The new cash cows are in the SME sector

The must have accessory for every insurer and distributor this year is a coherent SME strategy. Historically, the SME market, using the former DTI definition, was largely taken as a somewhat amorphous portfolio of business which delivered good profit. In truth, it was the classic cash cow. It was benign, predictable, profitable and perhaps a little dull.

Management interest, attention and funding focused on the high growth, relatively higher profit segments of the portfolio or ‘stars’ such as personal lines direct, aggregators or affinity.

So what changed? Why is every major insurer and broker now seeing what was once a cash cow portfolio rapidly becoming a ‘dog’ characterised by shrinking market share and declining profitability?

In the past 20 years insurers’ understanding of channel and customer profitability has improved significantly. But it still lags behind many industries with a significant third party distribution dependency. Insurance industry analysis tends to focus on product line net loss analysis and be overly actuarial in focus. Also allocation of direct and indirect costs has been limited or rudimentary.

Understanding the inherent profitability of the ‘cube’ – the interaction of customer segment, product offering and channel overlay – has become a priority only in the past couple of years.

Why is this so important? In reality, the SME market is now witnessing the same cherry picking of profitable segments that took place 20 plus years ago in personal lines by the boys with the red phone.

This time, the game changers are the broker consolidators and rapidly regionalising brokers with the accompanying panel rationalisation and managing general agents (MGAs). The slow to respond are now left with a SME business portfolio which increasingly resembles a Swiss cheese – the holes representing the lost pools of profitability.

Across many areas of commerce, consumers are increasingly self educating and taking control of the purchase process. This trend equally applies to insurance, especially to SME segments such as ‘man with a van’, small traders and owner manager businesses. As consumers shop around and educate themselves on the web, the effect is a better informed, better educated consumer with a clearer sense of a target price for the risk they represent.

The industry appears to be at a tipping point in consumer behaviour with the increase in call volumes and quotes with the phone and web-based players yet to translate into new business. The changes in consumer behaviour and attitude demand a level of insight and understanding beyond the classic trade or factual based segmentation which has dominated SME thinking for so long – especially at the smaller end of the market.

The profound importance of distribution in the SME market is finally understood. The emergence of the broker consolidators, the emergence of MGAs and panel rationalisation have been well documented.

However, less attention has focused on the high volume end of the SME market; the ‘man with a van’ or sole traders. The future importance of the bancassurers, affinity and direct distributors is now being recognised. Ernst & Young’s research with the CII in 2007 suggested this segment of the market was already worth £600m plus and set to increase to £1.2bn plus. We may well see the final take-off of these distribution channels with the high profile entry of the power brands such as Direct Line, the high street banks and specialised SME web aggregators.

However, while the emergence of the direct underwriter and pseudo direct distribution is a prominent and potentially significant shift in the volume market, the reality is that for the forseeable future the bulk of the UK SME market is, and will remain, intermediated – as opposed to broked. Insurers need to recognise that successful scale players in the SME market demand a multi distribution strategy with truly differentiated propositions aligned to each distribution segment.

Economics teaches that cash cows – or highly profitable market segments – will attract increased competition driving down average profit, so long as there are no barriers to market entry. The SME market is no different. Increased manufacturing capacity has come from London market players diversifying into specific SME product lines, such as personal injury.

But a major source of new manufacturing capacity has come from the distributors themselves. By underwriting a proportion of the portfolio through some form of delegated authority, distributors are blurring the distinction between manufacturer and intermediary. The impact is reducing the amount of available business and driving up competition. In parallel, distribution costs are rising, further eroding profitability.

Increasing competition is forcing established distributors and manufacturers to re-examine the business and operating models they can afford for each segment of the SME marketplace. As a result, new entrants are being allowed to design a very different approach and model for specific market opportunities, further compounding the problems faced by established players with their legacy infrastructures.

Traditional SME product development has tended to focus on what the insurer is willing to underwrite rather than the risks that clients want covered. SME research shows client concerns focus around: cash flow management; customer defaults; key man dependency; and lost profits following an incident. Opportunities exist for those distributors and manufacturers that can combine cover for the risks the insurers consider insurable alongside those that the SME wants to mitigate or transfer.

We are beginning to see the emergence of new and traditional distributors bundling traditional insurance with true risk management to provide a more complete package answer. Innovation is appearing around the rating variables used and analytics being applied to the customer and risk related data.

Against a backdrop of increasing competition, established players will need to look at how they are differentiating themselves especially as the SME market starts to see more innovation around product and pricing.

The SME market is undergoing significant structural change with value creation and profit potential shifting towards the distributor away from the manufacturer. Insurers’ strategic responses need to reflect the following givens:

• Recognise the threat and scale of the challenge with the current SME business. What worked in the past is not going to work in this new marketplace.

• Develop deep insight and understanding around consumer behaviour and attitudes - trade segmentation alone is not enough.

• Develop a multi distribution strategy especially if you want to be a scale SME player.

• Maintain relevance through real, tangible differentiation for each distribution channel and customer segment.

• Transform underwriting and pricing approaches to focus more on individual risks.

• Understand and optimise profitability pools by understanding the cube – the interplay between product, channel and customer.

The biggest transition challenge is faced by the established insurers that built up large, highly profitable SME portfolios. But the difference between retaining the cash cows or creating new stars and avoiding the dogs will come down to quality of execution.

Andy Baldwin is head of insurance at Ernst & Young.