Actuarial Notes

Porter's Five Forces

Study guides: Exam DISC-RM, Exam CFE-201, Exam CP-311

Porter's Five Forces is Michael Porter's model of industry structure: the rivalry among existing competitors, the threat of new entrants, the bargaining power of buyers, the bargaining power of suppliers and the threat of substitutes together determine how much of the value an industry creates its firms can keep as profit. Value chain analysis is its companion at the level of the firm, finding the firm's internal strengths and weaknesses, and SWOT analysis sets the external picture beside the firm's own strengths and weaknesses. All three are tools for building a business strategy.

\pi = P - C

\bar{\pi} = \bar{P} - \bar{C}

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

  • Symbols: P and C are the firm's price and cost per unit sold, and \pi is its profit per unit. \bar{P}, \bar{C} and \bar{\pi} are the industry averages. The five forces set the industry average \bar{\pi}, because powerful buyers push prices down and powerful suppliers push costs up. The firm's competitive advantage is \pi - \bar{\pi}, which comes from a higher relative price, a lower relative cost, or both.
  • Rivalry among existing competitors: Rivalry is most damaging when it is fought on price, because price cuts pass value straight to buyers. It is intense when there are many competitors of similar size, products are hard to tell apart, and exit is costly. Personal lines insurance, sold as a standardized product to customers who can compare prices, is a common example.
  • Threat of new entrants: The threat limits how high prices can go, since high profits would attract newcomers. For insurers, the barriers include the capital that solvency regulation requires, licensing in each jurisdiction, access to distribution, and the claims data needed to price accurately, while insurtech entrants and new capital after a hard market test those barriers.
  • Bargaining power of buyers and suppliers: Buyers are powerful when they are large, buy in volume, face low switching costs or can easily compare prices. Large commercial accounts and the brokers who place them have more power than an individual auto buyer. An insurer's suppliers include reinsurers, capital providers and the producers who control access to customers, and each gains power when there are few of them or the insurer can't easily switch.
  • Threat of substitutes: A substitute meets the same need in a different way and caps the price an industry can charge. Substitutes for commercial insurance include self-insurance, captives, risk retention groups and insurance-linked securities, and buyers turn to them when insurance becomes expensive, as it does in a hard underwriting cycle.
  • Value chain analysis: A firm's value chain charts the path by which its product is created and sold, and the product becomes more valuable to the buyer at each step. Primary activities create and deliver the product; for an insurer these include marketing and distribution, underwriting, policy issuance and claims. Support activities, such as firm infrastructure, human resources and technology, underpin them. Value chain analysis finds the internal strengths and weaknesses, and VRIO asks whether a strength is valuable, rare, hard to imitate and supported by the organization, and so a source of competitive advantage.
  • SWOT analysis: Strengths and weaknesses are internal to the firm, and opportunities and threats are external. The five forces are a structured way to find the opportunities and threats, the value chain is a structured way to find the strengths and weaknesses, and the strategy should use the strengths to pursue the opportunities while defending against the threats.

Where a Direct Writer's Advantage Comes From With illustrative figures, the average personal auto insurer in a market charges $1,500 per policy, with losses and LAE of $1,095, commissions of $225 and other expenses of $135. A direct writer sells without commissioned producers, which changes its value chain: it charges $1,450, its losses and LAE are $1,080, advertising and its sales center cost $110 and other expenses are $130. Find each profit per policy and split the direct writer's advantage into its price and cost parts.

Answer

\begin{align*}
\bar{\pi} &= 1{,}500 - (1{,}095 + 225 + 135) \\
&= 1{,}500 - 1{,}455 \\
&= 45 \\
\pi &= 1{,}450 - (1{,}080 + 110 + 130) \\
&= 1{,}450 - 1{,}320 \\
&= 130 \\
\pi - \bar{\pi} &= (1{,}450 - 1{,}500) + (1{,}455 - 1{,}320) \\
&= -50 + 135 \\
&= 85
\end{align*}

The direct writer earns $85 more per policy than the average insurer, a margin of about 9.0% against 3.0%. It gives up $50 of price to attract customers but saves $135 of cost, most of it in distribution, so its advantage is a cost advantage built in one activity of the value chain. The five forces explain why the industry average is only 3%: buyers who compare prices online and intense rivalry keep \bar{P} close to \bar{C}.

Five Forces and SWOT for a Cyber Insurance Entry A mid-sized commercial insurer is deciding whether to start writing cyber insurance. It finds that several large insurers already write the line, reinsurance capacity for cyber is limited and expensive, large buyers increasingly use captives for the first layers of cyber risk, and loss data is short and changing fast. The insurer has a strong broker network and a good claims reputation, but no in-house security expertise. Place each fact in the five forces and in a SWOT analysis.

Answer Several large incumbents mean rivalry is significant, and the short, changing loss data is a barrier that protects incumbents with more experience against entrants such as this insurer. Scarce, costly reinsurance is high supplier power, which raises the entrant's cost. Captives are a substitute that caps the price of the lower layers, and large buyers who can self-insure have bargaining power. In the SWOT, the broker network and claims reputation are strengths, the missing security expertise is a weakness, the growing demand is the opportunity, and the reinsurance cost and substitutes are threats. One strategy that follows is to enter through small and mid-sized accounts, where buyers have less power and fewer substitutes, while buying or building security expertise to fix the weakness.

How it appears on the exam

  • DISC-RM: The strategic management section presents the five forces and SWOT as the methods for analyzing an insurer's environment. Questions ask candidates to describe each force as it applies to insurers and to classify facts from a short case as strengths, weaknesses, opportunities or threats.

Exam traps

  • Industry versus firm: The five forces explain the average profitability of an industry, not why one company beats another. A firm's advantage comes from its positioning and its value chain, so an answer that uses the forces alone to explain one insurer's results is incomplete.
  • Strong force, low profit: A strong force takes value away from the industry, so the strongest forces set the limit on profitability. Saying that high buyer power is good for the insurers in the industry reverses the model.
  • Substitutes are not rivals: A substitute meets the buyer's need by a different means, such as a captive instead of an insurance policy. Another insurer selling the same coverage is rivalry, not a substitute.
  • SWOT direction: Strengths and weaknesses are internal and opportunities and threats are external. A competitor's new product is a threat, not one of the insurer's weaknesses.