UK: Going organic – driving growth from within - Insurance Market Update – June 2005

Growth is back. But experience shows that product innovation rarely delivers, while process and service innovation are far more likely to offer genuine differentiation and lasting competitive advantage. We look at how companies harness their creativity and turn good ideas into business growth.

Growth is back on the agenda. But this time around, it’s tempered by a continuing focus on cost containment. The growth frenzy of the 1990s – and subsequent rollback – has led most financial institutions to adopt a more cautious and measured approach to growing the business.

Yet the pressure to grow is as great as ever. Share price appreciation is largely driven by future expectations, with past and present performance merely an indicator of what’s to come. In fact, more than 70 percent of a company’s total shareholder return is generally attributable to revenue growth.

In the financial services industry, product innovation has been the predominant strategy for organic growth. Yet most companies see very little return on their development investments. Our research shows less than a quarter of new financial products are actually profitable, and those that succeed in the marketplace are often quickly copied by the competition – usually in less than three months – negating any competitive advantage. Plans to grow through increased share of wallet have also gone largely unfulfilled, with cross-sell ratios for the global industry barely exceeding the theoretical minimum of one product per customer.

Companies can use innovation more effectively, expanding the focus from product innovation, which is easily replicated, to process and service innovations, which are much harder for competitors to copy. The goal is to create a virtuous circle – attracting and retaining customers through process and service innovations that improve efficiency and convenience, then using those gains to fund additional innovations – leading to sustained differentiation and an enduring competitive advantage.

In the 1990s, strategic acquisition was the growth strategy of choice. But today, the industry’s focus is shifting back to organic growth – building the business from within.

One reason is the dwindling number of attractive and viable merger candidates. Another is the mounting evidence that mergers and acquisitions are not the best way to create lasting shareholder value. That’s not to say there won’t be further consolidation over the medium term. It’s just that organic growth will be the predominant focus.

To achieve the goals of increasing revenue and total shareholder returns from within, companies must relearn the growth habit. And they must do so quickly – particularly with respect to net earnings. In general, firms should be patient for revenue growth, but impatient for profit.

Over the past few years, organic growth has largely been stagnant, often barely keeping pace with inflation. General insurers face a wide range of obstacles, including:

• maturing markets and product saturation;

• slow-growing economies that increase risk while reducing overall demand;

• increasingly sophisticated customers who are more demanding, informed and cautious;

• capital shortages stemming from underperforming investment markets;

• increased margin pressure;

• competition from new players with different business models and distribution networks;

• similar customer segmentation strategies, with a common focus on high revenue segments and minimal differentiation between companies;

• limited contact with end-customers, reducing the opportunities for customer intimacy, brand building and cross-selling. Regulation adds to the problem by raising compliance costs – a significant barrier to entry for small, innovative companies that lack the necessary economies of scale.

The industry’s growth problem isn’t for lack of trying. Over the past decade, growth-related investment has more than doubled – without generating a commensurate return. In other words, it’s not an issue of money or effort. It’s an issue with the underlying approach. Often simple, joined-up, cross-company innovation is lacking.

For most companies, product innovation is at the heart of their growth strategy. By our estimate, the world’s top 100 financial services companies combine to spend nearly $11 billion on product development annually. Yet the results are generally unimpressive, with most firms only achieving minor improvements in revenue and market share. This appears to be a relationship that is relatively consistent across different financial service sectors and geography. We looked at numerous product markets across insurance, securities and banking and found that over the medium term (five to ten years) that changes in market share were small (after adjusting for mergers and acquisitions).

Product innovation can drive short-term demand, but generally doesn’t create a sustainable advantage. A recent study of the UK market found more than 29,000 different financial products. Yet among that flood of products, there was actually very little differentiation. Most products were strikingly similar, with any real innovation quickly copied by the competition – generally in less than three months. That’s scarcely enough time to get a customer’s attention, much less to significantly grow market share.

Many products are cash traps, costing more to design and deliver than they ever generate in revenue. Shrinking product cycles are exacerbating the problem, driving up development costs and reducing the size and likelihood of a potential payoff. Studies show the average cost of bringing a new product to market has more than doubled in the past decade, with failure rates ranging from 60 to 80 percent, and with the minority actually producing a significant profit.

Companies with tired products will lose market share in the long term. There are many examples of companies growing share from innovative products; but the reason for this success is the strong linkages between the product improvements together with service and process innovation. Direct Line in the UK is a clear example of a new innovative business model, where advantage came from lower prices offered based on a lower cost business approach. The product itself might not have been a "eureka" product but the proposition was market winning.

Although it may seem counterintuitive, step-change revenue improvements come from internal innovation, not external products. Superior performance is first achieved by "locking-in" customers for positive reasons such as service innovation, then using that captive base of happy customers to generate additional revenue.

There are two main levers to achieve that kind of growth:

• Process innovation – which focuses on the way work is done, making it better, faster and cheaper. Examples include value chain reengineering, performance-based incentives, and sales force effectiveness.

• Service innovation – which focuses on the customer experience, bringing a company closer to its customers and using that intimacy to deliver better service by for example, conducting mystery shopping tests, customer collaboration, service excellence and channel integration to ensure customers are getting a good experience.

In recent years, the biggest disruptions in financial services have come from process and service innovations. Offshoring is a disruptive process innovation that is literally changing the way financial services companies are structured. The internet – despite falling short of some expectations – is nevertheless an important service channel that continues to grow in size and importance.

Most financial service companies don’t focus much attention on process and service innovations, making it easier for those that do to achieve differentiation and competitive advantage. And because process and service innovations generally occur behind the scenes, they are harder for competitors to detect and replicate – providing an advantage that is much more enduring. This is particularly true in commercial lines where savvier risk assessment and management can lead to material competitive advantage around pricing correctly for risks written.

Progressive Insurance – a leading personal lines company in the United States is an example of a company achieving impressive success through process innovation. Progressive’s proprietary processes and systems do a better job identifying and targeting the market’s most profitable customers, giving the company a distinct advantage over its competitors.

The offshoring trend is another example of process innovation. Early movers such as American Express and Standard Chartered enjoyed an extended period of lower costs and greater operational flexibility from specialisation (for instance through offshoring); advantages they used to improve their overall market position. Norwich Union Insurance in the UK has also been a leader in offshoring as it seeks the lowest possible operating costs in a commoditizing market.

We have developed a way of measuring innovation so as to understand the linkages between innovation and growth. The innovation premium uses market valuation to quantify a company’s innovation capabilities. Innovation premiums for financial services companies vary widely. The industry’s top 10 innovators enjoy premiums ranging from 35 percent to 55 percent, meaning that one-third to one-half of their total market value is specifically tied to innovation. In comparison, the industry’s least innovative companies command a premium of less than 15 percent – a difference that translates into tens of billions of dollars in shareholder value.

Investment banks and large, diversified financial companies tend to command the highest innovation premiums. Retail banks show mixed results, with banks in the United States generally exhibiting more innovation than their European counterparts. Insurance tend to have the lowest innovation premiums. But none of these patterns are set in stone. Ultimately, a company’s ability to innovate isn’t driven by size, sector or market value. It’s driven by mindset.

Measuring innovation is easy; making it happen is hard. It requires a strong and unwavering commitment across the enterprise, as well as formal processes and systems to nurture and develop new ideas. People often equate innovation with creativity. But the truth is most companies have plenty of good ideas. In a recent survey of CEOs, 75 percent said their people generate a sufficient number of promising ideas. Yet only a small percentage of those ideas are actually commercialised.

The true measure of an innovative enterprise is its ability to commercialise good ideas – converting them into superior market performance and financial returns.

Transforming a company into an innovative enterprise is a major challenge that touches everything from people and strategy to systems and external business partners. Indeed, for innovation to thrive, it must be embedded into the very fabric of the organisation. We suggest companies look at project spend and see what percentage is on product innovation vs product development linked with process and service innovation. Also there should be a rigorous checklist on any new product development e.g. will product provide competitive advantage? If not, do we still need to do it for market parity? What service and process changes will give us a march on competitors? Etc.

However, it is important to note that a holistic cross company innovation is organisationally hard and this is why few get it right. It’s easier organisationally to pursue silo innovation – it gets you to the wrong answer though.

Enabling change. Successful innovation starts at the top. Companies that excel at innovation weave it into their business strategies – evaluating resource requirements and capacity for innovation; quantifying the organisation’s appetite for risk; and aligning innovation activities with the company’s overall strategic objectives. Senior executives promote innovative behaviour through their words and actions, while a company-wide network of change agents nurtures innovation and growth at every level.

Building organisational capabilities. An organisation’s existing behaviours and mindset are often the biggest barriers to innovation. To succeed, companies must create a stimulating work environment that fosters innovative behaviour. That means encouraging people to take initiative for identifying problems; redefining individual roles to focus on customer needs, rather than products and transactions and breaking down productoriented silos.

Aligning infrastructure. Innovative companies often have dedicated systems and tools to support the innovation process. Their performance measures and incentive structures align with the organisation’s overall innovation goals – rewarding employees for figuring out how to do things better. They also use knowledge networks, enterprise portals and other technology tools to promote collaboration and information-sharing – a critical first step on the road to innovation.

Organisational and mindset barriers are normally the greatest inhibitors to innovation. Many ideas have been around for several years but are not adopted despite their potential for obtaining competitive advantage. For example, Progressive Insurance has been experimenting with "telematics" for over 5 years for use in pricing personal auto policies based on type of driving undertaken. Few other insurers have seriously looked at its potential and tried to integrate it into their business approach.

Innovative companies typically have formal processes and systems to nurture and develop good ideas. Many of the best innovations come from interacting with customers and analyzing customer behaviour. Yet, all too often, managers find themselves drowning in internal metrics and key performance indicators, while remaining heavily insulated from the dynamics of the external market. An effective innovation process generates external insights, evaluates their economic value against the needs of the marketplace, and then rapidly drives the most promising ideas through development and commercialisation.

An effective innovation process produces a steady stream of sustaining and breakthrough ideas: new products; new services; new processes; new business models – innovations that enable a company to create and capture value in entirely new ways, ultimately leading to continuous revenue growth and an enduring competitive advantage.

Companies looking for a competitive edge generally focus on product innovation, but most have little sustainable competitive advantage to show for their effort. Many new products never generate a profit. And those that do are often quickly copied by the competition – negating any long-term advantage. To achieve sustainable growth, companies must better tie together product innovation to process and service innovation – finding new ways to improve efficiency and customer service. That’s the kind of innovation customers want. And it’s the kind of innovation competitors find hard to duplicate.

Transforming a company into an innovative enterprise is a major challenge that generally requires new strategies, new tools and new behaviours – as well as a dedicated process for nurturing and commercialising good ideas. That deep commitment to innovation is the surest way to achieve meaningful and lasting differentiation. Companies with broad-based innovation capabilities enjoy higher customer satisfaction, greater loyalty, faster revenue growth, stronger earnings, and ultimately, the glittering prize of dramatically improving investor returns.

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