Although the recent hard market has helped insurers improve their underwriting ratios significantly, the pressure on claim organizations has by no means eased. Insurance carriers are decreasing their target combined ratios, just as price competition is creeping back into the industry and threatening to undermine underwriting profitability once again. In addition, under the cover of recent price increases, little has changed in the typical claim organization, where overworked adjusters struggle with heavy caseloads, often hindered by a variety of out-of-date claim systems and overflowing paper files.
Evidence from throughout the industry indicates that claim organizations still suffer from systematic and unnecessary overpayment of claims. Whether called leakage or improvement opportunity, the industry incurs excess claim costs and unnecessary loss adjusting expenses that are estimated by leading consulting firms at approximately 10 percent of premium revenues, or $35 billion for property and casualty lines in the United States. These losses are caused by the difficulty of enforcing best practices in claim handling throughout the claim operation, despite the fact that, at many leading insurers today, the primary goal of the claim organization is to control and reduce leakage.
Given these pressures and opportunities, claim executives everywhere are evaluating their options and studying process or technology initiatives that promise to reduce leakage, control costs, and improve performance. In doing so, however, they face a significant challenge: competing within their corporations for scarce capital and resources.
While some proposed projects could return 10 or 100 times their costs in future benefits, CFOs and risk managers have grown skeptical of these all-too-frequent promises. As a result, an important skill for any claim executive is the ability, not only to select equipment or program investments that can improve claim performance, but to justify those investments in financial terms. Without this skill, the claim organization risks falling behind in the internal competition for investments and resources.
Luckily, there is something of a standard for measuring and evaluating technology or project investments: return on investment modeling. ROI assessment is one of several techniques for evaluating investment decisions, such as internal rate of return and payback period. Today's sober reality has led to a renewed insistence on more rigorous measurements. Overall, this return to a more conservative analysis is a healthy development; the factual support and quantification required are much less likely to encourage foolish or faddish projects.
In this environment, ROI analysis is an important tool in the claim executive's portfolio. A project team can demonstrate how a valuable process or technology investment translates into bottom-line savings, making the difference between rapid approval and months or years of indecision. While an experienced professional may know intuitively that a project will have a dramatic impact on the claim organization, boiling its benefits down into ROI terms will make that argument clear to people without a lifetime of claim experience. A careful ROI analysis also will help the claim organization focus on achieving the most important benefits in the shortest amount of time.
Despite its nearly ubiquitous usage, however, ROI is a poorly understood concept that is mangled more often than not. Eager technology salespeople will talk about a six-month ROI or a $10-million ROI, both of which are (strictly speaking) nonsensical.
ROI does have a precise definition, captured in the following formula: Where n is the number of years in the forecast period and d is the discount rate. In simpler terms, ROI is the value of all the benefits of a project, divided by all initial costs. As a result, ROI is always a percentage, not a period of time or a dollar amount.
To take a (relatively) simple example, let's say that you are considering replacing a traditional incandescent light bulb with an LED-based bulb. The LED bulb will cost $20, but will reduce your electricity bill by $8 per year. Is it worth $20 today to save $8 per year for five years (the lifetime of the bulb)? Assuming that the time value of money (discount rate) is 10 percent per year, those five years of electrical savings are worth $30.33 today. The ROI of buying the bulb, then, is $30.33/$20, or 152 percent.
To calculate the ROI of a project, then, the only information required is the initial investment, the ongoing benefits and costs, and the appropriate discount rate. Many companies have standard discount rates that they use to evaluate all investments, and the initial investment is fairly simple to estimate. For example, for a new software project, the initial costs include license fees paid to software vendors, new hardware costs, consulting or other initial service costs, and the costs of the internal project staff.
The most difficult challenge in any ROI model is estimating future benefits and costs in a credible and realistic way. For example, if leakage currently is estimated at 10 percent of premiums, and a new claim system is expected to reduce leakage to 8 percent, the benefit being asserted is far too simplistic to be credible. It may be true that the new system will reduce leakage by two percentage points, but any reasonable person is going to want to know how before committing resources and time to the effort.
Step 1: Identifying ROI Drivers
The most important element of a compelling ROI model is identifying credible, significant ROI drivers, and organizing them in a clear and logical way. In this case, these are the specific benefits that a new claim system will provide. This requires a review of the existing claim organization to identify potential areas of improvement. These areas will vary significantly across insurers, but will range from improved claim quality and customer satisfaction to reduced cycle time, legal costs, and information technology expenses.
For example, one objective may be improving adjusters' abilities to recognize and act on joint and several liability situations (increasing the proportion of claims in which there is shared liability, and reducing the percentage of liability assumed). A claim system can help by identifying potential shared liability situations and providing tools to help adjusters calculate and document the apportionment of liability.
Step 2: Calculate Financial Benefits
Once an ROI driver is identified, the factors necessary for calculating financial benefit need to be determined. The example above has two critical variables: the average percent liability assumed in shared liability claims and the percentage of all claims in which liability is shared.
Let's assume that the first figure can be reduced from 50 to 48 percent, and the second can be increased from 10 to 10.5 percent. Let's also assume that there are 100,000 claims a year with an average loss payout of $5,000. A few minutes with a spreadsheet reveals that reducing average liability from 50 percent to 48 percent could save $1 million over the course of a year, and increasing the percentage of claims with shared liability could result in another $1.3 million. In all, this single item can realize total annual savings of $2.3 million.
Step 3: Repeat
This analysis should be repeated for every improvement expected from the new system, which can number in the tens or even hundreds. Depending on how they are configured, today's systems have the potential to enhance results in virtually any area of claim handling. Among the possible benefits are more accurate reserving and prevention of shortfalls; elimination of duplicate payments for medical treatments; improved fraud flagging and prosecution; improved subrogation pursuit; reduced time spent on clerical tasks; reduced ongoing maintenance costs; and increased supervisory control.
Carefully identifying specific improvements and estimating the magnitude of their corresponding benefits are crucial to building an effective ROI model.
Step 4: Focus Implementation
Creating a model is only the first step in achieving the promised returns, of course. Once an ROI model is in place, the implementation should focus on producing the results specified in the model. If one target is improved capture of subrogation opportunities, it is critical to identify the indicators of potential subrogation, write the business rules that flag subrogation opportunities, organize the teams to follow up on those opportunities, and track their success.
One benefit of an ROI model is that it helps focus a project team on achieving these concrete financial benefits, rather than spending time on miscellaneous "good things," such as look-and-feel improvements or individual team members' pet features.
Step 5: Measure the Benefits
The final, crucial step in delivering ROI is assessing the benefits of the new system. Many of the key measurements may not be captured by current processes and reporting tools. This information may be accessible only by pulling a random sample of closed paper files and conducting file reviews.
Any new system should be configured to track the ROI drivers. This will make it possible to compare actual ROI to forecasted ROI and, most importantly, take action where necessary to improve results.
From beginning to end, creating, implementing, and tracking a sophisticated ROI model requires a significant amount of work. It is not surprising that the vast majority of such models are optimistic guesses at improvements in unmeasurable terms, held together with the digital equivalent of duct tape and string, and quickly forgotten once the project is approved and underway. Given the appropriate investment of time and skills, however, a model can be both a compelling argument for undertaking a project and a powerful tool for managing that project to ensure that all objectives are achieved. A good ROI model can serve as both a map of new frontiers of opportunity and a compass to chart the course along the way.
Marcus Ryu is vice president of consulting services at Guidewire Software. He can be reached at email@example.com.