The next frontier for sustainable growth: Capturing the cost advantage of direct insurance

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This article was a collaborative effort by Ulrike Deetjen, Simon Kaesler, Björn Münstermann, Sanaya Nagpal, and Ulrike Vogelgesang, representing views from McKinsey’s Insurance Practice.

Over the past few decades, direct insurers have gained ground on traditional insurers. By engaging directly with customers, direct insurers cut out intermediaries, benefit from a comprehensively streamlined and focused product portfolio, and excel at low-cost business models. By comparison, the offerings and operating models of traditional insurers have evolved more slowly. Yet standing still may put long-term profitability at risk: cost advantage is a core driver of growth, as evidenced by the correlation between cost ratios and expansion across markets. For example, German car insurers with the lowest cost ratios achieved growth rates 60 percent above the market average from 2013 to 2017. This relationship is even stronger for direct insurers, as aggregators put additional pressure on price transparency and amplify winner-takes-all effects for cost leaders. The COVID-19 crisis has further accelerated this development, as digital interaction requires increased speed in periods of physical distancing, and some customer segments increase in their price sensitivity as a result of economic constraints.

However, the direct business models in today’s insurance landscape can vary starkly. Near the turn of the millennium, an early generation of direct property and casualty (P&C) insurers left traditional agents and brokers behind, instead focusing on sales teams that maintained phone contact with customers—leading to a flourishing call center–based model. While the initially anticipated growth into a mainstream model did not materialize in all markets, some of these early players became strong leaders in their local markets, setting expectations high on customer satisfaction and cost ratios. Just one decade later, sophisticated digital technologies and the emergence of a generation of digital-native consumers unlocked a second wave of digital-focused direct P&C insurers. Today, the latest generation of attackers is being built as incumbents’ subsidiaries as well as independent, venture capital–backed insurtechs. With each successive wave, direct players gain speed, technological excellence, and improved customer experience.

Given these trends, McKinsey’s Insurance 360° Benchmarking Survey analyzed direct insurers as a group for the first time—and revealed new insights into the differences between direct and traditional insurers, as well as between early and recent direct insurers (see sidebar, “About the survey”). Our analysis found substantial differences in the cost mix between traditional and direct P&C insurance models. For example, while direct models have lower costs on average, their marketing costs are often significantly higher because of the high costs associated with digital lead generation, particularly in markets with high shares of aggregators and for players whose sales strategies largely depend on these channels. However, the survey also confirmed that leading direct insurers often have lower acquisition costs and leaner operations than multichannel players.

At the same time, the results show that the success of direct insurers is much more nuanced. While direct insurers have achieved higher growth in recent years, they often must contend with lower average premiums, higher claims per policy, higher churn, and overall smaller scale—all of which can erode their competitive advantage.

We determined three success factors that direct insurers—and traditional insurers looking for a toehold in the space—should strive to include in their business models to ensure sustainable cost advantages and excellent customer experience. These are critical to reach the next frontier for growth: the expectations of increasingly digital customers are driven by standards from other industries, even more so in the global acceleration in the aftermath of COVID-19. These priorities comprise fully digitizing their operating models, implementing work-arounds to scale disadvantages, and reducing customer-acquisition costs.

Direct players—a closer look at costs

The big picture is that direct players—in both the top quartile and the median of cost ratios—achieve lower costs per gross written premiums (GWP) than their multichannel peers (Exhibit 1). This cost advantage is primarily driven by lower sales and sales-support costs, though marketing costs are substantially higher than those of multichannel players due to the costs of digital lead generation, particularly for insurers whose sales strategies largely depend on aggregators and search engines. When looking closer at individual insurers, the top quartile of direct insurers stand out as having achieved larger scale, more digitized operating models, and more cost-effective distribution models than median direct insurers. At the other end of the spectrum, the three highest-cost direct players have sales costs three or four times higher than those of median players.

Direct players and multichannel peers greatly differ in marketing, sales, and sales-support costs.

Of course, within the group of direct insurers, cost drivers fundamentally differ between early and recently established insurers. Many early direct players share the same challenges as multichannel players, such as legacy IT systems or an online presence that no longer meets customer expectations. As a result, many of these direct insurers are currently investing in digitization. Recent digital entrants benefit from a greenfield digital operating model—with state-of-the-art automation and customer experience—yet face stiff costs to establish their brand and substantial disadvantages as a result of their (often) small scale, resulting in lower fixed-cost degression. High overhead for IT and brand building can thus form the crux of a major cost downfall for direct insurers.

While direct insurers, in principle, are set up to achieve best-in-class cost ratios, our analysis found high variance in three specific areas: customer acquisition, operations, and IT costs. In combination, these areas have a substantial impact on overall cost ratios—and thereby affect the ability to gain market share, particularly in highly competitive markets.

Customer-acquisition cost: Structures for lead generation vary substantially

Direct insurers benefit from lower sales and sales-support costs, with cost ratios more than 70 percent lower for the median direct insurer compared to the median multichannel insurer.

By contrast, marketing cost ratios are five to six times higher for median direct players than for median multichannel players. Some early direct players are still highly dependent on traditional marketing (particularly television and radio), which comes at a high cost. For more recent digital players, higher marketing costs usually result from acquiring their initial customer base and building up their brand. An estimate of scale effects shows that marketing cost ratios for direct players with GWP less than €150 million are more than twice as high as those for larger-scale players.

High acquisition costs are also due to steeply rising costs for digital lead generation. German insurance players, for example, saw costs per lead double within only a few years. The increasing prominence of aggregators in many direct insurers’ business models contributes to a further increase in those insurers’ marketing and sales costs. As a result, direct players that heavily depend on aggregators pay commission ratios that are substantially above the ratios for traditional intermediaries.

Established larger-scale direct insurers, which make up the median and top quartile of our sample, have a high total acquisition cost advantage of more than 50 percent compared with other direct or multichannel insurers. They achieve low acquisition cost ratios through large shares of organic traffic and therefore are less dependent on aggregators. At the other end of the spectrum, smaller-scale insurers that need to invest in building a new brand and that sell predominantly via aggregators have at least the same level of acquisition costs as their multichannel peers.

Operations: Direct insurers generally enjoy lower costs for operations

Operations are another fundamental differentiator between multichannel and direct insurers. Our analysis found that the median direct insurer’s issuance cost ratios are more than 30 percent lower than the costs for median multichannel players, though there are variations depending on the business model, scale, and degree of outsourcing. Such lower costs result from direct data capture through either portals or call centers and ubiquitous straight-through processing thereafter, particularly for purely digital players. Another distinguishing factor is the tendency of direct insurers to offer a comprehensively streamlined and focused product portfolio, which simplifies end-to-end business processes—from distribution to pricing to claims.

However, policy-servicing cost ratios are higher for median direct players than for median multichannel players, with wide variations among the direct player group. The greatest differences are evident between purely digital, more recent players and earlier, smaller-scale players with call center–based models, which can come with substantial cost. One reason may be that multichannel players are able to save costs by partially outsourcing servicing to their intermediaries or achieve stronger fixed-cost degression due to scale effects. Another reason lies in the higher growth and larger share of new policies in the portfolio. First-year customers are more likely to submit requests, such as for policy changes or clarification, driving up average costs per policy. Churn ratios tend to be higher for direct players, which means their higher share of first-year customers will remain a structural disadvantage.

Claims-management costs are also lower for direct insurers overall (at 17 percent), despite a higher number of claims per policy. In this area, we again find a strong influence of scale (Exhibit 2). Comparing the claims-handling cost ratios of differently sized direct players, we found that players with less than €250 million in premiums have particularly noticeable scale disadvantages—which is the case for most of the direct peers in our sample.

Economies of scale influence claims management for direct players with less than €250 billion.

Overall, the cost performance is largely driven by the relative full-time equivalent (FTE) productivity of direct players. Thanks to streamlined product portfolios and a high level of digitization, direct players outperform their multichannel peers for both new policies per policy-issuance employee and claims per claims-management employee. In issuance, the median direct player is nearly three times as productive and more than 1.5 times more productive in claims than the median multichannel player. However, one area in which multichannel players enjoy higher productivity is policies per policy-servicing FTE. Here direct players achieve only about half the productivity of multichannel peers, which is the result of structurally higher costs from a higher share of first-year customers and a lack of outsourcing to intermediaries, as previously discussed.

Direct and multichannel insurers demonstrate similar cost ratios for support functions and IT

Cost-ratio similarity was an unexpected finding given direct players’ smaller scale and intense need for investment in digital platforms. Some direct players can tap into the parent company’s shared services, allowing them to reap the combined scale effects. Others follow a heavily outsourced model to escape the scale trap. These effects were evident, for example, when we looked at the HR function in more detail. Here the median direct player has approximately 30 percent higher productivity (FTEs covered by one HR FTE) than the median multichannel player. Besides a generally slimmer support structure, this better coverage ratio directly results from taking advantage of group services and higher levels of outsourcing.

On IT, our initial hypothesis was that direct players have a higher need to invest in IT to create a state-of-the-art digital customer experience. On closer inspection, we found that incumbent players often have still higher IT spending: a large part of traditional insurers’ IT spending is the result of their complex business models as well as their legacy landscape (with both high running and investment costs). While a new digital entrant surely must make a substantial investment in IT, the streamlined nature of the business and lack of legacy systems make this investment comparatively moderate. In addition, some direct players choose software-as-a-service models that lead to lower IT costs while they are still at smaller scale or have already invested in state-of-the-art IT systems in their initial years. They therefore benefit from a reduced investment need as time wears on.

Three priorities for success

Accelerated by COVID-19, direct insurers have strong potential to lead the market in the coming years and diversify their distribution channels. At the same time, structural disadvantages—such as scale, churn, and high acquisition costs in aggregator-dominated markets—add challenges to their cost advantage. So too do increasing customer expectations of the seamless, convenient digital experiences that are common in more advanced industries. Three priorities have emerged for direct players to achieve market-leading cost ratios coupled with state-of-the-art customer experiences.

Direct insurers have strong potential to lead the market in the coming years and diversify their distribution channels.

Fully digitize the operating model

While call centers may continue to play a crucial role for multichannel and even some direct players, they also lead to additional costs. New technology, best-in-class operational processes, and advanced analytics can substantially reduce costs in this area while also forming the indispensable basis for excellent customer experience. To adapt, direct insurers need to ensure their technology investments elevate them to compete with leading purely digital players from other industries; anything less could be wasted effort. The bar is set high for competing in the digital space, and the customer base of purely digital players is not limited to digital natives—all customer segments are rapidly gaining comfort with technology and expecting seamless digital interactions with their insurers.

Implement work-arounds to scale disadvantages

As direct players work toward increasing scale, they will need to find creative ways to circumvent their existing scale disadvantages. For example, smaller-scale direct players pursuing growth may consider shared services with another insurer to save on their operating platforms. Using a parent company’s services will provide advantages in technology procurement and brand recognition. At the same time, it is necessary to ensure enough independence, flexibility, and speed to keep up with fast stand-alone digital attackers and digital players from other industries, and not be held back by other players operating at slower speed. In addition, direct players should actively address churn and claims through product design features and smarter state-of-the-art analytics approaches.

Reduce customer-acquisition costs

Finally, while direct distribution offers potentially huge savings opportunities for activities such as customer acquisition, the rise of aggregators and the growing costs of digital marketing can undermine these savings. Direct insurers need to play the game of other digital champions: continuously allocating budgets to the best converting channels, personalizing how customers are addressed, and comprehensively improving the funnel to optimize lead conversion. As the next frontier, direct insurers may also integrate ecosystem approaches into their portfolio for efficient lead generation in moments of need. However, any moves beyond the core business need to be critically evaluated against costs—given that low costs, next to an excellent customer experience, form the central strategic asset for direct insurers.

The digital industry amplifies the effects of economies of scale and scope and allows players with cost advantages to grow faster. New entrants from other industries set a high standard for excellent customer experience and efficient cost structures, and with the COVID-19 crisis, customer demand for state-of-the-art digital interaction models with offerings at competitive prices has soared to new heights. Consequently, it is crucial for players in the direct insurance business to move quickly and decisively, relentlessly driving customer experience and continuously elevating their cost advantages. In doing so, they will thrive in a highly competitive but growing market throughout the coming years.

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