Claims

Controlling claims costs: A long look at litigation expenses

by James Cerone

Background

Primary general casualty insurers are justifiably concerned with the costs of defending lawsuits against policyholders. Payments to defense attorneys are a measurable percentage of earned premiums, and next to the costs of staff claim personnel, legal fees are the largest segment of loss adjustment expense. The amount of defense costs is particularly significant since these expenses are related to a relatively small portion of total claims. Typically, 20 to 25% of an insurer’s claims are in litigation requiring the use of defense attorneys. The legal defense costs and percentages are even higher for insurers of professional liabilities.
Focusing on the amounts of paid expenses, insurers perpetually seek methods, approaches, and schemes to contain these costs. Litigation Management manuals and monitoring reports are published and updated by, in some companies, dedicated personnel. Spanning a half century, this article presents and assesses an inventory of favored approaches used by insurers. The observations and comments are based upon reviews of insurer claim files in the course of a career as a claim professional and a consultant retained by insurers. Suggestions are provided for the use of time tested practices which remove non-lawyer work from defense counsel to staff claim personnel.

Financial relationships: Tough to monitor

Staring at the amounts of paid and projected payments to defense counsel demonstrates the costly issue faced by executives. The amounts call for decisive action but often result in declaring a single condition or element as the cause of the problem. This narrow focus will drive monolithic strategies to address the cause of the problem.
Some insurers have decided that defense attorneys’ hourly rates are too high and have designed strategies to lower them. These strategies include the use of fixed-fee schedules in which attorneys agree to handle certain types of lawsuits, usually the less complex ones, for agreed-upon prices. A broader variation is the use of an annual retainer wherein a law firm agrees to handle a loosely defined number of lawsuits of all types in return for fixed monthly payments. Another approach is to simply shop around for the lowest hourly rate and to assign the work to the attorney with the lowest hourly rate; a cheap labor strategy.
It is difficult for an insurer to monitor the fixed fee or retainer contractual arrangements to determine whether they actually reduce defense costs. Also, for all of the financial arrangement strategies there is a potential loss of quality in terms of the level of defense services provided. This is an acute problem, given the duty of an insurer to defend and the duty the defense attorney has to his client, the policyholder. Cut-rate defenses can backfire into bad faith actions against the insurer and professional liability actions against the defense attorney.
The underlying reason why these strategies typically fail is the fallacy that the hourly rates charged by defense attorneys are too high. Nationwide, insurance defense attorneys charge about $130 per hour, with higher hourly rates often found in big cities. Actually, insurance defense rates are not high, compared with the hourly rates of most other legal practice areas such as work relating to the Securities and Exchange Commission, mergers and acquisitions, labor law, corporate litigation, real estate syndications and domestic litigation. Quite often, the hourly rates attorneys charge insurance companies for defense work are upwards of 40% lower than what they charge insurers for corporate work.
The use of staff employee defense attorneys is a fine extension of the do-it-yourself approach. The hourly cost of staff attorneys, including support staff and overhead, is approximately $80-$90. Therefore, companies enjoy a $40-$50 an hour savings for every hour of defense work shifted from an independent attorney to a staff attorney. This is an excellent method to lower defense costs, but its use is limited to those insurers who have sufficient geographic concentrations of lawsuits to keep a staff attorney busy. To be cost effective, there must be sufficient billable defense work to shift at least 1,900 hours per year from an independent counsel to a staff counsel.
The use of staff counsel can be undermined by hiring less experienced attorneys who cannot otherwise obtain employment in the market which charges $130 an hour for services. This error occurs as insurers seek to lower the hourly cost of staff counsel operations below a reasonable market value. Because of the difference in competencies, real or perceived, and potential conflict-of-interest considerations, staff attorneys often handle only the routine, less explosive cases. Given the necessary concentration of work, staff counsel can contribute to the reduction in overall defense costs. To work, however, staff attorneys must be competent and experienced to be an equivalent alternative to independent counsel.

Other approaches

A naïve approach, perhaps taken out of frustration, finds insurance companies forming advisory councils with defense attorneys or defense organizations to discuss and design plans to lower defense costs. This approach is doomed. Defense costs are expense to the insurers and revenue to the attorneys. Does anyone really believe that attorneys are interested in determining how they can earn less?
More directly, the “cost of defense” settlement will reduce payments to independent counsel. The notion is to pay in loss an amount up to the expense cost of defending a threatened lawsuit. This can absolutely reduce legal expenses but it will certainly raise loss payments. A perversion of this concept is to assign a settlement value to virtually any asserted claim. In practice this does happen and subscribers will defend the concept as being financially prudent. Notes to claim files often describe the conclusion of a settlement negotiation as agreeing to pay an amount to avoid the cost of defense. Letters from defense counsel will also suggest a settlement amount to consider paying as the cost of defense. This is wrong since the insurer violates the insuring agreement to pay (only) those sums for which the policyholder is legally liable. It also fosters the notion that the insurer is an easy or liberal payer of claims; a perception that will bring demands to pay something for anything. The appeal of this approach should disappear with the presence and use of staff counsel.

Back-end techniques

In the mid 1990s, responding to pressure to lower legal defense costs, claim executives intensified and developed specific techniques directed toward lowering the billed amounts of defense counsel.
For decades, insurers have published general guidelines setting forth the duties and obligations of defense counsel selected to provide defenses to policyholders. This proper practice grew in scope in many unintended and often negative ways. Over time, the guidelines replaced a case specific letter of assignment provided by the staff claim handler to the selected defense counsel. (The recommended elements of a proper assignment letter are provided later in this article.) This was an initial step in reducing the affirmative role of insurer claim personnel in the management of litigated files. It fostered the concept of abandoning the file to defense counsel. Insurers recognized this as a bad practice but few focused on change. Actually, the use of guidelines is sound. It was the replacement of assignment letters and the often eventual removal of the role of the claim person that was bad. From defense counsel’s view, their primary duty was to the policyholder. With little or no direction from the claim person, counsel had no choice but to do what they were left to determine was necessary and in the best interest of the defendant policyholder. This evolved to counsel performing non lawyer work including taking the lead in gathering documents such as medical records; determining the need for and arranging for medical examinations; providing periodic status reports to the claim department; initiating the valuation of claims including recommendations for the amounts of case reserves; effectively deciding whether and when to try a case to verdict or to settle; conducting negotiations; and, essentially handling all aspects of the claim.
The unintended changes in the scope of the role of defense counsel described above resulted in a greater number of billed defense hours and higher defense charges per case. This began the use of general guidelines as a post billing hammer to adjust downward the number of hours charged. For example, if a billed item was not specifically included in the attorney’s responsibility as set forth in the guidelines, the billing charges were deducted and not paid. Often, the issue of whether the charged work was necessary to the defense of the policyholder and the fact that no one except the attorney elected to obtain the work was not addressed. This approach marked a deterioration of the working relationship between insurer staff claim handler and defense counsel. This is not a good thing.
To further manage litigation and defense costs, insurers properly required attorneys to provide budgets of estimated costs typically through discovery and exclusive of trial; a good management idea. In the wrong hands, the budget became the bar under which no management of the file by insurer staff was delivered. The budget also provided an opportunity to automatically rule out any charges that exceeded the budget. These cuts to bills overlooked the issue of necessary work as discussed in the preceding paragraph.
The success in actually and simply eliminating charges for work performed is moving the management of legal defense costs toward a health insurer model. The defense attorney (provider) submits an itemized bill for services; the insurer unilaterally compares and adjusts the charges against litigation management guidelines and pre-work estimated budgets (fee schedules); and, then sends a check in payment along with a marked and adjusted bill (EOB). This approach has not been seen to be successful in lowering defense costs. It has eroded the relationship between insurer and defense counsel.
Completing the back end approach is the creation of staff and vendor auditors of attorney bills. These auditors receive and scrutinize bills to identify variances to guidelines, budgets, and often subjective determinations of overcharges. The attorney then receives the lowered audited amount. Some vendors are paid on the basis of a percentage of savings. A vendor has confided that all attorneys intentionally over-bill. Perhaps this is a sign of “gaming” the system in expectation of bill reductions. An attorney remarked that the current adversarial relationship with insurer clients is prompting a move away from tort defense.

What can be done?

There is no magic bullet or quick fix to contain legal defense costs, and the so–called litigious society is not going away. Insurers will continue to be buyers of expert services and, in the case of litigation, those services are provided principally by independent tort defense lawyers. Therefore, the guiding principle for insurers should be to hire lawyers to do only the work that requires a lawyer’s services and not to ask them to do work that could be done by claim people. This means minimizing the need for lawyers in the first place by working to control the numbers of lawsuits filed against policyholders. This also means working to adjudicate matters by using alternative dispute resolution forums such as binding arbitration.

Pre-litigation strategy

The control of defense costs begins before the suit is filed. The handling of claims should be directed, to the extent practical, toward limiting the numbers of lawsuits to those claims where the loss amount demanded is greater than the insurer is willing to pay. Lawsuits filed because the insurer has been slow in investigating or negotiating often result in unnecessary defense costs and should be avoided. Of course, this excludes cases where the lawsuit constitutes the first notice of a matter.
As a quick test, claim management personnel should review the claim file upon the receipt of a lawsuit to determine whether the claim adjuster has been responsive to the claimant or his attorney. If it is a case in which the insurer would pay some amount to settle, has this been communicated or has an offer been made? Based upon independent studies, a conservative finding is that 5 to 10% of all lawsuits – and their resulting expenses – were probably unnecessary. This first test identifies the need for training and, perhaps changes in the supervision process such that claim personnel exercise greater contact and communication with third parties or their attorneys to eliminate the filing of potentially avoidable litigations. Of more direct and immediate consequence, the claim personnel can request an extension of time to file and answer to permit an evaluation of the claim and perhaps a successful settlement. In the latter case, a successful and justified negotiation means eliminating the need to retain counsel and the avoidance of legal expenses. Any extension of time must be confirmed in writing from the plaintiff’s counsel.

Alternative dispute resolution/arbitration

Working to reduce the potential of lawsuits to fair differences means a claim reaches the point where there is an impasse between the amount demanded and the amount the insurer is willing to pay. At this point, the matter requires adjudication. There are two courses available to the parties. An alternative to the filing of a lawsuit is the selection of an arbitration forum to apply for binding arbitration. The American Arbitration Association is an example of an organization which is equipped to facilitate arbitration. Arbitrations require the consent of both parties. Arbitrations are typically decided by a three member panel of arbitrators. Each side appoints one panelist and the two selected arbitrators agree upon the third member, the umpire. Arbitrations typically produce lower legal fees and are decided in a much shorter time. An insurer is missing the opportunity for reducing legal expenses if it has not attempted arbitration.

Assignment to counsel

Another critical point in managing legal expenses occurs when an unavoidable lawsuit is initially assigned to defense counsel. The initial assignment is the first opportunity the insurer has to direct the work of attorneys, and it often sets the stage for the insurer-attorney relationship over the course of the litigation.
Insurers typically assign work to attorneys through the use of a letter of transmittal. The extent and quality of assignment letters vary greatly from insurer to insurer. At one extreme, the letter consists of a few brief sentences typically telling the attorney to file an appearance and do whatever is necessary.
This type of letter does not restrict, define or limit the attorney’s activities, nor does it provide the insurer’s assessment of the claim and plan for future activity. As a result, it invariably produces a multiple-page letter of first impression from the attorney in which the attorney reviews the file which he has just received from the insurer. There is no benefit to pay someone to tell you what you already know. These “feedback” letters conservatively cost between one and two hours of attorney time charges, or from $130 to $260 for every suit assigned.

The assignment letter

Insurers who effectively manage and control litigation use a very detailed, case specific letter of assignment which tells the attorney how to proceed instead of leaving the assignment open-ended and undirected. Following are some guidelines regarding the specific points that should be included in the insurer’s initial assignment letter:
  • Coverage. Identify the coverages and limits of liability of the policy involved in the case. Discuss any coverage questions or state affirmatively that there are no coverage issues.
  • Identification of plaintiffs and defendants. Review the relationships of all parties to the litigation and identify any additional parties to be joined.
  • Identify the insured defendant. Specify the defendant(s) for whom a defense is owed. If the defendant is other than a named insured, explain the basis for coverage and defense.
  • Facts. Review the facts of the claim, including physical evidence, official records, witnesses’ versions of what happened and the position of the plaintiffs and defendants.
  • Damages. Outline the claimed damages and provide an assessment as to the accepted damages.
  • Current evaluation. Give the insurer’s evaluation of liability and damages, including potential claims for indemnity or contribution.
  • What the insurer will do. List any additional activities planned by the company, including additional investigation to be obtained and a timetable plan for disposition.
  • What defense counsel will do. In addition to filing an Appearance and Answer, list the items of requested Discovery. Request that the attorney simply acknowledge receipt of the assignment and limit any further comments to only those parts of the assignment letter which the attorney disagrees with or finds deficient.
  • Request an estimate of defense fees and expenses. Require the attorney to submit a budget of expected future costs. This will allow the claim supervisor to compare his own expectations as to defense costs to those of defense counsel. A wide variance signals the need for discussion with counsel. The defense attorney’s budget should be compared to actual costs as the case moves forward. The budget should be updated over time.
This type of letter supports the goal to manage legal expenses. It also ensures that the file supervisor has performed an up-to-date assessment of the claim and has a clear plan for the future handling of the case. Both purposes served by the letter should ultimately produce financial benefits.

Lawyer and non-lawyer work

After the initial transmittal of the suit, the level of legal expenses is related directly to the amount of work performed by the defense attorney, which should be limited to only those activities which require the services of an attorney. These typically include the preparation and filing of pleadings and interrogatories, appearance at trials and motions and the taking or defense of depositions. The insurer should recommend or approve all affirmative depositions. As noted earlier, defense attorneys should not perform work which can be done by adjusters, such as ordering and obtaining items in investigation and conducting negotiations. Insurers can review their closed suit files and paid attorney bills to determine the extent of work performed by attorneys that could have been performed by staff claim personnel. By identifying line item time charges for work not requiring an attorney, the insurer can develop an estimate of the amount of money paid to lawyers for performing work not requiring a lawyer.

Estimating the savings

Step 1. To estimate potential savings on attorneys’ fees, first estimate the number of avoidable lawsuits each year and multiply that by the historical average defense cost per closed litigated claim.
Step 2. Figure what can be saved by writing comprehensive assignment letters and thus avoiding long attorney “feedback” letters by multiplying the number of lawsuits per year times the average hourly cost of attorneys. (This assumes that the attorney spends only one hour on the response letter.)
Step 3. Take the average estimated number of hours of work per lawsuit that was unnecessarily completed by a lawyer and multiply that by the average hourly attorney fee. If no improvement is needed in an area, enter zero and consider this to be unique, extraordinary, and illusionary.
The sum of these three figures provides an estimate of the money to be saved by eliminating unnecessary litigation and attorneys’ fees. Studies have shown that unnecessary attorney activities (step 3) average five to twelve hours of charges per case. At $130 an hour, this adds $650 – $1,560 to the cost of defense for the insurer for each case.
Alternatively, insurers can probably skip the process of reviewing files and estimating potential savings on defense costs. Savings are possible for every company. Carriers that adopt the policy of providing prompt evaluation and responsive communications to third parties, sending explicit letters of assignment and not paying lawyers to do work which can be done by staff or other non lawyer parties will find that the dollar savings are there.

Jim Cerone is an independent consultant to the insurance industry, former Executive Vice President of the Travelers Property Casualty Corporation and former President of the technical services division of their claim organization.  Prior to joining Travelers, Mr. Cerone served as Senior Consultant and Equity Principal of Milliman & Robertson, Inc. (M&R). At M&R, he founded and directed the claims management consulting practice, specializing in consulting with management on a wide range of strategic and organizational issues. His background also includes service as Vice Presidents and Consultants with Tillinghast, Nelson & Warren, Inc.; Kramer Capital Consultants; and senior executive positions with three other U.S. insurers; Commercial Union, John Hancock, and American Reserve. In these positions, he was responsible for organizational design, acquisitions, automation, training and education, and the general management of large scale claim operations.

Claims from a core perspective: Strategic considerations in enterprise deployments

by Marcus Ryu

Introduction
Of the multiple business disciplines found in a P&C carrier –  underwriting, policy administration, billing, reinsurance, client management, and claims – claims has traditionally been the underfed stepchild. The P&C insurance industry is no exception to the rule that enterprises invest enthusiastically in revenue generation and only reluctantly in their cost centers.  Guidewire Software, which was founded as a provider of next-generation P&C systems, has argued for years that this bias overlooks the significant economic potential locked in claims organizations constrained by legacy system environments.  This argument was built on the consulting work of firms such as McKinsey and Accenture, who quantified for their P&C clients that process inefficiency and indemnity “leakage” through systematic handling errors could be costing their organizations several points of combined ratio.  The root cause of many of these errors was a system environment that underserved the needs of claims adjusters and managers for data, workflow, analysis, and best practice enforcement.  Guidewire ClaimCenter is a modern claim system directly targeting these challenges.
Through countless discussions with a broad cross-section of carriers domestically and internationally since 2001, however, Guidewire has come to identify the challenge of modernizing claims technology as just one part of a larger story about the future of P&C core systems overall.  Core systems – the transactional systems-of-record at the heart of a carrier’s business processes – are the immensely complex “mother ships” around which many ancillary sub-systems extract and feed data.  Guidewire has arrived at the estimate that approximately 90% of the global P&C industry relies on legacy core systems: 15-30 years old, mainframe-based, written in COBOL, and sustaining the minimum enhancements necessary to continue processing business.
The encroaching obsolescence of these systems imposes three strategic dilemmas on today’s CIO:  First, how to distribute finite IT resources between current and new systems overall?  Second, in what sequence should business areas be targeted for modernization?  Third, should investment in new systems take the form of building or buying new systems?  Whether, and how, to modernize a carrier’s claims technology are questions that must be answered in this larger enterprise context.
The conclusions we shall reach are: First, it is vital that carriers develop a long-term strategy for core system management and eventual replacement.  Second, that the inherent challenges of initiating and succeeding in core system projects often support beginning with claims versus other business domains.  Third, that the evolution of software technology and the industry track record of P&C core system projects argue strongly for “buying” versus “building” new systems.
The case for core system replacement
Any consideration of these questions should start with the null hypothesis, why not forego investment in future core system platforms altogether?  A system’s age and legacy status alone do not render the case for replacement open-and-shut.  Optimized for high transaction volumes and tested by hundreds or thousands of person-years of use, the legacy generation of core systems that replaced the filing cabinets now set a high standard for reliability and performance that any new system must meet or exceed.
There are four broad reasons to undertake core system replacement.
First, legacy systems have become structural obstacles to higher performance in every processing domain of a P&C carrier.  Precisely because they were designed as transaction engines, legacy core systems provide minimal support for the evaluative and interactive dimensions of P&C insurance work.  In the best practices paradigm of the 70s and 80s, the human actor – the underwriter, adjuster, or billing specialist, for example – relied on paper files, notes, phone calls, and his own judgment to make decisions and communicate externally, while only the transaction execution was left to the system.  Today, virtually every carrier aspires to a significantly more automated and controlled business environment in which routine decisions and many standard tasks are handled without involving human action.  While the specifics vary widely by business process and organization, some key examples are:

  • Rule-based automatic evaluation of risk quality, claim severity, fraud and litigation potential;
  • Automated segmentation, division, and assignment of work on individual cases to different specialists;
  • Automated workflow supporting complex, high-volume, rule-driven processes such as new submissions, recoveries, and policy renewals;
  • Exception-based monitoring of data quality and service level achievement;
  • Automated support of complex cross-functional business models such as loss-sensitive programs and aggregate policy limits; and
  • Real-time or near real-time presentation of operational and financial data tailored appropriately for each level in the supervisory hierarchy.

Target enhancements such as these reflect the increasing adoption by P&C carriers of process management philosophies pioneered by manufacturing industries.  It is now typical for P&C executives to measure their operations in terms of quality control, productivity, cycle time, and customer service level attainment – beyond the traditional insurance metrics of sales production and underwriting profit. Optimized for batch transaction processing, legacy core systems are poorly architected to support this more data-intensive, business-rule-driven, process automation paradigm.
A second, related reason for replacement is core system flexibility.  Legacy architectures are ill-equipped to support continuous change.  In any COBOL-based system, business logic and data structures are densely packed in procedural code.  Any change to logic or data – or to higher-level business entities such as products, customer segments, and billing plans – requires extensive custom design and development work.  Consequently, even the most agile organizations expend months or even years of expensive effort to respond to changing business and regulatory requirements.  This rigidity is inherent in the architecture of legacy system environments and has long been endured simply as a cost of doing business.  Providing core system flexibility for products, data, and processes in an environment of continuous business change is hence a key requirement domain for the next generation of core systems.
Third, while the Internet has not yet dramatically transformed P&C distribution, it has raised expectations for new models of self-service by policyholders and producers.  Compared to its peers in retail and financial services, the P&C industry has much further to go to enable its customers and distribution channels to manage interactions through web-based self-service. True “no-touch” models for new business, endorsement processing, billing, account management, and claim lodgment are still early in their development – but few question that they will become the eventual norm.  This introduces a new category of end-user and integration requirements on a generation of systems designed long before the Internet was a household word.  It is only through numerous compromises and ingenuity that a batch-based, code-driven, monolithic architecture can serve as the transactional platform for a widely distributed population of ad hoc end users expecting an Amazon.com-like experience.
The final motivation for core system replacement is human-, not system-related.  The language of legacy core systems is overwhelmingly COBOL, which has been almost entirely displaced throughout the IT and software industries as a programming language.  Very few university computer science curricula offer COBOL programming classes today since object-oriented and web-native architectures have become the norm for enterprise software development.  Moreover, because legacy systems are adapted only through custom programming, each has become a unique artifact quilted through countless waves of modification and enhancement.  Consequently, it is all too typical for even the largest carriers to have the true understanding of the workings of its core systems concentrated in the heads of a handful of employees approaching retirement.  Addressing this key point of enterprise risk provides for many CIOs the most “non-negotiable” motivation for investing in future core system platforms that both align with evolved technology standards and are fundamentally more transparent than procedural languages such as COBOL.
Over the next decade, P&C carriers will be split into two categories: those who respond to these four motivations – process control/automation, core system flexibility, self-service enablement, the retiring legacy system knowledge pool – and those who do not.  Those who do respond will invest steadily in new core systems with fundamentally different architectures, while those who do not will continue to make tactical fixes that extend the life of, but do not ever aspire to replace, existing systems. These performance trajectories of these two categories will be close in the early years of this transformation.  Over time, however, they will diverge dramatically as those carriers who successfully make the transition to next generation core system environments are able to deploy fundamentally more automated and efficient business processes while providing customers and agents more compelling products and web-based service models.  If this is true, carriers who bet on our “null hypothesis” years earlier will find that working the traditional levers of P&C performance – such underwriting focus, expense discipline, and claims leakage management – will be inadequate in themselves to support competitiveness with the other group.
Investing in core system replacement: three key challenges
Concluding that to neglect investment in core system replacement would be foolhardy only scratches the surface of deciding how and how much to invest.  Because carriers vary widely in their current states, quantifying a “proper” range of investment for all organizations is of little value.  But there are relevant generalizations: Guidewire’s experience over dozens of core system projects has uncovered three key challenges that typically confound carriers as they grapple with core system replacement.
First, unlike more tactical IT projects, core system initiatives require long timeframes. The full transition to a new transactional system-of-record will take multiple years for all but the simplest of enterprise IT landscapes.  In order for a project phase to deliver meaningful value, its scope must encompass a large portion of the legacy system, if not complete replacement.  This entails the broad canvassing of end user and management requirements, redesign of business processes, development of numerous integration interfaces, and a testing period which can amount to a quarter or more of the total project duration.  Guidewire’s own experience has been that – regardless of the technology involved – the sheer complexity of current state business and system environments entail standard project durations of one to two years for a single phase project on a single core system area.  And since there are multiple core systems areas, time spans as long as five to ten years would not be unreasonable for a P&C enterprise to achieve complete sunset of its legacy system environments.
Such a long horizon of change gives rise to multiple challenges.  Rushing a project to achieve an arbitrarily designated completion date and allowing a project to limp along interminably are opposite but equally dangerous pitfalls.  There is no substitute for the hard analytical work of defining an achievable scope that delivers meaningful business value and then rigorously estimating how long it will take to complete with high quality.  For an organization to “internalize” and clear-sightedly accept the duration and level of effort required to replace its core systems is the most vital step it can take toward eventual success.  Yet this challenge is heightened by the inevitably high expectations of business end users and management generated by the prolonged effort invested in a core system project.  These expectations may not appreciate the extensive amount of foundational technology work necessary to define a new architecture and to achieve functional parity (let alone superiority) with the status quo.  Because project teams are pressured by these expectations, there is a great risk that decisions to “get something delivered” will trump making the right long-term investment.  As will be discussed further below, this is one of the most important motivations to begin with a properly architected vendor-delivered product that provides a concrete representation of the end-state.
A second challenge arises from the blind spots of corporate decision making and financial planning. While the requirements of quantitative business cases, ROI models, projections of payback periods, and cost-benefit analyses all have their place in imposing financial discipline on capital investment, they are ironically the most limited when the stakes of an initiative are the highest. To take an analogy from everyday life, tactical financial decisions such as whether to refinance a mortgage, invest in a mutual fund, or pay for the help of a tax accountant are readily estimated in their cost and benefit.  In contrast, decisions which have far more profound effects on one’s financial well-being – such as paying for a university education or changing one’s career – are virtually impossible to quantify. The costs may be clear, but the benefits are open-ended and include the option value of new opportunities not clearly visible from the starting point.
Similarly, core system projects fit uncomfortably into the framework of financial analyses appropriate for tactical system modifications.  A cost-benefit model well-suited to estimate the value of avoiding regulatory fines from a missing data element will typically struggle to quantify (or even identify) the value of such open-ended benefits as improving product and pricing flexibility, enhancing claim quality by superior data capture and presentation, and increasing retention of skilled personnel by creating a more automated and professionally fulfilling work environment. In deciding the proper allocation of resources between current and future core systems, far-sighted organizations overcome this quantification challenge without compromising financial discipline, while “follower” organizations often talk themselves out of all but the most tactical of system fixes.
The gravest mistake is to undertake a half-hearted core system augmentation effort which may deliver some short-term benefit, but which brings no closer the eventual retirement of the legacy core system.  While it can be perfectly appropriate to decide consciously on tactical enhancement versus a strategic replacement initiative, too often short management attention spans and the pressures of internal funding abandon a once ambitiously scoped project at the “Phase 1 front-end” stage, thereby only complicating the IT landscape in the long-run.  That so many P&C IT environments are littered with orphaned “Phase 1” systems is a testament to the difficulty of planning and following through on core system replacement.
The third challenge in core system replacement arises from the disparity in skills required for the maintenance of existing systems versus the development of new systems.  In Guidewire’s experience, even large IT organizations that have successfully maintained and evolved a legacy core system platform for decades often find themselves lacking the skills to design a new system from the ground up.  Analogous to a team of mechanics proficient at repairing cars but unequipped to design new ones, most P&C IT teams are neither trained nor organized to design and develop a modern, web-native enterprise application.  In part this is because they lack expertise in newer software technology disciplines such as object-oriented programming in languages such as Java, web-based user interface design (including recent advances such as AJAX), clustered architectures, relational object mapping, metadata-based data model design, automated performance tuning and tooling, and web security infrastructure.
More important than specific technology knowledge, however, is the inexperience and missing organizational structures to manage foundational application development.  For example, in most P&C organizations, the task of framing requirements for fulfillment by a development team rests on the shoulders of “business analysts.”  These analysts are often drawn from the ranks of former business end users, who draw upon on their field experience to articulate necessary changes to existing systems.  The division of labor between the business analyst and the technical staff serves maintenance needs well, since requirements are always incremental to an existing system framework.  Developing a core system from the ground up, however, requires much deeper technical design skills – namely, the synthesis of a vast set of business and technical requirements into a coherent and achievable system design.  Because software companies live or die by the quality of their software products, they recruit, cultivate, and reward this “product manager” skill.  It is less common for P&C carriers to do the same.
A core system replacement initiative must therefore plan for a multi-year sustained effort, achieve internal justification without complete quantification of value, and assemble an entirely new corpus of skills even before it gets off the ground.  In light of such challenges, Guidewire strongly recommends to carriers contemplating different core system initiatives to choose based on maximizing the chance of project success –rather than by business preference or even by the potential value to be achieved.  After all, a failed project is worse than useless, no matter how valuable the starting aspirations.  From this perspective, claims projects often have key advantages over projects in other P&C business domains.  In particular, claims projects involve shorter timeframes, fewer integration points, and simpler business processes than policy administration replacement projects.
“Buy” versus “build”
This leads us to the last of the dilemmas posed earlier: should investment in core systems take the form of implementing a core system product from a software provider, or custom developing a solution (either alone or with the help of a consulting partner)?  That is, to buy or to build?
Historically, simple necessity answered this question for many P&C carriers: either building an application was simply impossible given available resources, or there was no procurable packaged solution that would meet the need.  While this may still be the case for many, there have been developments on both the “buy” and “build” sides that render the question potentially more complex than before.  On the “build side,” the emergence of numerous offshore development firms offer to smaller carriers access to large pools of technical labor. Also, the evolution of certain software components, such as workflow tools, rules engines, application servers, and object-relational mapping tools, seem to offer a set of building blocks that could accelerate internal development efforts. On the “buy” side, the emergence of a new breed of vendors has proven that highly configurable packaged core system applications can support the varied needs of a wide array of P&C carriers.
We believe that, appearances of “balance” notwithstanding, technology advances of the last decade overwhelmingly favor P&C carriers buying over building core systems. Specialized software providers have numerous advantages over any custom development initiative.  Let us consider why.
First, the huge costs of developing these enterprise software applications can be distributed over numerous customers and amortized over years of distinct initiatives, rather than concentrated into a single project.  Software companies must justify their development expense not by potential business benefit to any given project, but by the tougher standard of market adoption: either the application proves itself in the market and is broadly adopted, or it fails and never repays its cost of development. As an example, Guidewire’s market success has been built on a product-based strategy of distributing the cost of the 150 person-years of development invested to date in each application (PolicyCenter, ClaimCenter, and BillingCenter) over its growing customer base.  As in many other domains, the pressure of the free market to meet demand as fully as possible is a much more efficient and accurate guide than any management directive.
Second, software companies are better equipped to recruit and mobilize the skilled engineering teams necessary for modern enterprise software development. As business processes, integration requirements, and automation expectations have risen, the minimal “table stakes” for a mission-critical enterprise system have steadily risen.  Today, the technology requirements of a P&C core system include:

  • Clustered and multi-threaded architecture to support massive horizontal scalability;
  • A metadata-based data model enabling unlimited extension and automated upgrade;
  • User interface frameworks supporting building large numbers of screens with complex components such as sortable listviews, filtered typelists, cross-field validation and embedded functional “widgets”;
  • Support for complex screen flows with extensible business logic;
  • Security and community modeling enabling a rich hierarchy of users, groups, and roles, including external users and organizations;
  • An integration layer supporting multiple integration channels including event-based messaging, web services, custom adapters, and dedicated APIs;
  • Security infrastructure and design principles to thwart sophisticated new models of Internet-based security attacks; and
  • Native performance testing and tuning tools, including dedicated test harness, automated test suite, and large volumes of sample data.

Despite being well-established, standards such as J2EE and .NET do not yet provide extensive enough development frameworks simply to dive in defining business logic and creating screens.  To fulfill these “platform-level” requirements, a development team cannot merely select attributes from a menu of choices.  Rather, many person-years of technically demanding foundational work must be invested before end user-visible functional work can even begin.  Most P&C carriers have rationally concluded that there is little value and significant risk to re-invent the wheel at this foundational level, unless there were good reason to believe no vendor has gotten it right.
A third consideration is flexibility.  If indeed business process and product flexibility are key motivations for undertaking core system replacement, replacement systems must support dramatically greater and easier adaptability to changing business requirements.  This is an especially vital requirement in light of the high switching costs, and therefore extended target lifespan, of core systems.  In short, a new policy administration or claims system must not only meet the universe of business requirements specified today, it must be architected to maximize support of future requirements not yet specified, or even imagined.  The requirement for generality, therefore, is not merely the concern of software vendors striving to meet as broad a segment of the market as possible; rather, it should be an inherent requirement of every organization maximizing the longevity of its IT investments.  Unlike the legacy generation of core systems, modern applications can be architected for upgradeability and configurability in virtually all its key dimensions: user interface, business logic, data model, organizational hierarchy, screen flows, and so forth.  Building for this level of future adaptability imposes a considerable additional development burden – a burden which both the software engineering skills and investment disposition of most P&C carriers are ill-equipped to bear.
Fourth, the buy decision supports a logical division of labor between the competencies of a software vendor and a carrier’s IT organization.  The internal resources who thoroughly understand the business and system environment can focus on requirements gathering, legacy system documentation, business process re-design, and planning for system migration while the software vendor remains accountable for system architecture, product features, product performance and quality, and integration.  Because business analyst personnel and end users are on the more solid terrain of interacting with a working base application, their input and gap analysis can be fine-grained and iterative, rather than high-level and theoretical.  Because legacy system experts can write integration code against a working system, they can proceed more rapidly to testing actual integration, rather than planning potential code on whiteboards. Because the vendor application has an implementation history at other customers, the joint implementation team can estimate project tasks and overall duration with far greater confidence.  And because the software vendor is highly motivated to continue to evolve the application, an upgrade path of enhancement avoids the functional stagnation inevitable in a custom development effort which must eventually declare victory or failure.
Fifth, a vendor solution can offer a surer course to true core system replacement than a build effort which may lose its will before achieving the goal.  For all but the smallest of P&C carriers, both buy and build approaches will typically require multiple phases – organized by function, line of business, or business unit – before a core system and all its integrations can be replaced.  Regardless of how many phases are planned along the implementation path at any given customer, leading-edge applications are designed with the functional target of assuming full system-of-record responsibility, eliminating the technology risk of a “stranded Phase 1” lacking the functionality or architectural foundation to replace the legacy system with which it may initially coexist.
In the aggregate, these five considerations have less to do with cost than risk. Because of the scale and effort of any core system project, the consequences of even an “inexpensive” failure can exact a devastating cost on an organization’s focus, morale, and future competitiveness. And if it is true that replacement of legacy core systems is not a luxury but a necessity over the coming decade, then no organization can afford to spend years in an effort that brings it no closer to its next generation system platform.  Hence, while any potential “build” effort is limited only by an organization’s optimism and imagination, the inherent risk and complexity of a core system development heavily weight the tangible assets and implementation track record – even if limited – of a packaged application built on the right architecture.
Conclusion: Finding the right technology partner
The multiple advantages of “buy” just described, of course, assume that a quality vendor alternative is available at all.  Guidewire Software itself was founded precisely because of its founders’ conviction that the P&C industry had in fact been underserved by software solutions during the past decade, and that the industry would need next-generation core systems to replace the faithful, but superannuated mainframe systems supporting all of its core processing.  Hence, in arguing for the long-term urgency of legacy replacement and the clear advantages of buying rather than building, this paper does not suggest that carriers have an abundance of equally good options.  Guidewire believes it may be unique in approaching the challenge of delivering the next generation of policy, claims, and billing systems to the P&C industry as a lifetime goal worthy of assembling world-class development and implementation teams to serve.

Marcus Ryu is co-founder and Vice President of Strategy and New Products for Guidewire Software, Inc. Guidewire is an enterprise software company focused entirely on the development and delivery of superior web-based core systems to the property and casualty insurance industry. Marcus’ responsibilities for Guidewire include product strategy, corporate development, and product marketing; he also serves on Guidewire’s board of directors. Before co-founding Guidewire in 2001, he was Vice President of Strategy for Ariba, Inc., an enterprise software and consulting firm providing procurement and spend management solutions. Prior to Ariba, he was an Engagement Manager at McKinsey and Company. Marcus has an A.B. from Princeton University, and a B. Phil from New College, Oxford University.