RegulationDec 14 2012

‘Disruptive innovation’ will cull big businesses

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Similarly, new business models will emerge that are capable of operating profitably where embedded value, or the lifetime value of an investment policy, for new business will fall to just £150 to £200 for each policy in the UK and sophisticated advice will be provided for below 0.25 per cent of the value of funds being invested. Key elements of the new business models can already be seen and the question is whether existing incumbents or new players will seize the opportunity to dominate in the new world.

While respected observers, such as Ernst & Young, are forecasting that a third of advisers will leave the profession over the next five years as a result of RDR, some large insurance companies do not appear to be too concerned about the potential impact on their own business. But given the impact of disruptive innovation across a wide range of other industries, such as retailing, newspapers and mobile phones, causing many of the leading incumbent businesses to go bust, it may lead you to ask: Is this outlook by the large insurance companies realistic?

Disruptive innovation is a phenomenon first observed by Professor Clay Christiansen of Harvard University whereby a new business model leads to most of the major incumbents in an industry going out of business.

The new business model introduces a new customer proposition that offers customers an appealing product or service with a significantly higher price performance than those offered by the existing major players. It can be the same service for dramatically lower cost, such as Ryanair and EasyJet, a much better service, such as Google advertising versus traditional advertising, or a combination of both, such as the Apple iPhone compared to Nokia phones.

Classic disruptive innovation arises when someone decides to release a new product or service with a dramatically lower price, typically aimed at the low-end of the market to begin with. Initially, the market appeal is small in terms of potential customer volumes and the pricing is way below the level that the existing dominant incumbents can afford to do business.

The product or service may appear to be inferior in many ways to those offered by the major players (think Ryanair service compared to BA service), however the price performance tempts a small but growing number of customers to switch to the new offering. Over time the new offering starts appealing to more and more customers causing prices, margins and sales volumes to be squeezed leading to many of the once dominant incumbents to go bust or be taken over.

While many insurance product providers see that RDR will lead to huge numbers of IFAs and tied advisers leaving the industry, their underlying assumption is that this will have very little impact on their own business. The insurers seem to be assuming that, one way or another, those consumers with investment assets will find their way to get their assets to the insurers’ business. Indeed some feel that the disappearance of commission payments and the reduced number of IFAs will increase their profitability by reducing distribution costs.

As investment assets are concentrated in a small proportion of the UK population, and those individuals with significant investments to manage will continue to be motivated to find and pay for advice, many people believe that the loss of the UK mass market post-RDR implementation will have little material impact on overall business volumes.

Under the RDR consumers will have to pay for their advice directly. As the true unsubsidised cost of providing advice and placing regulated business on the books is substantially beyond what mass market consumers are willing to pay, it is expected that bancassurers and IFAs will cease marketing to the UK mass market leaving a substantial hole in the market. But it is this “hole” that then provides an opportunity for new offerings to become established.

The existing business models for advice and distribution of regulated products come with such high costs that bancassurers, such as Barclays and HSBC, have decided to close their retail branch operations ahead of RDR implementation.

We envisage that, over the next five years, new business models will emerge that can survive and prosper within a world where new business has embedded values of around £150 to £200 with acquisition costs below £100 a case.

Royal London, for example, already offers a sophisticated website that provides consumers with substantial tools to research and explore their financial needs. The website already covers much of the ‘informational’ value provided by a traditional IFA although it does not yet fully replace their role. However, if we look over to the US there are already services such as Wealthfront that are providing full portfolio modelling and management tools that would allow smarter consumers to replace the need for an IFA completely.

The WealthFront service is designed for high net-worth individuals to manage their complete advice and portfolio management needs at just 0.25 per cent a year. The service is designed to manage clients’ investments at extremely low cost with their implementation of Modern Portfolio Theory, the US’s industry-standard investment framework. The service provides a fully personalised and diversified investment portfolio with continuous monitoring and periodic rebalancing.

There are always winners and losers in periods of disruptive innovation. Some winners may be indirect beneficiaries such as Phoenix who will find a new source of struggling insurance businesses to acquire from their current owners.

We may see some major ‘manufacturers’ decide for specific product offerings to shut down new business operations and apply aggressive cost-reduction strategies to the “run off” business. Clearly those outsourcers, who can offer 25 per cent to 30 per cent cost reductions when taking over insurers’ business operations, can expect a healthier pipeline as sales volumes and margins become ever more squeezed.

The most exciting opportunities will fall to new players and the more aggressive existing insurers who take the opportunity to implement new low-cost business models and then acquire the struggling players who are slower to fundamentally change their business model.

If anything, considering what may happen in the next five years, E&Y’s estimate that only a third of advisers will be lost may prove over optimistic. The good news is that there will always be a need for a “trusted adviser” to help people through their most difficult and complex financial issues and the very best IFAs will continue to adapt and prosper to the new circumstances.

John Corr is managing director of business consultants Close Quarter

Key Points

Half or more of major insurance ‘manufacturers’ are likely to disappear over the next five years as a result of the retail distribution review

While many insurance product providers see that RDR will lead to huge numbers of advisers leaving the industry, their assumption is that this will have very little impact on their own business

We may see some major ‘manufacturers’ decide for specific product offerings to shut down new business operations and apply aggressive cost reduction strategies to the “run off” business