Actuarial Notes

Business-Level Strategy

Study guide: Exam CP-311

Business-Level Strategy is the integrated set of commitments and actions a firm uses to gain a competitive advantage in a particular product market, by exploiting its core competencies to serve chosen customers. Hitt, Ireland and Hoskisson describe five such strategies, formed from the source of advantage (lowest cost or uniqueness) and the competitive scope (broad or narrow): cost leadership, differentiation, focused cost leadership, focused differentiation, and the integrated cost leadership/differentiation strategy.

\Pi = q \times (P - C)

\pi - \bar{\pi} = (P - \bar{P}) + (\bar{C} - C)

  • Symbols: q is the number of units sold, such as policies in force, P is the price per unit (the premium) and C the full cost per unit (claims, expenses and the cost of capital). \pi = P - C is the margin, and the barred values are industry averages. A cost leader earns its advantage through \bar{C} - C, and a differentiator through P - \bar{P}.
  • The customer questions: A business-level strategy answers who the firm will serve, what needs it will satisfy, and how, meaning which core competencies it will use. An insurer might serve young families, meet their need for cheap protection, and do it with automated underwriting.
  • Cost leadership: The firm sells a standard, acceptable product to a broad market at the lowest cost, through scale, a lean value chain and simple products. Its risks are that a competitor's new technology removes the cost edge, that cutting cost blinds the firm to changes in what customers want, and that rivals imitate its processes.
  • Differentiation: The firm offers features customers value and will pay for, such as brand, service, advice, underwriting flexibility or riders, and recovers the extra cost through price. Its risks are that customers decide the premium over cheaper products is too large, that the feature stops being valued, that experience teaches customers they can do without it, and that imitations narrow the difference.
  • Focus strategies: Focused cost leadership and focused differentiation apply the same logic to a narrow segment, such as a region, an occupation or high-net-worth clients. They fail if a competitor focuses on a narrower part of the segment, if a broad competitor decides the segment is worth serving, or if the segment's needs converge with the broad market's.
  • Integrated strategy: The firm pursues low cost and some differentiation at once, often with flexible technology and processes. Done well it serves a wide range of customers, but its risk is ending up "stuck in the middle", with neither the lowest cost nor a difference customers will pay for.
  • The five forces link: Each strategy defends against Porter's Five Forces. Low cost leaves margin when buyers or rivals push price down and deters entrants who lack scale, while differentiation builds loyalty that weakens buyer power, substitutes and rivalry. The value chain shows where the cost or the uniqueness is created.

Cost Leader and Differentiator in Term Life Two insurers sell 20-year term life. Insurer L is a cost leader that sells online with automated underwriting: its annual premium per policy is $400, its full cost per policy is $370, and it has 100,000 policies. Insurer D is a differentiator that sells through advisers with flexible underwriting and conversion riders: its premium is $520, its cost is $460, and it has 45,000 policies. Compare their profits, and find the volume D needs to match L.

Answer

\begin{align*}
\Pi_L &= 100{,}000 \times (400 - 370) \\
&= \$3{,}000{,}000 \\
\Pi_D &= 45{,}000 \times (520 - 460) \\
&= \$2{,}700{,}000 \\
q_D^{*} &= \frac{3{,}000{,}000}{60} \\
&= 50{,}000
\end{align*}

L earns $30 a policy on a large volume, and D earns twice the margin on less than half the volume. D needs 50,000 policies, about 11% more, to match L's profit. The two strategies can both be profitable because they serve different customers: price-sensitive buyers who are comfortable online, and buyers who value advice and flexibility.

When Each Strategy's Risk Arrives Continuing the previous example, consider two shocks separately. First, an insurtech with a full cost of $350 per policy enters and prices at $380, and L must match to keep its 100,000 policies. Second, customers stop valuing D's riders and advice, so D can charge no more than L's $400 while keeping 45,000 policies. Find each insurer's new profit.

Answer

\begin{align*}
\Pi_L &= 100{,}000 \times (380 - 370) \\
&= \$1{,}000{,}000 \\
\Pi_D &= 45{,}000 \times (400 - 460) \\
&= -\$2{,}700{,}000
\end{align*}

L stays profitable but loses two-thirds of its profit, which is the cost leader's risk of a rival with better technology. D loses money, because its cost base was built to deliver a difference that customers no longer pay for. D's response is to find a feature customers will still pay for or to cut its cost, and failing at both leaves it stuck in the middle.

How it appears on the exam

  • CP-311: Questions describe an insurer, its customers and its competitors, and ask the candidate to assess its current business-level strategy and recommend one for a given situation. Strong answers name the strategy, tie it to the firm's core competencies and value chain, explain how it defends against the relevant five forces, and state the risk that comes with it.
  • CP-311: Some questions give simple price, cost and volume figures, as in the examples, and ask which strategy is more profitable or how a change in the market affects each.

Exam traps

  • Business-level versus corporate-level: Business-level strategy is about how to compete in one market. Which markets and businesses to be in is corporate-level strategy, and confusing the two is a common error in written answers.
  • Low price is not cost leadership: Cost leadership means the lowest cost, not the lowest price. A firm that cuts price without a cost advantage is buying volume at a loss, which in insurance invites adverse selection as well.
  • Differentiation must be valued: A feature counts only if customers will pay more for it than it costs. Listing features without the price premium they earn misses the point of the strategy.
  • Integrated is not a compromise: The integrated strategy works when flexible systems deliver both advantages at once. Describing it as halfway between the two strategies describes being stuck in the middle, which is its risk.