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The Cost Structure in the Insurance Industry

Prachi Juneja
management study guide
Related Topic
:- Risk Management Analytical skills.

The Cost Structure in the Insurance Industry

 

Insurance is one of the most regulated industries in the world. Also, there are multiple players which offer every type of insurance. As a result, the competitive pressures are very high. This ensures that the insurance companies are not able to charge exorbitant premiums. Almost every insurance company across the world is a price taker and not a price maker. This means that they are forced to sell insurance at a price prevailing in the market. Hence, these companies can only become profitable if they control costs. For this reason, it is important to understand the main drivers of costs in the insurance industry.

The major cost drivers have been listed in this article:

Complexity

Complexity in the insurance industry refers to the fact that the same company can have several brands and can offer several different products. For instance, insurance companies use different brands to sell life insurance and general insurance products.

It has been observed that insurance companies that offer the widest variety of products tend to have the highest percentage of costs. This is because they have to advertise separately for each brand. Also, they tend to have separate sales channels for different brands. The bottom line is that having multiple lines of business in the insurance industry does not mean that economies of scale will follow. In fact, consolidation and increased regulation make operations more complex. As a result, insurance companies that have multiple insurance products find themselves paying more costs as compared to companies that only sell one type of insurance.

Back Office Operations

Back office operations are a major cost element in the insurance industry. All policies that are purchased need to be verified and entered into a central system. Similarly, every claim also needs to be verified and logged on in a central system. There are lengthy processes which need to be followed each time. This means that the insurance business is prone to a lot of paperwork and administrative processes. These processes are important from a risk mitigation point of view. Hence, they cannot be overlooked. However, since they form a major chunk of the costs, any company that is able to streamline these processes has an obvious cost advantage.

In many developed countries, optimizing back-office performance simply means outsourcing to the country with the cheapest cost structure. However, that does not need to be the case always. The truth is that there is no one size fits all approach. Some companies can save costs by centralizing all their back-office work in one location. Other companies can save costs by keeping their back office work decentralized across different locations where they may be closer to the customer.

Using a simple pricing structure can also be beneficial when it comes to reducing back-office costs. Companies that use a wide variety of brokers and offer several different prices based on customer channel tend to have a lot more back-office work than companies that keep their processes simple.

Technology

Digitization has been the latest buzzword in the insurance industry. Insurance companies have discovered that by using digitization, companies can reduce their costs by a large amount while simultaneously improving customer service. However, for this to be possible, it is important that the information systems be streamlined and up to date.

The problem is that a lot of insurance companies tend to have legacy information systems which are highly fragmented. This means that they are unable to truly leverage the benefits of economies of scale that new software systems provide.

Information systems tend to be extremely important. This is because these systems indirectly drive employee productivity as well. Updated IT systems end up reducing back-office costs. However, they also reduce the time required for an insurance company to take any new product to market. This gives insurance companies the first mover advantage and allows them to corner the market before more competitors come into the market.

Conclusion

The cost structure at most insurance companies is driven by four major factors, i.e. the size of the company, geography, product lines and the sales channels used. However, this traditional structure does not take into account individual factors. For instance, motor insurance companies provide almost the same quote to two drivers if they use their cars for about the same mileage. However, this does not take into the fact that one of them may be a rash driver or maybe driving on dangerous roads. This is because until now, this information has not been available to insurance companies. Now, with the advent of technology, cars can be fitted with devices which will allow better determination of premiums based on the risk being borne. This will help insurance companies charge premiums based on the actual risk involved.

It is therefore likely that the traditional cost structure being used in the insurance industry may become defunct. A completely new system is likely to replace the old system. This means that the rules of the game are likely to change very soon!

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