Creative destruction, global insurance, and the London Market Group

Creative destruction, global insurance, and the London Market Group
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The global insurance industry tends to focus on the more immediate threats facing it, but its real problems are chronic and lie deep within the structure and strategies of the industry itself. The industry is engaged in what Joseph Schumpeter called “the process of creative destruction.”

Two immediate threats face the global insurance industry. A persistent low interest rate environment, fostered by central bank monetary policies, is one. More stringent capital rules issued by the Basel Committee on Banking Supervision last December are an additional problem.

There is no doubt the industry must develop strategies to manage these threats, but they may not be the most important factors in the long run.

Interest rates are too low

BlackRock CEO Laurence D. Fink complained last month, “As we live in a world of persistent low rates and, in the case of Europe, negative rates today, when you put a macro-prudential framework on it…we are destroying the viability of insurance companies,” according to a Bloomberg report.

Fink continued, “I don’t think there is enough talk about what are the costs of the low rate environment to the other components of our global society — pension funds, retirees, savers, and insurance companies.”

BlackRock Inc, a major investor in insurance companies, serves as an important manager of insurance industry investment portfolios. Low interest rate policies hurt BlackRock’s investments and asset management business.

Capital charges are too high

High capital charges threaten the global insurance business and markets for asset-backed securities (ABS). Another BloombergBusiness report quotes Nomura’s head of European ABS strategy, David Covey, who says the new capital requirements are “punitive” and “make securitization uneconomical for banks and insurers.”

However you look at it, low interest rates and high capital charges burden insurance companies with greater costs that they may not be able to bear. But the global insurance industry suffers from internal weaknesses that compromise competitive advantage and make these external costs especially unbearable.

The London Market Group (LMG) is an excellent example of this dynamic in action. GRI has reported on the impact of big data on insurance and inherent problems affecting the London Market Group’s competitive advantage.

London Market under SWOT

To its credit, LMG is has begun the difficult effort of understanding its problems. But more needs to be done.

In collaboration with the Boston Consulting Group, LMG published London Matters, a fairly objective study of the London Insurance Market’s competitive position. While not really a SWOT analysis, the study lays out LMG’s perception of its strategic situation and identifies its strengths, weaknesses, opportunities, and threats.

A simple SWOT matrix developed from the internal and external factors analyzed in the London Matters report is illustrative. One can view a PDF version developed for this post here. An explanation of its use can be found in the top left cell of the matrix.

What stands out is this: the positive factors enjoyed by the London Market Group – its strengths and opportunities, which in the main constitute its competitive advantage, are greatly outnumbered by the negative factors – its weaknesses and threats – by a ratio of over 2:1. The count in and of itself does not mean anything, but the list of factors is derived from LMG’s own study. It is built on LMG’s own analysis.

LMG must be aware of the extent of its own internal weaknesses and the external threats facing it relative to the strengths and opportunities it can use to build strategic responses.

It’s not a difficult matter to use the SWOT matrix to develop basic strategic ideas, and a handful created for this post are included in the matrix. That’s more than LMG identifies in the report. LMG lays out its problems quite admirably, but it seems at a loss to determine what the strategic solutions are. This lack of strategic solutions has to be troubling.

How to insure against creative destruction?

In his classic work, Capitalism, Socialism, and Democracy, Joseph A. Schumpeter argues the dynamic core governing capitalism is the process of creative destruction. He describes it in terms that seem applicable to the global insurance industry in general, and to LMG specifically.

Schumpeter talks of an “evolutionary process” of “economic change” that drives the dynamic. What keeps it in motion are the new goods, new methods of production, new markets, and new forms of organization that “capitalist enterprise creates.”  To him, creative destruction is an “industrial mutation…that incessantly revolutionizes the economic structure from within” (emphasis original). “It is…what every capitalist concern has got to live in.”

Reading London Matters, one sees LMG living in that dynamic. Consciously or not, the London Market Group’s report describes this process revealing itself within LMG and global insurance. “Every piece of business strategy acquires its true significance only against the background of that process,” Schumpeter writes. All these trends are present in its analysis, but LMG has yet to draw the necessary strategic conclusions.

Schumpeter hints at LMG’s and the industry’s problem. These trends are forces that unleash a new kind of competition which established industries are not quick to recognize. “The problem that is usually being visualized is how capitalism administers existing structures,” he writes, “whereas the relevant problem is how it creates and destroys them.”

At the Berkshire-Hathaway annual meeting on 2 May, Warren Buffett spoke of new competition in the industry and other challenges. He said, “It’s a business whose prospects have turned for the worse and there’s not much we can do about it.”

Over the coming decade, Buffett says reinsurance “will not be as good as it has been in the last 30.” Reinsurance has been a major competitive advantage of the LMG.

LMG has taken the first important step: it has begun the process of describing the problem. But before it can take action and develop the necessary strategies, LMG has to come to a fuller understanding of its situation, internally and externally.

Strategic action isn’t likely to succeed if the situation isn’t understood. London Matters begins the process, but Schumpeter’s dynamic is already well underway.

Categories: Finance, International

About Author

Steven Slezak

Steven is on the faculty at Cal Poly in San Luis Obispo, California, where he teaches finance and strategy. He taught financial management and financial mathematics at the Johns Hopkins University MBA program. He holds a degree in Foreign Service from Georgetown University and an MBA in Finance from JHU.