05 · Strategic Review

Growth Has a Cost

Understanding the economics of scale, complexity and diversification.

A profitable business with an expensive problem

The business was a European insurance group with three Lloyd’s syndicates and a European insurance company. It was considering adding an MGA to its portfolio.

It generated approximately $1.2 billion of GWP and employed around 110 people across its UK and European offices.

It was profitable.

But the executive leadership team believed its expenses were too high for the size of the business.

The organisation operated 12 lines of business across four divisions. The lines were materially different, with different business models, application requirements and processing models.

The leadership team struggled to understand why a business of this size needed such a complex technology and operating estate.

Complexity follows operating models

I assessed the application estate and operating model across the four divisions.

The 12 lines of business could be consolidated into seven materially different operating models. Some lines shared sufficiently similar processes and requirements to operate together. Others genuinely needed different capabilities.

That distinction mattered.

The business wasn't running 12 completely independent businesses. But it was still carrying the cost of seven different ways of pricing, writing, processing and managing business.

Underwriting teams were naturally dedicated to individual classes. Accounting, operations, credit control and other functions also had to support the different models.

The result was an organisation with the complexity of a much larger business.

Without the scale.

The economics told the story

For every $100 million of GWP, the organisation was returning approximately $4.75 million.

A competitor approximately four times its size was returning around $6.40 million for every $100 million of GWP.

The larger competitor wasn't necessarily better managed.

It had something the smaller organisation didn't have: scale over which to spread its operating costs.

Every line of business carries a minimum cost of operation. It needs appropriate expertise, governance, controls, systems and operational support.

At sufficient scale those costs can become proportionately small.

Below scale, they become expensive.

Don't solve the symptom

The executive leadership team's instinct was to reduce the number of applications.

It was an understandable conclusion. Comparable businesses appeared to operate with fewer applications.

But it was also an example of identifying the solution before understanding the problem.

Reducing applications might simplify part of the technology estate. It would not necessarily reduce the underlying cost of operating seven distinct business models.

I needed to change the conversation from:

to:

Four strategic choices

There were four broad options.

Grow the existing businesses. Increasing profitable revenue across existing lines would allow relatively fixed operating costs to be spread over a larger base.

Reduce complexity. Each line could be assessed for its profit, loss and cost of processing, then classified as Increase, Hold, Decrease or Stop.

Move operating costs. Some activities could potentially be delivered from lower-cost locations.

Accept the cost of diversification. A more diversified portfolio could justify a higher expense base if it generated sufficient profit, resilience or capital benefit.

There was no universally correct answer.

There was only an answer that made sense for the shareholders.

Horizontal growth or vertical growth?

This was the central strategic choice.

The business wanted to add an MGA.

An MGA would increase revenue and diversify the portfolio, but it would also introduce another operating model and a step change in expense.

The new business would therefore make the expense ratio worse before it made it better — unless it achieved sufficient scale.

There was no guarantee that it would.

Vertical growth offered a different proposition.

The business could increase capacity within existing lines where there was profitable demand. Existing capabilities could absorb more volume without the same increase in complexity.

But that wasn't risk-free either.

Writing business simply to fill capacity is never a good strategy. Additional profitable premium is valuable. Premium for its own sake is not.

Additional underwriting capacity also has capital implications.

Make the economics visible

My recommendation was not simply to cut applications.

I recommended increasing capacity in existing lines where there was evidence of profitable demand and allocating corporate expenses to each line based on actual usage.

The existing generalised allocation methodology could hide underperforming businesses by spreading their costs across the portfolio. It could also make genuinely profitable lines look less attractive by allocating costs they did not actually consume.

The Board needed a clearer view of the economics of each line of business.

Only then could it decide whether to invest, hold, reduce or stop.

The uncomfortable conversation

The CEO owned the decision, supported by the executive leadership team.

Their responsibilities included regulatory obligations, but profitability and capital efficiency were particularly important.

The COO was unhappy with my conclusion.

The leadership team wanted a simpler answer: the organisation was unnecessarily complex, so the technology environment should be culled.

I was telling them that their hypothesis was incomplete.

The applications were not the root cause. They were partly an expression of the business model the organisation had chosen.

The answer

I recommended vertical growth in existing lines where profitable capacity existed, combined with a true allocation of expenses to the lines of business.

The business subsequently chose to focus first on a known inefficiency in its back-office operations.

The analysis had nevertheless changed the strategic conversation.

The Board now had a clearer view of the relationship between revenue, complexity, operating cost, diversification, capital and profitability.

That visibility could be used to inform future strategic decisions.

The lesson

Businesses often look for one thing to fix.

Too many applications.

Too many people.

Too much cost.

Too little revenue.

But fixing the individual item doesn't necessarily fix the economics.

You can reduce applications and leave the underlying complexity untouched.

You can reduce headcount and damage the capability needed to grow.

You can add revenue and make the expense ratio worse.

You can diversify the portfolio and increase the cost of doing business faster than you increase profit.

The mistake businesses make when they think about growth is to segment the opportunity rather than consider the holistic challenge that growth brings.

Standardised growth playbooks are used time and again. Executives can then be surprised when the expected results fail to materialise.

Sometimes accepting a higher expense base is entirely rational if it produces superior profits.

Sometimes freeing up capital to invest elsewhere is more valuable to shareholders than another two percentage points of expense reduction.

The important thing is to understand the trade-offs.