Did You Say Controlled Tech Spending? Aw, Not Again!

Insurance is an industry that reacts decisively to its business cycles and urgently to intrusions of reality such as catastrophic claims, economic issues and regulation. The last several years introduced new challenges such as terrorism, burgeoning regulations from state and federal bodies, and competition from the financial services industry.

Coupled with current global economic conditions, these circumstances create one of the most challenging environments the insurance industry has faced in recent memory.

In terms of overall performance, the property and casualty (P&C) and life and annuity (L&A) insurance industries are performing well in the United States, albeit with a few pockets of concern. Many expect the P&C industry will post stellar 2004 underwriting performance, below a combined ratio of 100, its best since the early 1950s. However, concerns persist about the adequacy of reserves, especially in commercial lines and reinsurance segments.

The L&A industry is riding positive momentum from the financial markets because of its increased focus on equity-based and spread-based products. Many expect the L&A industry to remain stable amid competitive pressures from other financial services institutions. The emerging risks in product complexity and pricing adequacy will also present challenges for individual insurers without sufficient scale. As a result, we should expect an increase in consolidation activity among L&A insurers in the coming years. Overall, for all lines of business in 2005, insurers must concentrate on the present opportunities to gain competitive advantage and drive shareholder value by means of business strategy and technology investment.

Buy Trumps Build

TowerGroup projects IT spending in the U.S. insurance industry to remain relatively flat from 2004 to 2005 at $36.4 billion. Estimates for external spending are $10.9 billion for software, services and outsourcing (see chart, at right). We anticipate that insurers will continue to focus more on buying software applications, as opposed to building them on their own. Further, growth in external spending comes from the overarching trends for added support from outsourcing and consulting services. This figure currently accounts for approximately 30 percent of the total IT budget, but we expect increases as insurers redistribute dollars gained from efficiencies in resource management and infrastructure reengineering.

Internal spending at 50 percent of the total budget continues to be the largest portion of total IT spends. Hardware spending remains elusive because expenditures are often buried in project budgets and the drive for server consolidation is indeterminate. With that, we expect insurers to use the remaining 20 percent of the budget for hardware purchases such as servers, networking and storage, among many other devices.

Each insurance business line in 2005 is likely to face challenges in considering bigger IT budgets. P&C and L&A insurers will need to concentrate on the effective use of finite resources. There will, then, be differences in the way each business line directs its resources.

TowerGroup forecasts a slight increase in total IT spending for P&C insurance to $17.3 billion in 2005 from its 2004 estimates (see chart, below right). This forecast reflects the pent-up demand for new technology. The P&C insurance industry invests in IT in two basic ways. First, carriers and large agencies often respond to their most recent combined-loss ratio by curbing discretionary spending. This tactical modus operandi means that the level of IT investment per annum is predictable, yet it may compromise longer-term goals. Second, P&C carriers tend to confine IT spending to product silos, a practice that increases the cost of technology because it results in duplicative buying. Consistent planning at an enterprise level is necessary if P&C carriers expect to compete successfully in the financial services industry.

TowerGroup continues to forecast flat IT spending in L&A insurance at $19.1 billion. We expect L&A insurers to continue their efforts to capitalize on existing investments and explore alternative sourcing strategies. The IT budgets of L&A insurers are less susceptible to claims severity or underwriting changes but more exposed to fluctuations of the financial markets. Competitive demands and capital market dynamics make IT spending difficult to predict and to influence. Individual companies' responses to the business and economic drivers that have an effect on the L&A insurance industry dictate their IT spending options and behaviors. L&A insurers should carefully evaluate their core businesses and make tough decisions about mature and closed books of business. These older blocks of business drain valuable resources needed for development and growth businesses.

As executives in both markets evaluate enterprise needs, some may determine that a 5 percent to 10 percent budget increase is necessary to tackle enterprise projects. Further, external influences such as regulation, customer demands and technology advances may have a direct influence on IT spending projections. For example, as L&A insurers assess their capabilities relative to the impending demographic shift, an emphasis on new products and services may necessitate an increase in spending. Changes to compensation structures and a directive for transparency in this data are other external factors that may force insurers to invest in an incentive compensation solution.

A Delicate Balance

Insurers will need to spread budgeted dollars to various operations in infrastructure, maintenance and development. The biggest challenge facing insurers today is the effective use of budgetary dollars in these three areas. Insurers have yet to find the balance that would permit them to allocate more money to development and less to maintenance and infrastructure. What prevents this reallocation is the fact that insurers are not unplugging legacy systems, for which maintenance costs continue to escalate. Insurers must address this problem by employing the same discipline for return on investment (ROI) and priority setting to the maintenance budget as they do to the development budget. Insurers must also replatform and reengineer systems as necessary.

Moving IT from a cost of doing business to an integral component of business strategy is necessary if insurers are to improve operational efficiency, lower operational risk and align IT with operational objectives. Insurers can rationalize a strategic investment in the enterprise journey because the long-term benefits gained from leveraging existing IT investments in applications, the infrastructure and internal skills outweigh the short-term costs. Insurers want an integrated array of applications and processes to drive ROI, so they must be able to deploy technology solutions decisively to improve that equation. Managing IT with a strategic focus to reengineer operations in relation to enterprise architecture in data, business and presentation offers a number of benefits, such as flexibility to extend IT capabilities, reductions in maintenance and development costs, and improvements in speed to market.

Diligence in the maintenance and infrastructure budget is the only way that insurers will find remedial, hidden costs so more money can be made available for development. A closer examination of the development budget demonstrates how difficult it is to secure IT budget dollars for truly new projects. TowerGroup estimates that approximately 20 percent of the development allocation, or as little as 10 percent of the total IT budget, funds actual new initiatives. Insurers allocate the development budget dollars primarily to three areas: major enhancements, projects carried over from prior years and current-year projects. Typically, 50 percent of the development budget is for major enhancements - investments greater than $100,000 - and the remaining 50 percent of new development dollars split-fund both the current-year and prior-year projects.

It is common for 30 percent of a new development budget to fund projects that may be multiyear activities or incomplete projects carried over into the current year. An example of a carryover initiative would be completing an agent portal to facilitate application submission and policy servicing. This work may have companion projects that draw on the infrastructure budget to make necessary extensions or additions to support additional requirements. Other types of multiyear projects include reengineering in claims and policy administration, business intelligence (BI) initiatives, and work to upgrade or replace existing applications.

To estimate insurers' allocations of technology spending to new initiatives in the 2005 budgeting process, TowerGroup categorizes development projects according to five main business priorities in insurance - operations, distribution, profitability, customer service and governance:

- Efforts to streamline processes to reduce manual work in insurance operations will include projects such as core system enhancements and reengineering, enterprise content management, and various initiatives for straight-through processing.

- Insurers focus on attracting and retaining profitable producers, so Web services, enterprise incentive compensation and relationship management are likely to drive distribution initiatives.

- Key to an insurer's success is achieving profitable and sustainable growth. Therefore, underwriting, fraud and BI will be of strategic importance.

- The ability to enhance customer service and delivery channels is a competitive advantage, but we remain cautious about insurers' willingness to invest in call centers and communications.

- Governance throughout the enterprise in areas of metrics and measurement, project management and compliance will help insurers integrate risk management with daily operations.

TowerGroup foresees that the climate for insurance will mitigate aggressive technology investments by insurance companies over the next 12 to 18 months. IT spending will remain controlled and allocations will be limited to short projects of 12 months' duration or less. Enterprise initiatives will be broken into tactical projects of similar duration to meet milestones and demonstrate ROI along the way. It is likely that spending increases will moderate at less than 5 percent for the next five years. However, each insurer will assess total IT spending on an individual basis. Eventually, the industry will reap additional benefits as the result of improved performance from business and IT reengineering. What is apparent is that insurers do not necessarily need to spend more, but they do need to spend more effectively.

Cynthia Saccocia is a senior analyst in the insurance practice at TowerGroup (Needham, Mass.), a research and consulting firm focused on the global financial services industry.