KBB Final Paper - Berkeley-Haas

Transcription

KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
Game Theory Final Assignment
May 12, 2010
Introduction
Fabio is currently developing a start-up, SGZ, that will operate in Brazil as the first
online car insurance broker in which the consumer compares several options of car insurance
plans from different insurance companies and acquires the one that best fits his/her criteria (e.g.
price, coverage). Revenues come from commissions paid by the insurance company for each
policy sale.
Although common in other markets, this business model faces a unique legal context in
Brazil, which empowers incumbents to apply a mix of market and non-market strategies to fight
SGZ’s entry.
Car Insurance Market – History, Structure and Stakeholders
In Brazil, an individual or a company cannot buy an insurance plan directly from an
insurance company due to a law that was implemented by a populist government in the 1970’s.
According to the legislation, insurance must be purchased through a broker. The rationale
behind this law is very controversial: it was created to avoid the formation of a cartel by the
insurance companies and to provide a small part of the population with a way to make a living by
creating an artificial market for car insurance brokers.
To stop insurance companies from forming a cartel, the government allowed the
formation of a smaller, yet powerful cartel of insurance brokers. This action created an anomaly
in the market in which the brokers operate in a pocket of artificial demand. Every new player in
the insurance brokerage business needs to earn an authorization by the national insurance
brokers’ association under a very intense selection process creating high barriers to entry. In
1 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
addition, this artificial market provides low incentives to modernize and compete with other
brokers. There is also tacit coordination on advertising expenditures and targeting. As a result,
the industry is heavily fragmented and old-fashioned. With all these conditions, brokers earn an
average of 16%1 commission from insurance companies on every sale, including policy
renewals. The Brazilian car insurance brokerage business is a $1BB/year1 industry, only
considering individual car policies.
An increase in the Brazilian population’s purchase power, the emergence of a middle
class and increasing competition among car manufacturers has enabled the Brazilian car
insurance market to grow at a strong and steady pace. In the midst of the financial crisis in the
beginning of 2009, car sales in 1H2009 increased by 4.1%2 when compared to the same semester
in 2008 (before the crisis was fully in place). The estimated growth in the industry for 2010 is
over 10%2. In addition, insurance is an increasingly important product for many Brazilians, not
only due to the chaotic traffic in cities, but also due to the high car theft rate.
To enter the car insurance market, SGZ needs to be incorporated as a brokerage company
to be eligible to sell insurance policies from insurance companies directly to the consumer.
Since SGZ is bringing a disruptive business model to Brazil – current insurance agents only sell
through phone – the Company must make sure to consider the reactions and strategies of all
stakeholders involved, including insurance brokers, insurance companies, consumers and the
1
Source: Superintendência de Seguros Privados (SUSEP): Brazilian Government’s Agency, which regulates the car insurance industry -‐ http://www.susep.gov.br/menuestatistica/ses/principal.aspx 2
Source: Associação Nacional de Fabricantes de Veículos Automotores (ANFAVEA): Brazilian Association of Car Manufacturers and Importers -‐ http://www.anfavea.com.br/tabelas.html 2 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
government. SGZ must analyze the decisions and best responses each party may utilize in the
event of SGZ entering the market.
Repeal of legislation?
The car insurance brokerage business relies on current laws to sustain its market.
Without this law, insurance companies would no longer need to use middlemen and would
immediately start selling insurance directly to the end-user. In this case, the car insurance
market would resemble that in the United States, decimating the demand for car insurance
brokers.
SGZ will attempt to profit on the current inefficiencies and inconvenience of current
brokerage practices by introducing an efficient and transparent means for consumers to directly
pick the best policy for them, without having the need for a traditional broker. While there
certainly is a tremendous opportunity to capitalize on a market that has been allowed to wallow
in inefficiency, SGZ, like the current brokerage industry, also relies on the artificial market that
Brazilian law has created. The repeal of this law would eliminate the opportunity.
Since SGZ relies on this law, the Company must determine whether the law will be
repealed (eliminating the current entrepreneurial opportunity) in the near future before deciding
to enter the market. To do this, SGZ must analyze the mental models of the stakeholders that
would be involved and affected by this decision. The players in this game are the government,
consumers (voters), insurance companies and the brokers.
Local insurance companies, who make up the majority of market share, are on the fence
regarding the repeal of the law. Although it might seem obvious that they would want to get rid
of a step in the value chain and be able to sell directly to consumers, the brokers’ law gives these
May 12, 2010
insurance companies the opportunity to lock in brokers and protect markets from the
international insurance companies, which have always struggled to grow in Brazil due to the
channel protection by the local companies. International insurance companies, on the other
hand, would definitely want to have the opportunity to sell their own products direct to
consumers. This would help them overcome the lack of channels and use the knowledge of
online sales they have developed in other countries in North America and Europe.
All in all, the domestic insurance companies, which have more political power than the
international companies, would likely want to keep the law to inhibit transparent competition
amongst each other and from the middle-market international insurance companies, keeping the
status quo.
For SGZ, the analysis should revolve around the politicians, brokers and consumers, as
these groups will likely have the most influence on the decisions regarding the law. Lawmakers
are the only group that has the final say on the status of legislation and these politicians are held
accountable by their constituents. Therefore, the decision of whether to repeal the law will come
down to the costs and benefits to the brokers and consumers and the subsequent change in
approval ratings, and thereby votes, that any change would bring for the politician.
With the hopes of getting re-elected, politicians will choose to repeal the law if they feel
that doing so will increase the overall number of voters who will support them in the next
election. To analyze this situation, SGZ must calculate the approximate amount of voters
politicians would lose due to the broker community losing jobs and compare this amount to the
number of voters gained from consumers based upon the insurance savings they would gain if
they no longer had to transact through a broker (note that the only gains in votes from consumers
would be from those who do not already support the current government.)
May 12, 2010
Exhibit 1 outlines the analysis of gained and lost votes. In terms of the consumers’ votes
gained from the repeal of the broker law, SGZ must first see how much money each family with
car insurance would save and then how much this savings relates to their disposable income. In
2009, $992.2MM was paid in commissions to insurance brokers. Approximately 9MM families
currently pay for car insurance, paying an average of $110/per family.
If brokers were
eliminated from the value chain, each of these families would save approximately $110, which
amounts to a 3.1% change in disposable income for a family making $3,500/year (this is low end
of the range of family incomes, but is used to be conservative.)
We estimate that the total change in votes received by a politician due to the savings
brought by the elimination of brokers would be approximately 58K based on current government
support levels and assuming that the change in a family’s disposable income has a 50% effect on
political sentiment.
On the other side of a decision to repeal the current broker law is the brokers and their
families. Currently there are approximately 21K brokerage companies, with an average of three
employees per company, in Brazil. Assuming that each of these 63K employees has a family
and that each family contains 2.5 voters3, a repeal of the broker law would most certainly cause
the loss of approximately 158K voters who will have been put out of work.
Given these approximations about votes won and lost given a repeal of the broker law, it
is in the best interest for politicians to keep the current law in place for now. Given this
assessment, SGZ can go forward with plans to enter the market without fear of the government
repealing the law under the current circumstances.
3
Source: Instituto Brasileiro de Geografia e Estatística (IBGE): Brazilian Government’s agency for geography, statistics and census -‐ http://www.sidra.ibge.gov.br/ 5 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
Market Entry
The structure of the insurance market can impose several barriers to entry. Due to the
disruption SGZ is bringing to the market, insurance companies might be afraid of triggering a
price war. This price war could be caused by the easier approach to comparing benefits and
prices caused by a service like SGZ. Although in markets dominated by this sales approach (e.g.
UK, Switzerland, Spain) the evidence shows that insurance companies sustained a 5%
profitability average4 – the current average in Brazil. The fear of a price war is justified and
might provide insurance companies enough arguments to not allow SGZ to sell their policies.
The strategy to overcome this resistance is to take advantage of the current distribution of
firms in the market. Currently 15 companies own 98% of the market with the top 4 having a 60%
share5. The top 4 companies are naturally more averse to a disruption in the market, especially
one that could expose them to increased transparency and therefore more fierce competition that
would harm profitability. Hence it is very unlikely that these companies, wanting to keep the
status quo, would allow SGZ to sell their policies initially.
A few of the bottom 11 companies though are large international insurance companies
that are struggling to grow in the Brazilian market mainly due to the fact that the big domestic
insurance companies have locked up most of the brokers. This means that a lock up of the
distribution channel is preventing these companies to grow more rapidly. For these big
international companies – which are the middle market in Brazil – the creation of a new channel
with a potentially strong reach could be very valuable. These companies have the decision of
4
Source: Yahoo! Finance 5
Source: Superintendência de Seguros Privados (SUSEP): Brazilian Government’s Agency, which regulates the car insurance industry -‐ http://www.susep.gov.br/menuestatistica/ses/principal.aspx 6 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
whether or not to allow SGZ to sell their policies, facing the risk of a price war or a more clear
exposure of flaws in their value proposition, but having the benefit of having access to an
innovative sales channel.
To outline this game SGZ needs to also understand the structure of the car insurance
consumer market. There are 3 main types of consumers: those loyal to insurance companies,
those loyal to brokers and those that are free agents.
The first group (15% market share) is comprised of those consumers that are loyal to a
specific insurance company. Even if SGZ presents itself as a more convenient way of signing up
for a policy, these consumers would not use it unless the insurance company they are loyal to
offers its product through SGZ.
The second group (10% market share) is comprised of those consumers that are loyal to a
specific broker. They are highly influenced by those brokers and the advent of a new channel is
unlikely to affect their behavior.
The third group (75% market share) is comprised of those clients that usually compare
multiple insurance policies. They are not loyal to any specific insurance company or broker, but
are looking for value for their money. This value can be translated in terms of benefits and
convenience.
Consider an entry into the market in which SGZ targets the middle-size companies. To
assess whether or not the international insurance companies will accept SGZ as a sales channel,
let’s design a game. For example we can take two large international insurance companies that
are among the mid-size in Brazil: Liberty Mutual – one of the top 5 insurance companies in the
May 12, 2010
US, but with a 5.1% market share in Brazil6 – and Allianz – the 2nd largest insurance
organization in the World, but also with a 5.1% market share in Brazil2.
The decision Liberty faces is whether or not to have SGZ as a sales channel, especially
considering that a competitor – Allianz in this case – also faces the same decision.
Consider that SGZ might achieve a market share of 10% in the first year, which is a
conservative penetration estimate based on penetration rates observed by similar companies in
other markets7. If none of the companies accept SGZ as a channel, they stop the company from
entering and they keep their 5.1% market share each. If only one of the companies accepts SGZ,
we can project that the penetration SGZ achieves is only 5%, which is fully taken by that one
company. Hence that company has its original 5.1% market share plus 5% from SGZ less a
potential loss in market share due to increased exposure to product comparison by consumers.
Due to the current size of Liberty and Allianz, the probability of them losing market share by
deciding to sell through SGZ too is small, as their current market share is composed of either
loyal clients or those that find a better value-to cost ratio with them, hence it does not depend
much on the increasing exposure they might gain from starting to use SGZ as a channel. We
assumed the loss to be one-tenth of their current market share, i.e. 0.5%. If both companies enter
then SGZ achieves 10% and due to the current market share of the companies, we assumed that
they will evenly share the 10% penetration of SGZ, achieving 10% penetration market share
each less the loss in market share from increased exposure, which in this case we assumed to be
6
Source: Superintendência de Seguros Privados – Brazilian Government’s regulatory board for insurance companies 7
Source: Admiral Group: Owner of similar service websites in Spain, France and the UK. 8 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
1%. As outlined in the diagram in Exhibit 2, it is in these middle-size insurance companies’ best
interest to start selling through SGZ, enabling the company to enter the market.
By continuing with the strategy of going after the mid-size insurance companies, SGZ
offers an interesting value proposition for them: access to a powerful sales channel and the
possibility of growth by overcoming the current lock-up of brokers by the big insurance
companies. Hence, the upside for mid-size companies to join – especially after a critical mass of
them has signed up with SGZ – is higher than the potential downsides as they will already be
losing market share when a critical mass is with SGZ. The next step then for SGZ is signing up
with the big insurance companies.
Fight with Big Insurance Companies
The secret when dealing with big insurance companies is scale. Once SGZ achieves
enough scale, the benefits for big insurance companies to use this channel increase for three main
reasons. First, they might be losing market share already if customers start using more and more
of the SGZ service due to its convenience and unparallel customer service. Second, similarly to
the above game, the first mover among the big companies might enjoy access to this increasingly
important channel, thus having the opportunity to offer its products in a competition only with
mid-size companies in the beginning. Third, once a big company has moved in, all other big
companies would want to follow to avoid an acceleration of market share loss to this first mover.
In overall terms, once SGZ achieves scale, there is pressure for big companies to sign up with it.
Empirical evidence from other markets show that similar players to SGZ managed to sign up
with the insurance industry leaders in less than 1.5 years of market entry.8
8
Source: Admiral Group: Owner of similar service websites in Spain, France and the UK 9 KBB – Fabio Massuda, Jesus Palacios, Sean Kelly
May 12, 2010
However let’s suppose that, due to the threat to their current channel lock-up, big
companies would try to kill SGZ instead of joining it. There are two ways they might engage in
this war. The first way is politically and the second way is market-based through a price war.
The political option is to lobby with the Brazilian government to change the legislation
and lift the brokers’ exclusivity as a sales channel to consumers. Due to reasons outlined before,
several barriers exist against that. Being labeled as a company that pushed for the repeal of
legislation that would extinguish the livelihood of brokers and related members for the sake of
increasing profits would sound bad among the public and likely have an adverse effect on
business. Also, SGZ would still be the only relevant channel for mid-size insurance companies
if the government decided not to lift the law, keeping the big companies’ lock-up over brokers.
Finally, if the legislation is lifted, insurance companies will start using the Internet as a direct
sales channel and SGZ would not need the companies’ authorization to compare benefits and
price anymore. SGZ would adapt its business to the new environment and create a service like
Kayak, which simply has automatic systems to check companies’ websites. Hence it seems that
the political tactic is unlikely at this point.
The market-based tactic, however, might seem relevant. Basically, the insurance
companies, using their deep pockets, could try to cut prices to a point where all policies being
offered by SGZ are more expensive. It is unlikely that small brokers would contribute financially
to this war by lowering their commission rates due to their short cash position. In addition, since
mid-size companies might not have enough cash to fund a price war, the only way for SGZ to
compete is to cut the amount of its commissions. Hence, to simulate such a war we designed a
game dynamic with 2 players: big insurance companies, who will lower the cost to consumers
May 12, 2010
through premium cost cuts (in collusion) and SGZ, who will lower the cost to consumers through
a reduction of its commission rates.
In this game, both players have 2 options: engage or don’t engage in a price war. This
game only makes sense to big insurance companies if they see SGZ as a credible threat. In this
sense, we assumed that a trigger to a price war is when SGZ achieves 10% market share.
If both players choose not to start a price war, SGZ would gain market share reaching
30% in Year 5 and benefit from a 3% profit margin over policy prices. On the other hand, big
insurance companies would keep their 5% profitability and lose market share due to SGZ.
If SGZ engages in a price cut strategy and big insurance companies do not, the former
would reach 40% market share by Year 5, sacrificing profits until then; and the latter would lose
more market share, but keeping the profitability percentage.
If big insurance companies engage in a price war and SGZ does not, we estimated that
SGZ might go bankrupt in 4 years, losing 2.5% market share per year. On the other hand, big
insurance companies would give up their 5% profitability for those 4 years and be back to their
current market share level after that, benefiting from the standard profitability.
If both engage in a price war, SGZ would go bankrupt in 3 years as insurance companies
have deeper pockets and big insurance companies would have not only to give up profits but
have losses in those 3 years to be able to undercut SGZ in terms of pricing.
The calculations of outcomes can be seen in Exhibit 4. The game diagram in Exhibit 5
shows the outcomes, proving that the dominant strategies for both players are not to engage in a
price war due to the razor-thin profitability of the industry.
May 12, 2010
Fight with Brokers
As mentioned before, due to shallow pockets, it is very unlikely that brokers could start a
price war with SGZ. In that sense, the most likely way they might fight SGZ is through politics
by claiming that although being incorporated as a brokerage company, SGZ cannot be
considered a valid player under the broker law, and therefore SGZ could not operate in the
market. This strategy is very powerful and would immediately hurt SGZ. Applying game theory
concepts, a counter-strategy is to position SGZ as a ‘friend’ of customers – by bringing
transparency to the market – and threat that, if it is stopped from operating, it will engage
customers to campaign against the brokers’ monopoly, eventually leading to the lifting of the
law. In regards to the aforementioned decision that the government faces – whether or not to lift
the law – this threat means to make the general population more aware of the issue and more
willing to have the law lifted, making it more beneficial for the government to cut the monopoly
of the brokers as a sales channel. Though SGZ would be hurting its own business prospects by
helping to repeal the law, the threat is still highly credible because SGZ would stand to lose very
little (except for the opportunity to take advantage of the artificial market) and the brokers have
so much to lose (their entire livelihood.) Given the risk of this threat being credible, brokers
would likely be apprehensive about pursuing this political strategy. To demonstrate the decision
that brokers face, we designed the decision tree pictured in Exhibit 4. It is easy to see that, if the
brokers engage in this fight, SGZ’s best response is to fight to have the law lifted. Therefore, the
decision for the brokers depends on whether:
($992MM-X)*(1-MS1) < ($992MM)*(1-MS3), where $992MM is the total revenues of
the car insurance brokerage business.
May 12, 2010
In a free market without the protection to brokers it is more likely that SGZ has a higher market
share than with the protection, because its value proposition is a better match to the situation
where insurance companies sell their products online directly to clients. Thus, since X>0, then
insurance companies are better off by not engaging into a political war.
Applications of game theory to foster competition
In a later stage, once SGZ has reached a critical scale –measured perhaps by market share
or traffic volume milestones to be defined – an auction mechanism for brokerage fees will be put
in place in order for SGZ to extract the highest value from attracting customers that insurance
companies may consider either the most profitable or strategic for market expansion goals.
Today, the brokerage fees structure is flat, meaning that brokers have no incentives to
attract the best customers to an insurance company. An auction system will allows insurance
companies to bid higher brokerage fees in exchange for being featured in SGZ’s website as a
‘Featured Offer’ if they match the lowest price available to each customer from other
competitors within SGZ’s network, providing a higher commission than it would pay originally.
How will this work?
A customer will enter SGZ website to request a quote for car insurance. The system will
require policy specific information (car making, model, etc) as well as socio-demographic
information (age, sex, years driving, etc) that insurance companies will use to provide their best
base price (as illustrated in Exhibit 6). The base price list is immediately shared with all
insurance companies’ systems. In a second step, each company’s system will decide whether or
not to match the best price available and will place a bid for brokerage fee applicable to that
May 12, 2010
specific policy (the bid cannot yield a lower absolute commission than that under the standard
flat rate). As per Exhibit 6, you can see that Company B and Company C decided to match the
lowest price and offered the minimum commission to be higher than their initial offers. Finally,
the highest bid wins the auction and its offer is featured as a recommendation in SGZ’s website.
If the company is chosen as a provider, it pays SGZ the second best commission offer – to
stimulate the insurance companies to bid their willingness to pay. Naturally, all insurance options
will have to be equivalent in terms of policy characteristics (deductible, co-pay, coverage, etc).
By the end of this process, it is the consumer obviously that decides which company he / she will
have as a provider, however we increase our potential profits. In Exhibit 6, Company C is the
winner, being promoted as a ‘Featured Offer’ in. It is important to mention that the auction is
voluntary, hence those not participating (e.g. Company D in Exhibit 6) still are shown as options
to the client on their regular pricing.
Once, the offer is presented, the customer would chose whether to take the featured offer
or choose another insurance company, that is, being featured as the best alternative will not mean
that the customer is locked in with that option as this would be counterintuitive to the business
model.
It is important to note that this process will be performed in real time through the
insurance companies’ pricing algorithms and SGZ systems; so swift processing is a key success
factor. For this reason, the choice of auction mechanism would have to take into consideration
systems processing capabilities.
May 12, 2010
Of course, two elements ought to be present to have insurance companies willing to
accept this auction: SGZ’s scale – meaning that the service is relevant enough to be ignored by
insurance companies – and SGZ’s data capability which should be able to segment the market.
We consider systems processing capabilities as the main driver of choice as we know that
revenues will be maximized based on the revenue equivalence principle.
In summary, SGZ’s ‘featured insurance option’ proposal will add value to insurance
companies as they will be able to differentiate themselves from the competition in an ‘opt in’
basis. SGZ will be able to price this added value on a case-by-case basis through an auction
process and will be able to solve the single bidder problem by defining a minimum entry price.
Conclusion
The applications of game theory concepts on SGZ adds valuable insights for analyzing
the feasibility of entering a highly regulated insurance market as well as for determining the
appropriate strategies to be implemented based on competitors responses. In this complex
setting, it’s important to frame the analysis into the competitive landscape of the industry in
addition to understanding the behavioral aspects of every player including government
regulators, insurance companies, brokers and end customers. This is particularly interesting
given that the competitive landscape is highly determined by non-market strategies and
incentives; thus, getting a sense of non-market reactions is the key to assessing the actions that
SGZ has to undertake in order to be successful.
Finally, SGZ can leverage other game theoretic approaches to foster competition and
attract the highest value possible. In this case, we addressed the possibility of launching an
May 12, 2010
auction mechanism to set the basis for a more competitive market, shifting from a passive
intermediation system to a more active one where “shelf space” – a concept take from the retail
industry - plays a significant role in the pricing for brokerage commissions. In this case, game
theory contributes not only in the decision making process on whether and how to enter this
market, but also helps implement a competitive mechanism in line with the spirit of SGZ.
May 12, 2010
EXHIBIT 1
Political Outcome of Repealing Broker Law - Consumers vs. Brokers votes won/lost
(all figures in MMs)
Insurance commissions per family
Total insurance commissions paid
# of families with cars paying insurance
Insurance commissions per family
$
$
% increase in consumers' disposible income
Money saved by not paying commision
Minimum disposable income of families paying car insurance
% of increase in disposable income if law is lifted
$ 110
$ 3,500
3.1%
Increased Voter Support assuming income changes account for 50% of a voters decision
Current gov't popularity (% of people that approve of current government)
Insurance-paying families not supporting the government that would be impacted by the law [9MM*(1-83.5%)]
% of voter preference determined by change in disposable income
Increase in gov't popularity among these families [3.1% * 50%]
Additional # of families supporting the government [1.488MM*1.6%]
Voters per family
Additional voters supporting the government due to repeal
83.50%
1.488
50%
1.6%
0.02
2.5
0.058
# of insurance brokerage companies in BR
# of employees per company
Total # of employees (assuming each has a family)
Voters per family
# of voters lost due to repeal (assuming all brokers and families lose jobs)
0.021
3
0.063
2.5
0.158
Sources: Instituto Brasileiro de Geografia e Estatística (IBGE): Brazilian Government’s agency for geography, statistics and census
- http://www.sidra.ibge.gov.br/; Federação Nacional dos Corretores de Seguros (FENACOR): National union of insurance brokers
992
9.0
110
May 12, 2010
EXHIBIT 2
EXHIBIT 3
May 12, 2010
EXHIBIT 4
May 12, 2010
EXHIBIT 5
EXHIBIT 6
Base pricing
Company
Company
Company
Company
A
B
C
D
Price to consumer Standard comission (%) SGZ's potential revenues
1000
15.0% $
150.00
1010
17.0% $
171.70
1100
16.0% $
176.00
1250
15.0% $
187.50
After bidding
Company
Company
Company
Company
A
B
C
D
Price to consumer Offered comission (%)
SGZ's potential revenues
1000
15.0% $
150.00
1000
17.2% $
171.80
1000
17.7% $
177.00
1250
15.0% $
187.50
Company C is the winner, so it is presented as a 'Featured Offer'
20

KBB Final Paper - Berkeley-Haas

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