by: Anthony O'Donnell, Insurance & Technology

Indeed, the failure of AIG was properly understood as a demonstration of the strength of insurance companies, given that it was the holding company's dalliance in unregulated transactions that caused the failure, while the insurance operations of subsidiaries continued to exhibit vigorous financial health.

The sheer magnitude of the crisis, however, meant that insurers would be significantly affected in a variety of ways. As institutional investors, insurers would suffer both for their stock holdings in troubled companies and as a result of the declining values of their investments in general as the securities markets plummeted. General economic decline inevitably will have further consequences for insurers' bottom-line earnings in terms of both investment and premium income.

But whether insurers will benefit from consumer and investor distrust in banks and securities is an open question. Right or wrong, the failure of AIG implicates the entire insurance industry's involvement in the financial crisis, and that may affect insurers not only in terms of sales and investment, but also on the regulatory front.

Regulatory Fallout

As early as February 2007, Treasury Secretary Henry Paulson commented favorably on an optional federal charter (OFC), and his ''Blueprint for Financial Regulatory Reform'' reinforced support for an OFC. As the crisis worsened, a group of legislators led by New Hampshire Senator John Sununu made a public appeal in an essay published by The Wall Street Journal on Sept. 23 that was, in turn, tartly refuted by NAIC president and Kansas Insurance Commissioner Sandy Praeger in a letter to the Journal's editor three days later.

Among other points, Praeger noted that ''AIG ... is a federally regulated holding company under the jurisdiction of a federal regulator. ... And its problems arose under the watch of a federal regulator.''

Given the state-regulated insurance industry's performance relative to that of the banking industry, ''The NAIC and other proponents of continued state regulation will have no problem making their case,'' comments Matthew Josefowicz, insurance practice leader for New York-based Novarica. ''The crisis is likely to take the wind out of the sails of OFC.''

But others are not so sanguine, pointing out that, as obvious as the contrast between the insurance and banking industries' performance may be to industry insiders, the public simply sees an out-of-control financial services industry. Given the federal government's lavish use of public funds to provide a remedy, the public will expect the government to play a role in prevention, according to the argument, and the insurance industry is likely to be affected along with other segments.

Federal insurance regulation will be on the agenda for both Congress and whomever is elected president, believes Howard Mills, chief adviser of Deloitte's insurance industry group and former New York insurance commissioner. ''Parts of the Paulson Blueprint that were formerly seen as having no chance will now be looked at, and the idea of an OFC giving the federal government more of a say in the regulation of insurance will be very much on the table,'' Mills says. ''I find it difficult to envision a situation where Congress is going to look at the regulation of the financial services industry and not insert itself more proactively in the business of insurance.''

Public impressions of the insurance industry's involvement in the crisis were likely magnified by the plunging stock prices in late September and early October of some of the largest insurers, including New York-based MetLife and The Hartford. Following reported informal merger discussions at those companies, The Hartford took on a $2.5 billion investment from Munich-based Allianz. Such moves prefigure increased merger and acquisition activity in the industry, according to Boston-based Celent's recently released report ''Bad News on the Street: Insurance IT Strategy and the Financial Crisis,'' which states that ''companies will combine through government-forced shotgun marriages or voluntary elopements.''

Deloitte's Mills also anticipates that many carriers will entertain opportunities for inorganic growth that they might not have considered two months ago. ''The insurance industry seems fairly well situated, given what's going on right now, and that all goes back to its very strenuous reserving and solvency requirements,'' he comments.

While insurers need to do a better job of communicating the financial strength of the industry to consumers, even as things stand the insurance industry may benefit from investors' and consumers' skittishness about trusting their wealth to banks and securities firms, Mills believes. The retirement space in particular points to opportunities for insurers to realign their business strategies, he says, as consumers reevaluate their financial preparedness.

''I see the retirement space as a major area and believe that people may look to insurance as a safer haven than some other slices of the financial sector,'' Mills states. ''The insurance industry is well positioned to provide products and services that could help address those concerns.''

Stable IT Budgets

Technology spending will be a critical factor for insurers wishing to both take advantage of these opportunities and address the inevitably heightened compliance and risk management concerns raised by the financial crisis, Mills adds. ''Cutting IT spending is not a viable option,'' he asserts. ''There is too much risk in not updating infrastructure.''

Even before the most intense phase so far of the financial crisis had struck, research indicated that insurers were determined to continue to invest robustly, if somewhat less aggressively, in technology despite an economic downturn. The third annual joint IT spending survey conducted by Gartner (Stamford, Conn.) and the Property Casualty Insurers Association of America (PCI) found that P&C insurers' spending growth would decrease, with 2008 to 2009 spending increasing 1.9 percent, compared to an 8.1 percent jump in the previous annual cycle. Even with diminished growth, however, IT spending still outpaced change in revenue, with IT spending in 2008 representing 3.6 percent of the previous year's revenue, compared to 3.0 percent in 2007.

P&C insurers have also improved their maintenance-to-new development ratio, with 60 percent of budget dollars dedicated to ''lights-on'' spending this year, according to the Gartner/PCI study. ''This is down from 65 percent in 2006, indicating that these companies are able to invest in the future in a tough economy because they have become more productive in their day-to-day operations,'' comments Eric Stegman, associate director of Gartner's consulting department.

Following the passage of the government's $700 billion bailout plan, Celent forecast budgets either remaining flat or declining by 2 to 3 percent, having earlier predicted modest increases on the same scale. Speaking on a webcast to announce the figures, Celent analyst Donald Light said that while the picture remained fluid, insurers were not panicking and were unlikely to drastically revise budgetary plans that were largely formed by this time of year.

Catalyst for Sustainable Efficiency

Light expressed the opinion common to many analysts and other industry observers that the need for technology transformation at insurance carriers is at least as important in the wake of the crisis as it was prior to its arrival. The emerging industry consensus is that as investment income declines, insurers will look to IT to drive better underwriting results and to improve operational productivity and efficiency.

''For most carriers today, IT spending is a necessary catalyst for efficiency,'' observes Light's colleague, Craig Weber, SVP and insurance practice leader at Celent. ''In addition, there is so much work going on that carries over one budget season to another, and all the easy-to-kill projects were dumped years ago.''

Weber expects to see a return to cost-consciousness and a focus on spending discipline but not to the extent that strategic transformations and efficiency-focused initiatives will face cut-backs. He also foresees increased spending in targeted areas. ''Categories such as compliance and data mastery are almost certain to see increased action, some of which will be mandatory,'' he notes.

Current economic conditions provide an opportunity for carriers to achieve sustainable cost reduction, which will facilitate greater nimbleness in the future, asserts Michael Costonis, a partner with Accenture (Chicago). Costonis sees ''a combination of IT spend rationalization, organizational efficiency improvements and process improvements. This will require a 'rack and stack' of current initiatives to realize these improvements and deliver cost savings.''

Though IT budgets may remain flat, according to Costonis, technology must play a role in carriers' pursuit of greater profitability through core business operations. ''This means underwriting for a profit, processing at the right unit costs per transaction, and pursuing smart and tactical growth opportunities, both organic and inorganic,'' he says. ''The market will separate the winners from the losers -- having the right cost structure will be critical to determining which side of the line individual insurers will end up on.''

While insurers will be more motivated than ever to drive cost out of their organizations, IT provides a better option than outsourcing non-core activities, Costonis contends. ''If you look at the relative benefit of applying cheaper labor to a business problem versus applying automation, automation is a much more sustainable solution over the long term,'' he asserts.

And while the life and annuities business may be harder hit than the P&C sector -- owing to diminished consumer confidence in financial services industries -- life insurers still badly need strategic IT capabilities that are, if anything, more important under current conditions, according to Novarica's Josefowicz. ''With the marketplace in flux, competitive position becomes even more important, and insurers need IT improvements in order to compete in speed to market and service levels.''

Investing in Risk Management

The financial crisis has also called attention to the need for better risk management-related capabilities. Much has been written in the media about the failure of risk modeling to prevent the crisis, and some observers have noted how technology helped mask poor risk management. However, just as bad accounting isn't an argument against accounting itself, neither do examples of bad risk modeling constitute an argument against the need for the complex calculations that power such modeling.

The best risk models are vulnerable to the garbage-in, garbage-out phenomenon, and the number and quality of sources of input will affect the reliability of output. ''A consortium approach to data acquisition and subsequent modeling is necessary to avoid building models that have very limited scope,'' says David West, SVP, Valen Technologies (Denver). Furthermore, models have limited shelf life. As the multiple factors influencing risk change, the risk of a given investment may also change, and sometimes dramatically.

On top of these challenges and limitations, ''Models do not give black-and-white predictions -- everything is described in varying shades of gray,'' West adds. ''Yet banks and insurers want clear-cut decisioning.''

Insurers in particular suffer from poor-quality data that can influence the perception of risks, cautions Stuart Rose, insurance marketing manager, SAS (Cary, N.C.). And even where insurers successfully model one area of risk, the results can be dangerously misleading if not correlated with other pieces of the enterprise risk picture, according to Rose. To avoid missing the vulnerabilities associated with risk interdependencies, insurers need to take enterprise risk management seriously, beginning with the key technology capabilities, including an enterprise data repository, he insists.

''Without that foundation, you're always going to struggle,'' Rose says. ''Once you've built that, you need to put in place predictive modeling and some kind of competency center or group that oversees all the models, and makes sure that they're up-to-date and that they are applicable to your current business model.''

Kathy Burger and Nathan Conz contributed to this story.