest different ways for the company to become a more efficient, accurate, and customer-responsive operation. But in an overwhelming number of insurers, a primary roadblock in taking these great ideas forward will be their legacy core system or systems. Typically, these will have been implemented at some point between the late 1970s and the mid-1990s and utilise now out-of-date technology platforms. These systems will have been designed primarily for financial processing, so effectively constrain rather than enhance almost every aspect of today's insurance 'machine'. As a result, there is arguably now no higher-yielding long-term investment than to replace these old legacy warhorses.

Nor is there a better time to undertake such an investment. Not only are the alternative uses for capital less rewarding in this poor market and economy, but technology resources are more widely available and being offered at a more-attractive-than-usual cost due to the recession. Technology vendors may be more price-aggressive and open to risk-sharing arrangements in exchange for the business. Even internal staff members are more likely to stay onboard and welcome the opportunity to engage in projects focused on the company's structural improvement.

Minimising risk

Seeking to take the 'less risky' route by holding off on strategic IT investments during recessionary times may actually be risk-seeking. Of course, the obvious risk of project failure is avoided, but this approach advocates a more dangerous set of 'inaction' risks: the risk of having an outdated offering for brokers and policyholders; the risk of an uncompetitive cost structure in a commodity-driven insurance marketplace; and the risk of eventual core system collapse as the experts who understand and maintain ageing legacy systems retire.

Regulatory risk is a key issue for all businesses. The scale and reach of regulation in the financial services sector creates a whole raft of operational challenges. Differing regulatory regimes require businesses to access significant amounts of data. These operational requirements with specific needs for management information further support the investment in core technology. At a recent Post round table on the Financial Services Authority's treating customers fairly initiative, the insurers taking part all spoke about the important role MI plays in providing the evidence needed to demonstrate compliance with the principles-based regulatory regime (Post, 19 March 2009, pp22-24).

Forward-looking carriers recognise that an adverse market puts them in the enviable position of having the means to invest in their most strategic needs while costs are lowest. Those that take action having recognised this can realise sustained advantage over their competitors who either choose alternative investment options or do nothing.

- Chris Maddox is UK general manager of Guidewire Software.