Insurance industry at crossroads

I previously indicated that the insurance sector in this country is in a great deal of trouble and needs to reform itself. In this Industry Insight, I will examine just how we got here.

The modern world of insurance began 339 years ago after the Great Fire of London, premised on the noble idea of people pooling their cash and then sharing risk among each other. Property and ships, to mention two areas of the market, were insured against loss. Then came the notion of insuring one`s own life and property, and insurance rippled out into other areas of the world.

In the process, insurance companies became organisations awash with cash, which had to be invested. So these companies built a great deal of investment expertise, and continued developing new products. As it developed, people came to understand that they had to provide for their old age, and they began investing in special retirement funds with these insurance companies.

The industry developed in two essential directions. Short-term insurance enables people to claim for damages suffered, and companies are required to hold reserves to cover potential risk.

Life insurance, on the other hand, has a long-term component, also with reserves but different in nature. Companies and clients enter into a long-term agreement and there is relative certainty they are going to receive their payments in the long-term - sometimes for three decades or more.

With this relative certainty in place, these insurance companies can build long-term models which actuaries can test against every conceivable assumption. They can test them again and again until they have satisfied themselves their risk levels and potential returns are acceptable.

The crisis in which the insurance sector finds itself may be attributed to lower inflation, but this is merely a hiding place for an outdated business model that needs a serious relook.

Freda du Toit, Director, SDT Financial Software Solutions

On the other hand, these insurance giants created an opening for asset managers. With so much money on hand, there was a clear requirement for investing vast amounts of money, which created the need for investment products.

So far, so good. Now, let`s cast our minds back to the days when insurance companies first automated their systems, introducing computers in SA in the late 1950s and early 1960s. In SA, as the computer age dawned, insurance companies were among the first to adopt the new platform, mainly to help them manage their paper-intensive environments better and to get quicker access to basic information.

Remember, these organisations were heavily paper-intensive. Every policy carried with it the need for vast amounts of paper: the application; the acceptance letter; the contract itself; the monthly payments - all of these required more paper than was healthy for any organisation.

A critical problem arose: these insurance giants were using their massive mainframe computers not for processing, but rather storing the transactions. This is a vital distinction, as the status quo persists to this day.

Secondly, having created a model which would remain stubbornly and resolutely paper-bound or data storage-bound for the next four decades, these companies remained in the traditional environment of relatively cheap labour to manage the processing of transactions. And to this day these companies have vast warehouses of paper, and enormous edifices for housing the people who manage all this paper and the associated systems.

They certainly do not have these vast buildings for meeting customers: indeed, as a policyholder, enter any of these vast buildings and you will struggle to find a place where you can engage with the organisation, and where it exists this is a negligible part of the infrastructure. That, after all, is why they have created call centres (that customer-friendly contact medium).

Who pays for these edifices? You, the policyholder, that`s who. A significant component of the costs of administering each policy is tied up in these buildings, the people, the systems ... and up to 70% of this cost is unnecessary and redundant and could be stripped out, IF these companies would just grasp the nettle.

Now, none of this was important in a high-inflation environment, where there was more than enough margin for it to make no difference when throwing paper and people at the process. And prior to our new, democratic dispensation, SA was characterised by very high inflation and high interest rates.

Can you remember when interest rates ran as high as 27%, and inflation was running in the mid to high teens? In this environment, projected returns on long-term investment were in the order of 10%-15%. Now, with inflation low and stable, and interest rates at their lowest in more than two decades, investors are struggling to maintain real returns of 2%-4%. In many cases, as reported widely in the media, investors are seeing negative returns.

So the crisis in which the insurance sector finds itself may be attributed to lower inflation, but this is merely a hiding place for an outdated business model that needs a serious relook. It is a function of bloated administration costs, and the presence of intermediaries, typically brokers.

Brokers undoubtedly consume a percentage of investments, especially up-front, but some of them do add value, and it is unreasonable, impractical and unrealistic to expect all of them to be removed from the equation. It is also unreasonable to make commission the only culprit for high costs and lower returns.

What can be expected, and what is happening, is that the structure of the commission paid to intermediaries changes from the current system where at least the first year`s payments are made out to the intermediary, to one where a smaller amount is paid up-front, and the balance is paid out in subsequent years.

This has the dual effect of smoothing out the payment curve and incentivising intermediaries to provide ongoing service to investors.

Another aspect of the solution is to have a tiering system to cater for investors at the low and high end, since we need to acknowledge and embrace the diverse markets we operate in.

But - and this is critical - it leaves insurance companies` processes as the one area where rapid and major cost-cutting can be enjoyed. And it is the one area where the greatest resistance is being felt.

However, unless insurance companies change their processes, and soon, the government will intervene - and we know that the industry would prefer to stay self-regulated.

* In the next Industry Insight in this series, I`ll analyse what`s wrong with insurance processes, and start looking at what to do about them.