Opinion: Technical Debt & Legacy IT Could Sink a Few Insurers

A thought-provoking article in The Economist prompts DevOpsGroup co-founder Steve Thair to urge insurers to get to grips with technical debt.

The Economist’s recent article on the future of insurance, Run for Cover, has a stark warning for the sector. It says incumbents risk being disintermediated or replaced by non-traditional rivals unless they innovate and transform.

Four core trends and risks are highlighted:

1. Big Data techniques, and increasing commodification of data, mean leveraging existing data assets and plugging into new sources of data from third parties is a key competency.
2. Insurance risk is becoming less predictable and the impacts more severe. Issues are rooted in complex and far-reaching factors such as ageing population, cyberthreats and climate change.
3. There’s a shift in the nature of assets from tangible (property, plant and equipment (PP&E)) to intangible (intellectual property (IP), brand), which is inherently harder to price.
4. Customer expectations are changing, especially amongst Digital Natives. They expect seamless, fast and stylish ‘customer experiences’ across online, mobile and in-person interactions. This creates problems for ‘traditional’ insurers, particularly those with dated broker-centric channel models.

What’s hindering transformation?

While many insurers are talking about transformation, it seems the reality doesn’t match the hype. In BCG’s innovation rankings, the insurance sector comes second last. What’s more, insurers’ annual spend on computing technology is less than half that of banks and the range of ‘innovative ideas’ tends to be narrow.

These challenges are compounded by the increasing amount of money being poured into InsurTech: $1.42Bn in Q12019 according to Willis Towers Watson. If that pace is sustained for the entire year it will hit $5.68Bn. And assuming most InsurTech business plans tout at least 10x returns, that’s a bet on a $56.8Bn valuation, much of which will represent a transfer of wealth from incumbents to disruptors, not the creation of new markets. In fact, The Economist makes it clear that the overall insurance market is shrinking, or to look at it another way the ‘protection gap’ is widening, with fewer organisations and individuals taking comprehensive cover.

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There is an urgent need for insurers to adapt to these volatile circumstances. But technical debt is a major issue for many, obstructing efforts to innovate and transform.

Technical debt is the accumulation of sub-optimal technical decisions made over the lifetime of an IT application: Do we upgrade to the latest version? Do we automate the testing? Do we integrate systems to build a single view of the customer? And so on. The impact of technical debt is that it gets harder and harder to change things – it’s the sand in the gears that causes IT initiatives to grind to a halt.

Calculating the true cost of technical debt

It’s useful to quantify this from a financial perspective.

Many traditional organisations spend 70% or more of their IT budget on Business as Usual (BAU) and just 20% on innovation and new value-added services (the remaining 10% goes on overheads and running costs).

By contrast, high-performing IT organisations, with lower levels of technical debt, spend 40% of their IT budget on BAU, and 50% on innovation and continuous improvement.

This 30% difference in BAU spend is essentially the ‘interest payment’ on technical debt. And figures surrounding insurers’ comparatively low level of spend on computing technology suggest it’s unlikely that the principal of technical debt is being paid off.

If the idea of wasting 30% of IT budget on technical debt every year isn’t enough to give insurance CFOs apoplexy, let’s calculate the principal on that technical debt. This gives a rough indication of what you might need to spend to reduce it, so transformation initiatives can succeed, and innovation can proceed at pace to meet customer expectations (and avoid disruption from new entrants).

Taking an annual IT budget of £100M, the technical debt interest payment is £30M/year. Comparing this to repayments on financial debt, we can use a notional interest rate of 5.5% (according to KPMG, the weighted average cost of capital (WACC) in 2017 was 6.9%, and according the UK regulators the pre-tax cost of debt in the telecoms sector was 4% so let’s go for the middle of that range).

In this scenario, the technical debt principal is £545M. This is a ballpark figure of what you might need to invest to modernise IT capability and meet digital economy demands.

Or we can calculate it another way. Let’s assume the insurance sector has been systematically under-investing in IT relative to the financial services sector by 2x since the 2008 global financial crisis (when many IT budgets were slashed). That equates to £100M * 10 years = £1Bn in accumulated technical debt.

Regardless of which figure you use – £545M or £1Bn – it’s clear that IT modernisation requires significant investment. And it’s interesting to speculate the attention this would command in board rooms if CFOs were forced to carry technical debt on the balance sheet like any other liability.

Tech modernisation is essential, but it’s no silver bullet

It would be unrealistic to suggest that technical debt should be paid in one installment, or that it should never be incurred. In fact, in many circumstances technical debt is a necessary by-product of growth. However, it does need to be acknowledged, then managed proactively and intelligently to avoid repercussions which may prevent long-term success. Furthermore, it should be considered as part of an holistic modernisation strategy that also covers factors such as culture, organisational structure and ways of working.

In the digital economy, IT needs to transition from ‘cost centre’ to ‘strategic enabler’, making businesses inherently adaptive to external factors and evolving customer demands. That means rethinking the delivery of services and capabilities from the ground up.

Ultimately, it is down to CEOs to choose whether to lead their organisation into the future of insurance or remain in the familiar (declining) world. But failing to act is a choice too.

Whether the choice is action or inaction, there will always be consequences.