These two findings can be directly applied to insurance companies. The importance of price for the success of an insurer is evident when you look at the following simple calculation from non-life insurance: Let’s assume that a segment indicates a combined ratio of 90. What will happen to profits with a discount of 5%? It gets cut in half. In other words, the insurer has to sell double the amount than before the discount to generate the same profits for its shareholders or members.
What would happen if insurers managed to raise the price by 5% without any significant volume losses? The insurer would boost its profits by 50%. Let’s look at it the other way around: How much business can the insurer afford to lose and still generate the same profits? The answer (and this may surprise some): You could handle a volume loss of one-third and still be as profitable as before.
High potential in pricing today
This brings us to the decisive parameter of pricing: price elasticity. It tells us how strongly your sold units change if you modify the price. Without quantifying this effect, you cannot rationally and effectively manage prices.
Most insurance managers are totally off the mark when they estimate the effects of a price change. They often overestimate the added sales needed to compensate a price cut.
There are three important aspects to explain this market behaviour:
1. Management does not give pricing enough attention.
2. Prices are set with an overly technical perspective.
3. Price enforcement is poorly set up internally.
Management does not give pricing enough attention
Every two years, Simon-Kucher & Partners investigates business leaders worldwide from a variety of industries.
The study results: There is a significant connection between the economic success of a company and the attention its leadership pays to pricing. More specifically, companies whose leaders frequently deal with pricing have on average 35% better price implementation, 20% more success in enforcing price increases and more optimistic EBITDA expectations than other companies in which the leaders deal less with pricing.
Prices are set with an overly technical perspective
In actuarial services, prices are primarily set according to cost calculations, thereby factoring in purely internal aspects. The classic task in actuarial pricing can be summarised as such: “Explain the risk to me and I’ll set the price accordingly plus the necessary mark-ups and buffer.” In other words, tell actuarial pricing how high the minimum price needs to be to prevent any losses and to achieve a specific minimum margin.
One thing is clear: Every company must know what its costs of production are. While this provides a price floor, it would not express the ability of the company to create and harness value. Neither of which are being factored in today.
When it comes to pricing, it is vital for companies to not only acknowledge costs but also value. The management guru Peter Drucker put it this way: “Customers don’t buy products. They buy value.” It is all about how customers perceive value and how this differentiates you from competitors.
Price enforcement is poorly set up internally
Prices set based on internal cost considerations in actuarial pricing are sooner or later confronted with market reality. When that happens, insurers fall back on the old phrase, “What doesn’t fit, is made to fit.” Sales often uses discounts for that reason.
From a pricing perspective, the current approach in sales is a mixture of three dangerous ingredients: unmonitored sales processes, unsystematic discounts, and incentives that go against the interests of the insurer.
When we recently analysed the sales processes in insurance, one stunning result was: About 80% of all providers claim to offer 360-degree advice to their customers which involves complex and very time-intensive processes to determine their needs. But when it comes down to actually sealing the deal, two out of three managers admit that they switch from using an advisory system to a separate tariff calculator (Simon-Kucher & Partners, 2014, “Hurdles to Sales”).
The crux: Tariff calculators are built to get information from customers, to enter that into a cost calculation algorithm and then to create a price. This has nothing to do with sales; this is a tariff process and not a sales process. A sales process involves targeted value and advantage argumentations, countering objections and price defence.
Armed with high discount contingents
What is more, in this situation the sales teams are armed with high discount contingents and discounts are currently being managed much too carelessly.
This is hardly the sales teams’ fault. The insurance company leaves its sales team alone, pushing its products into the spotlight and essentially giving individuals the responsibility for sales.
This problem is exacerbated by false incentives that contradict the interests of the insurers. The current commission system is based primarily on the percentage rates of the premiums. This simply gives intermediaries an official excuse to conduct bad business rather than none.
A brief calculation sample: Let’s take a premium of 100 at a combined ratio of 90 and a commission rate of 20%. The intermediary earns a commission of 20; the insurer a margin of 10. What happens if the intermediary grants a 10% discount? The intermediary still achieves a commission of 18% and the combined ratio of the insurer quickly reaches 98. To put it a different way: The intermediary risks only 10% of his or her commission, but the insurer risks 80% of profit.
What needs to be done
In the future, the internal perspective of the insurance company needs to be boosted by consistently factoring in the market perspective. In doing so, the value created by the insurance company closely links internal price setting with price enforcement. This approach has three key components:
1. More market in products and prices.
2. More market in sales.
3. More market in the organisation.
More market in products and prices
What should you offer?
First off, the insurers’ products need to be consistently focused on customer value. When we talk about a product, we mean all of the benefits provided by the insurer. In other words, not just coverage, but also eg the brand, claim settlement or the quality and speed in customer communication.
That is why it would be wise for insurers to constantly and effectively investigate what works with customers in sales. Insurers need to identify covers and services that are relevant from a customer perspective and then to excel in them to offer a competitive advantage. Unimportant services either need to be removed to lower costs or should be left in the product if it offers existential protection.
A notable example of consistent value orientation can be seen at Progressive, a US insurance company. The company acknowledged that customers find the claim process after car damage to be unclear, annoying and time-consuming. In reaction to this, Progressive reorganised its entire service system in claim processing (and because it worked so well, they did it in application and policies, too) to be focused on speed, transparency and convenience. Its claim became: “We don’t sell insurance, we sell speed.” This and other similar measures keep Progressive at the top of industry rankings.
Aside from asking what should be offered, there are two more critical questions: How? And how much?
How much should you offer?
Our studies reveal over and over again that while the costs of a product rise linear with increasing features, the value perception of customers is degressive. To put it a different way: The better a product is, the worse becomes the relationship between perceived value, which translates into willingness to pay, and costs.
In product design, it is not about offering the maximum possible service, but about finding the point where the difference between willingness to pay and costs is at a maximum. This runs contrary to the frequent practice in product development of offering what the competitor offers – plus a little more.
It is also essential to integrate the sales perspective with the product strategy. The attitude of “sales will tell me what it needs and I’ll make it” is simply wrong. You must identify and assess deviations between the sales and customer perspective and, if needed, correct them for the product launch. This is definitely in the sales team’s interest as it is easier to sell the customer what he or she likes.
What should you offer?
Once you know which components the product should have, you need to determine in which structure the products should be offered. There are three basic structures: fixed bundles, fragmented additional services and modular products.
In previous studies, we have found out that the product structure plays an important role in a sales force’s success at the point of sale. We also discovered that modular products – ie those that form the basis for a targeted service bundle – are often advantageous. These products are on the rise not only in retail, but also in the industrial sector.
How should you price?
For these kinds of structured products, the cost perspective can be supplemented with the value perspective. Technically speaking, price decisions are based on three curves: a price-volume function, the premium function and the profit function.
The price-volume function is the core of pricing. It draws a functional connection between alternative price points and units to be sold. In reality, the price-volume function seldom follows a straight line. Rather, the line often bends, forming steep and flat areas. These lines are excellent indicators for optimal price points.
Price-volume functions are not a standard tool for insurers in the pricing process. In a few cases, we have observed companies trying to derive a price-volume function based on past price changes. This hardly ever works out. For one, you need to evaluate the cross-price elasticity (the functional connection between competitive price and the firm’s own volume) in order to gain a clear interpretation. Insurers do not systematically gather such information.
Based on a well-derived price-volume function, you can specify feasible premium volumes and anticipated profits. To do so, the units of the price-volume function are multiplied with the alternative prices and respective costs are applied.
That way, the insurer has the information it needs to achieve its targets with pricing. If growth is the target, the prices are reduced in elastic areas. If higher profits are the target, the price are increased in inelastic areas. The focus here is not on regulatory requirements that steer pricing in the insurance sector. Rather, the focus is on systematically utilising all available leeway.
Even the smallest price changes can have a considerable impact on profits. Let’s look again at the example of comprehensive coverage in car insurance with a premium of GBP300 and assume a combined ratio of 95. If the company could raise the price by only 3%, profits would increase by 60%. For customers, a price increase of 3% would mean paying less than GBP1 more per month. If a company is not able to push a GBP1 price increase in the market, then it has a major sales problem – or is just scared.
More market in sales
Value-based pricing is rejected by some insurance managers on the grounds that the customer does not perceive the value of products and services. This illustrates the root of the problem: The insurer never explained what its products can do and what gives them a competitive advantage. You need to ensure that the value of your product actually becomes a topic of sales talks.
But this is not happening today, which is why even two-thirds of all sales talks in non-life insurance are dominated by discussions about discounts. We often observe in our projects that intermediaries grant discounts without even being asked or even systematically manipulate tariff attributes to be able to offer a lower price.
It is important that you develop a consistent sales process that entails a (reduced) version of the comprehensive advisory series. The process should achieve four targets: better closing rates, more cross-selling, more up-selling and fewer discounts.
Current technology offers new and much more cost-conscious possibilities. More than 90% of the participants assume that mobile services will increase dramatically and the process for intermediaries and customers will simplify significantly.
Online channels play a critical role in sales processes. A while ago, it was easy to differentiate between online and offline customers. But now the internet is an integral part of everyone’s lives. Even if you plan to buy offline, hardly anyone nowadays does not compare prices online first.
The internet is often seen as the source of all price pressure. This is only a superficial explanation. The customer compares the price and not the service.
It is also to be noted that incentives need to be revised along with price implementation to boost the intermediaries’ motivation to defend prices.
More market in the organisation
Today, insurers have no function and no organisational unit that can deal with these topics in a comprehensive way. Instead, a holistic approach is broken down into many smaller responsibilities and distributed to many positions of the organisation. This inherently leads to linear thinking, an uncoordinated presence and lost profits and volume.
Insurers need to build the necessary skills and embed them into strong organisational units that have the capabilities and authority to manage beyond the norm. This all starts when leaders take the pricing lever into their own hands and practice comprehensive price controlling.
Pricing is a boardroom issue.
Dr Dirk Schmidt-Gallas is a Partner and Member of the Board at the strategy consultancy Simon-Kucher & Partners and heads the global insurance business. Dr Jochen Krauss is the Managing Partner of Simon-Kucher’s ASEAN operations.