On Business Strategy

On Business Strategy

By expanding their knowledge base, actuaries can develop a broad business perspective which in combination with the analytical skills characteristic of the profession can help them succeed in the areas of strategy and general management.

By Carlos Sanchez–Fuentes

It is hardly necessary to point out the value of strategic thinking in a variety of human endeavors;¹ recently the subject has even become fashionable. The central tenet of books that have popularized the subject is as follows: the "best" strategy entails emulating the actions to which a select group of firms owe their success. The authors of such works try to list and explain the "winning" principles in an easily understandable language that is neither too broad (e.g., reduce costs) nor too narrow (e.g., set the area factor at 1.25 in zip code XYZ for product ABC). With a seemingly inexhaustible supply of such "recipe" books, each one prescribing an original formula, one might suspect that no one–size–fits–all formula will ever be uncovered.

In contrast to this prescriptive approach, business strategy relies on quantitative models, abstract constructs that selectively capture aspects of the market participants' actions. Further, strategists recognize that behaviors are determined by each player's characteristics, their interactions with each other, the rules of engagement, and the environment in which they operate. Whether the features that distinguish one company from another are easily identifiable (e.g., assets) or elusive² (e.g., culture), they establish the unique best strategy for any given firm, which must evolve continuously to adapt to the changing conditions of the firm and its environment.

Economics provides flexible, yet robust, frameworks to analyze aspects of the financial world; other disciplines like Political Science, Sociology, Psychology, History and even Literature, when applied creatively, can enrich our understanding of the problem at hand. This understanding, though incomplete, is the first step towards crafting strategy; thereafter, the decision maker must develop an action plan that relies on professional training, experience, vision and critical thinking—the richer the background of the analyst, the better.

This paper has two purposes: (1) to demonstrate through the use of an econometric model how a robust framework can facilitate targeted inquiry and guide the decision maker in the development of an action plan; (2) to argue convincingly that actuaries interested in strategy and general management need to actively cultivate a broad knowledge base.

Example 1—An Insurance Problem in an Econometric Context

A key observation about Economics is that some of its fundamental principles are simple,³ yet powerful; this means that a solid background in the subject, even a modest one, is essential for the strategist. The case for this assertion can be better made with an example. Suppose that an insurer (company A) which has been the dominant player in a given market selling a certain medical product is challenged by a carrier (company B) that prices competitively identical offerings. The incumbent has to decide between lowering premium rates (thus increasing its loss ratio) or maintaining margins but losing market share. How can company A evaluate its position and assess possible courses of action? An econometric model can be useful for this analysis.

First, assume that the demand functions for incumbent and challenger B are given by

• Q_A= α_A – β_A Ρ_A + γ_A Ρ_B
• Q_B= α_B – β_B Ρ_B + γ_BΡ_A

respectively, where

• Ρ_A represents the price charged by Company A
• Q_A represents the number of policies sold by Company A

Similar definitions apply to Ρ_B and Q_B . The parameters α_A, α_B, β_A, β_B, γ_A,γ_B are positive and unknown.

If k_A and k_B represent the respective marginal costs, that is, the sum of claims and variable expenses per policy, then the incumbent's profit function can be expressed as

π_A = (Ρ_A – k_A) Q_A

In other words, company A's profit equals the gain per policy times the number of policies sold (actuaries typically express profit as a function of total premium, variable expense ratio and loss ratio).

Maximization conditions require the marginal profit of both companies to be zero at critical points; that is, earnings are optimized when the sale of an additional policy does not increase portfolio profits. It turns out that the prices charged by incumbent and challenger can be expressed in terms of the demand functions' parameters:

• Ρ_A= Ρ_A (α_A, α_B, β_A, β_B, γ_A, γ_B, k_A, k_B )
• Ρ_B= Ρ_B (α_A, α_B, β_A, β_B, γ_A, γ_B, k_A, k_B )

and also as a function of each other:

Ρ_A= Ρ_A (Ρ_B, α_B, β_B, γ_B, k_B )

Although it is impractical, perhaps unfeasible, to find out the parameter values, the model is still valuable. Employing it, however, requires a paradigm shift: one must abandon the quest for quantitative certainty (or the illusion of it) and embrace the less ambitious frame of mind that seeks insights. For the new paradigm to function, one has to make use of any knowledge that is relevant to the case at hand, and synthesize information that, at times, may be conflicting; and one must feel comfortable accepting a certain degree of uncertainty that cannot be controlled.

To start, let us take for granted that consumers are price–elastic, that is, their choice of carrier is mainly a function of price. Under these circumstances we can speculate (but the speculation must be grounded on a solid understanding of Company A's environment) that the demand functions are similar, and assume that they are equal. Our attention is then directed to the marginal cost, k: what factors, other than retained earnings, determine the amount of benefits that policyholders receive for each dollar of paid premium? The analyst may consider the following:

• Which carrier has negotiated more attractive reimbursement terms with providers?
• Which carrier has the better utilization program?
• To what degree is anti–selection affecting the incumbent as some members—perhaps the best risks—transfer their policies to the challenger?
• How do commissions compare between the two companies? Producers have an incentive to funnel business to the company with the most generous compensation structure. Table 1

Company A has a higher variable cost structure. The Nash Equilibrium Point, which identifies the optimal price for each of the two firms, is given by the intersection of the Best Response Functions.

The issue at hand is to compare the variable cost structures of incumbent and challenger to determine the magnitude of k_A – k_B and then focus attention to areas of concern. Let us assume that competitive research⁴ shows that the marginal cost of the challenger is lower (k_A – k_B > 0) due to more favorable provider arrangements. With this information it is possible to plot directionally the price functions, known as Best Response Functions, of each carrier.⁵ The econometric model shows that the prices under which Companies A and B maximize profits are given by the intersection of the best response functions, called the Nash Equilibrium Point: it is here that the optimal balance between loss ratio and market share is reached. In the Nash Equilibrium Point the price charged by the incumbent is higher than the price charged by the challenger. Furthermore, Company A's best response function is such that when faced with premium reductions by Company B it should respond in kind, but less aggressively; in other words, the incumbent should accommodate the challenger and resist the temptation of waging a price war.⁶

The business ailment thus diagnosed, the incumbent must address the fundamental problem, namely, that it finds itself at a disadvantage on negotiations with providers. This issue is critical and for some managers it may well be the most valuable aspect of the analysis.

Suppose that in due course the incumbent is able to level off the marginal cost difference (k_A – k_B = 0) . What then are the optimal pricing strategies for both companies? Contrary to what intuition may suggest, the Nash Equilibrium Point will not be reached when the incumbent decreases premium rates and the challenger increases them, but when both reduce them to some extent instead, more so the incumbent. This result is obvious from the graph: with a lower marginal cost, Company A's best response function shifts downwards and the Nash Equilibrium Point moves Southwest.

For the purpose of this paper it is not necessary to continue the example (e.g., what would Company A's optimal pricing strategy be if Company B decides not to adjust premium rates?). It should be clear that setting up a financial problem with an appropriate framework allows the decision maker to understand the particular circumstances of the company and gauge the effects of initiatives aimed at improving the condition of the firm.

Examples 2 and 3—Strategy Broadly Applied

Strategic thinking is equally useful to decision makers in situations that require the ability to integrate diverse components into a coherent whole. The creation of Wal–Mart demonstrates the successful execution of strategic planning at the corporate level; a second case, Bismarck and the unification of Germany, illustrates the use of strategy at the highest national and political levels.

Wal–Mart is a textbook example of strategic planning. Sam Walton realized that small towns, hitherto unattractive to large retailers, represented ideal locations to operate due to the absence of competition for first movers, and the stiff entry barriers for second movers. By opening stores in contiguous towns, Walton avoided cannibalization among his stores and discouraged new entrants from establishing a presence in their neighborhoods. As Walton's empire grew, he was able to extract price concessions from suppliers which, in combination with best–in–class logistics, resulted in low costs that attracted consumers, further deterring potential competitors. With these capabilities, Wal–Mart expanded beyond small towns, launching successful attacks in urban settings against established discounters such as K–Mart. Clearly, Sam Walton's success was not so much the result of financial sophistication—although it certainly played a role—but the product of strategic planning and precise execution.

The unification of Germany, engineered by Otto Von Bismarck, represents a clear example of strategic mastery and, some would argue, political genius. Bismarck's plans synthesized an understanding of the German ethos, knowledge of international relations, and military expertise. His plan was to subject weak states in the German Confederacy to Prussian rule, invoking nationalism instead of the more palpable benefits of economic prosperity and military safety.⁷ He achieved this through three wars, the last of which was "manufactured" to unite the hearts of the peoples living in the Germanic states. The unification of Germany was the product of Bismarck's willingness to focus on the long–term view and to undertake risky projects in the course of carrying out his plans—two qualities that have become rare in U.S. business practices (see "Managing Our Way to Economic Decline," Suggested Readings).

Strategic Thinking Requires a Broad Knowledge Base

Because business situations are often complex, we must guard against the temptation of blindly applying precepts derived from a context different from our own, no matter how similar they may appear to be. Actuaries rarely follow "recipes," but instead analyze problems in detail; this inclination is a natural byproduct of actuarial training, which historically has been appropriate and continues to be so for those who practice in traditional fields. However, actuaries with interests in strategy and general management—or perhaps all professionals—can become more effective players by expanding their knowledge base and expertise in different directions. To be explicit, an actuary who thinks strategically is an individual who has not only mastered his/her immediate trade but who has also explored Economics, Marketing, Human Resources⁸ and other disciplines. Familiarity with both classical and contemporary sages and the lives of leaders in the vein of Bismarck, Carnegie, Neeleman (JetBlue), Zimmer (The Men's Warehouse) would also be of great value. Above all, the strategist is an individual endowed with a healthy intellectual curiosity who makes concerted efforts to cultivate and apply multi–dimensional critical thinking.

Carlos Sanchez–Fuentes, FSA, MS, MBA, FCA, MAAA, is vice–president at ReAct Consulting International. He can be reached at carlosfuentes@reactconsultingintl.com.

Footnotes

1. Historical examples include the stratagem that gave Greece the edge over Troy described by Virgil in The Aeneid, and Bismarck's masterful plan to unite Germany; more recent ones involve Toyota's manufacturing strategy, and Southwest Airlines' lasting success in an industry plagued with bankrupt firms.
2. It is dangerously risky and frightfully common to disregard charac– teristics that manifest themselves in the long term or are difficult to quantify. Interesting cases where "intangibles" made the institution either a success or a failure include Horatio Nelson's career as an admiral, Southwest Airlines, and The Portman Hotel (see the list of suggested readings).
3. Simple in the sense of being easily understood once explained. It will invariably take a person of genius to uncover and express them concisely.
4. In The Art of War Master Sun acknowledges that obtaining a rival's information often entails the deployment of substantial resources, human and material; at the same time, he points out, intelligence in the hands of able Generals is a formidable weapon. The similarities between warfare in 5^th Century BCE China and business competition in modern times are remarkable.
5. Recall that Ρ_A can be expressed as a function of Ρ_B and vice–versa.
6. There are circumstances under which a price war may prove to be the optimal (although perhaps illegal) strategy, even if it depresses profits in the short run. The point to make, once again, is that the best course of action depends on the particular conditions of each firm.
7. Here is one of those situations in which the role of self–interest, at least temporarily, is overshadowed by other considerations (pride). Machiavelli recognized this human trait when he appealed to the Prince's virtú to restore order in Italy. See also the article on "Neuroeconomics" in the list of suggested readings for a review of thought–provoking ideas on the foundations of economic theory, including emotional mental processing.
8. It would be redundant to stress the value of enlightened HR policies, were it not for the fact that only a select number of firms are committed to them. The records unmistakably demonstrate the importance of people management as a strategic source of competitive advantage—Napoleon went to extremes to gain his people's hearts; so did Southwest's Herbert D. Kelleher.