There is a lot of material on the internet about the benefits of outsourcing . Naturally enough, most of it is from vendors of outsourcing services, or lawyers and consultants who will assist you in the process. One benefit always mentioned is that outsourcing will allow you to "focus on your core business". That is not very convincing. It seems unlikely that processing payroll (the most commonly outsourced function), or the computer operations are a significant distraction to the people involved in the acquisition and processing of insurance policies (the core business). It probably makes more sense to handle as much of your own business as you can, and outsource on a case by case basis when it is clear that the lower cost or superior expertise of the vendor make the risk and effort worth while. That is not what you will read on the web sites of the vendors or the consultants. There you see phrases like strategic enterprise outsourcing vision, business transformation, and integrated sourcing solutions. According to Gartner, current outsourcing practices in financial services won't work. My contrarian view is that current practices work just fine, if that means the company, rather than treating outsourcing as a goal, in and of itself, weighs the pros and cons function by function, and chooses accordingly. There probably are some basic principles, however, and that is what this discussion is about.

Notes

Discussion

It is hard to see why a life company that has its own data processing facility and at least one person in HR would outsource payroll processing. Either way, the same data input has to be done internally, so what you are buying is time on a computer program and the updates on taxes and deductions. If the problem is finding a web enabled payroll program, consider adapting one from the open source programs available. Try open source+payroll in Google. If you have people on the payroll in a number of states, keeping up with the changes can be a problem, but you can buy that service and still handle your own payroll.

Human resources (HR) is the most outsourced business process, with worldwide HR business process outsourcing (BPO) revenue on pace to reach $46 billion in 2003, an 18 percent increase from 2002 revenue of $39 billion. By 2004, HR BPO is forecast to reach $51 billion and represent 39 percent of all BPO revenue.
Payroll and benefits services are the most popular in HR BPO and are driving the growth of the market.
Companies that are already outsourcing HR processes expect to significantly increase their investment in HR outsourcing in the next 24 months. Gartner Weblog Observations, Outsourcing Summit Day 2, June 24, 2003.

In the last few years it has become impractical for an insurance company which does not market major medical policies to insure its own employee medical plan. The cost advantage provided by a predominately young female work force is more than offset by the preferred provider organization discounts which are now de rigor for any medical or hospital insurer.

The PPO concept was that providers would offer a discount from standard fees in exchange for the increased business delivered to the closed panel. Then things changed. The closed panel disappeared and essentially all providers joined. The "standard" fee of the provider was inflated to cover the discount. All medical insurers now acquire the "discount" by paying a national PPO a dollar or two per insured, which gives them the privilege of paying the pre-inflation cost. The net result is that the overall cost of the health care delivery system increased by the PPO charge for membership, and everything else stayed pretty much the same.

This is a tolerable Alice in Wonderland situation for the insured individual, but a tragic injustice for the uninsured, who is now billed the inflated charge and probably doesn't know it is negotiable. It would help if the PPOs would issue the $2 "discount" card to uninsured individuals, but that would spoil the illusion.

Investment management the clearest case of something that should be outsourced, and it almost always is, with the exception of the very largest companies. The knowledge, skills, experience and information required have nothing in particular to do with the life insurance business, and there is no advantage, and a huge cost disadvantage, to attempting to maintain the expertise and information sources necessary to handle the function internally.

Knowledgeable investment people are very expensive, as are their specialized information systems. The cost of handling the portfolios of 40 companies is not much more than the cost of handling one. At a reasonable fee of 7 to 10 basis points, the outside cost to manage $500 million is $350,000 to $500,000 a year. You can't match that internally. Doing the investment accounting will cost another basis point.

When negotiating fees, it is important to remember that there is essentially no incremental cost to the investment firm if the portfolio is twice the size. If you start with two outside firms each managing $500 million of a $1 billion portfolio, you can bet that either one would be willing to manage the whole with no increase in their $500,000 fee. The reason: the time and effort involved in coordinating investments with another manager is far more burdensome than handling the whole and just "adding a zero". So maybe 5 basis points is a better target for a billion dollar portfolio, but you will have to maneuver into it. The firms can't let that become common knowledge.

When you negotiate fees with outside vendors, it is helpful to think through their cost structure, i.e., what is fixed and what is variable. For example, the outside investment manager has a variable cost taking on a new client which is mostly in meetings, travel, reporting and coordination. That $100,000 (let's say) has nothing to do with the size of the portfolio, the cost of handling which is largely fixed. The manager just buys a bit more of each investment to cover the new client.

While portfolio management is a specialized skill with no essential relationship to life insurance companies, there is probably some advantage to selecting a manager that has a number of other life clients. Familiarity with the investment limitations and accounting is helpful, and the firm may be active in creating particularly appropriate investment vehicles with traunches that work well immunizing the usual life policy liability structures.

A word on traunches, an essential element in CDOs, CBOs and any securitized pool of liabilities. If you invest in a pool of high yield bonds that is not traunched, you are simply in a mutual fund. If there were two traunches, the senior and the equity, the flow of funds from the pool (interest, maturities, calls and so on), would be divided by a definition of which gets what, when. The senior traunch would have a fixed yield and amortization schedule, and the equity traunch would take whatever is left over. This gives the senior a higher investment rating than the fund itself would have, and insulates it not only from defaults, but from paying off either too slow or too fast. In return, the senior takes a yield lower than the fund is expected to have, the difference covering defaults and a higher expected return to the equity. Yield and amort on the equity is estimated for various default rates, but as Yogi says, it ain't over till its over. Commonly there are three or more traunches to these designed pools, allowing several flavors of risk and return, suitable for various portfolios and tastes.

Most companies will save money, and run better, if they have an actuary on the payroll. There is a base level of required actuarial activity which includes reporting, certifying reserves and and illustrations, and straightforward product development that is best handled by a full time employee. The actuary is usually by far the most expert on the technical aspects of the business, and is an invaluable participant in the day to day decision making process.

The time to outsource to an actuarial firm is when you think you may need more than one actuary, or plan to field products with which your company and internal actuary have limited experience. With products where the loss experience or practices are just developing, or are changing rapidly, the outside firm has the advantage of current knowledge from a number of companies, something not available to an internal actuary.

Cary Goggin, the actuary at American Amicable Life, handles all internal matters for the several affiliates and rapidly designs and prices life products. He attributes the ability to do this to the use of excellent PC based actuarial software for product development, and for reserving and reporting as well.

Cary Goggin: It is just a matter of actuarial efficiency. I think there are many companies that could cut their actuarial costs in half and get equivalent or improved actuarial service. Many companies obviously have too many actuaries, but it is probably hard for companies to tell that is so or even know how efficient an actuarial department should or can be. To me, the ever-increasing regulation burden argument is mostly a fallacy. If you have good access to data, the proper software, and reference materials, projects really don't take that long. New products, for example, involve a lot of approximation and the 3rd significant digit and beyond doesn't even matter.

For companies that are staying within their expertise, the extent of actuarial outsourcing should be limited to ongoing bits and pieces to obtain outside expertise as necessary. All critical functions should be done internally. If all the in force and new products seem to be outside the area of expertise, then you need to fix that internally. In my view the best approach is to work with a consulting firm at an hourly rate and use the time wisely - a couple of hours at a time - mostly mini-projects and advice that only take 1 hour to 5 hours at most. Of course, to make this work you need an efficient internal actuary with a broad knowledge base that overlaps well with the company characteristics.

Legal matters should usually be outsourced, for many of the same reasons as investment management. The lawyer has a specialized skill that has no essential relationship to life companies or most of the legal questions that come up. The everyday problems regarding claims, complaints, and regulatory matters should be within the ability of lay personnel in most companies. If a matter is of serious consequence or results in litigation, it is universally referred to outside counsel, whether or not the company has a law department.

This view may seem inconsistent with how busy the law departments are in companies that have one. Seldom can just one lawyer handle the work load, and at a minimum will require a legal support staff, and possibly one or more junior lawyers. Usually a great part of this is a result of top management insisting that anything remotely related to law must be "passed by legal". Some comes from the time involved to "coordinate" and "interface" on matters referred to with outside counsel. If you have a legal staff, you will end up inviting someone from that staff to attend most meetings. And, of course, any time a manager doesn't want to bother with something but hates to say "no" or "go away", it is painless to send the matter to the legal department.

Outside counsel is very expensive, but the issue is whether maintaining an inside lawyer will reduce that expense, or improve the service, to any appreciable extent. If you have no internal legal staff, you are likely to find that most of the "legal work" simply doesn't get done, with the company no worse for it.

Outsourcing EDP ( IT is the current phrase) is the next biggest growth area according to Gartner. Many of the reasons giving for outsourcing appear to be based in dissatisfaction with the internal management of IT. It might be a better idea to change the internal management. Working successfully with an IT vendor requires more diligence and know-how than working with an internal staff, so if things are not going well with internal IT, outsourcing is sure to be a disappointment.

Most life insurance companies now have dual IT operations, using the traditional mainframe for master file operations, and a server network for email and web based services, internal and external. The outsourcing of email and web server is discussed on the expert pages on Server and Network Issues and Network Computing Analysis. Those issues are fairly straightforward. As a practical matter, file services are usually provided by servers within the company LAN due to the necessity of transferring data at LAN speeds not available on the internet. On the other hand, email and web servers are often better hosted with an outside service unless web site data access issues overcome the significant cost advantages offered by the outside host. Unfortunately that is about all that is clear concerning IT outsourcing. Even data entry, for most industries one of the easiest processes to shift to low cost areas like India, is doubtful for a life company, where most entry is done directly from the application and involves multiple transactions with internal files.

Outsourcing the design and programming of a new system or project is like contracting the building of your house. It is impossible to make a perfect blueprint before you see some results, and then everything you want to change costs extra. Communicating a change is one thing when you can sit down with the programmer and talk until you are sure you understand each other, and quite another when you talk only to the vendor's client rep, who talks to the programming manager, who talks to the programmer. It can take more time to write the program request than it would to make the change.

Outsourcing day to day computer operations will be likely to have the same chilling effect on changes. The simplest change, for example to a letter, or how something is sorted, requires a formal program request, an price from the vendor (always more than $500), and some internal approval. It just gets easier never to make any changes.

There is also the dreaded conversion. Converting your files to fit the vendor format, and your systems to fit the vendor output, is always traumatic. Moreover, once done, the aversion to doing another conversion is a powerful disincentive to moving to a different vendor. That puts the vendor in the driver's seat as far as pricing is concerned, one of the traps of outsourcing.