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Measuring Intellectual Capital at Skandia GroupLeif Edvinsson, Director of Intellectual Capital, Skandia |
Åke Freij and I are very pleased to be with you today. We have learned about you from Bob Eccles and we're very pleased to hear Roger's input. We are smaller than British Airways, only a fraction of their size, but what I would like to show you and share with you are the invisible values of our business.
Åke Freij and I are working on trying to increase the visibility of business. The following statement is from Fortune magazine:
It says that even if one is a little bit invisible, the message is visible. Intellectual capital is something you cannot touch but it still makes you rich. That goes for a lot of new companies and the new economy. Look at Glaxo or Microsoft. Those companies are worth about 10 or 15 times their balance sheet. That is where you have the intellectual capital and that is why you probably sense there is something else driving the future for us rather than the traditional balance sheet. But still we are struggling with the attention focus and, as you said Roger, it is a question of getting people's attention onto the right things.
That is why we are trying in our company to develop this concept of intellectual capital and this goes back to saying how intellectual capital is becoming one of America's greatest assets. That goes not only for America, but also for the UK and Sweden. The starting point in our company was focused on the fact that one of the most important ratios might not be the financial ratio but the learning ratio.
To have a steep learning curve in our company does not mean that you should read newspapers or books faster, it means that you should read something else. What kind of reader do you have for the future? How do you sow the rules for the future? What are you observing? And that is not the speed of learning old things, it is the speed of learning new things. Just think about how much attention we focus on learning the history of the last quarter or the last year, or the budgets, which is all history. Do we spend as much on the intelligence for the future? There you see immediately the imbalance between how much we are learning about history, and about the future. We therefore came to the conclusion that we have to develop a new approach.
The focus in our company today is very much related to three cornerstones on how to organise this. This company, which is part of Skandia, is growing about 30% per year. It has been growing at 30% over the last six years and it is about 15 years old as an operation. Today it is the second largest unit in Skandia, and due to its growth will probably be the largest one. What you see here is how to focus on creating an intelligent organisation which is, to some extent, related to performance ratios.
The three cornerstones are: our intellectual capital, our IT and our values. The values of the organisation are: how you create new knowledge, how you spread new knowledge and how you capitalise on it. How do you get more money out of it and get the stock price leveraging 15 times the balance sheet, which is rather unusual for insurance and savings companies? The usual ratio is between 1 and 3. In our unit we have a ratio of about 5 to 6 times the book values. This is all based on going for the Sony concept and miniaturising. You should not have everything in your organisation entity, you should go for the virtual organisation concept, creating a network. So we employ only 10% of our staff. 90% of all people working for us are non-employees. We have a ratio of 9 or 10 times the number of employees in that networking concept. Therefore you get more speed, more flexibility.
We came to the conclusion that we need a new leadership language which is related to our attention to growth, a refined approach, another language, another taxonomy to describe this. One of the core pieces of this taxonomy says that intellectual capital shows up on a traditional balance sheet of a company. You have the assets, the debts, and the equity. This is 1/10th of the value of successful companies. This means that 9/10ths have the intellectual properties
This summarises very much the process, because if you look at it from an auditing or accounting viewpoint, you might find goodwill, technologies and competencies shown in the accounting stock. These are, of course, hidden values, but if you manage to transform them from hidden values into something tangible like software, then it turns out to be intellectual property, which could be treated differently from an accounting viewpoint. So you go from ideas to intellectual properties, which is the capitalisation of going from good ideas to intellectual property. This will change the accounting rules.
Another interesting point here is that intellectual capital is a debt issue. It is not an asset. You borrow it for a very short period. We are a federation who do not own our brokers. We borrow their time and their skill, which means that we have developed another leadership approach. This is the depth, and the leadership process is the transformation of this depth into intellectual property. Then you capitalise on something that is intangible, and that is the new leadership approach. For example, the skill of a good musician transformed into a CD is multiplied in a million copies. Or a good software idea is transformed into a network solution. That is what we are trying to do and it is very much visualised by a statement from Bob Crandle of American Airlines. He says that if he had to choose between the airline and the reservations system, he would go for the sell-out of airline operations. The hidden assets of British Airways might not be the aeroplanes or that part of it, it is something else which is much more fragile.
So you can see some of the small points that you could start to develop ratios around: trademarks, the concessions, the customer distribution system, the fund management, the IT systems. Our list of items was that long initially. Now we are trying to cut it down to a structure which is handsome for the board meetings. Another way to describe it is to say that these items are the small root systems under the tree that, after some 5-10 years would create flowers or fruits. The definition of intellectual capital would then be Skandia's possession of know-how, technology and skills applied to create a competitive edge. We say "possession", not ownership. Possession is the leadership implication of it. You do not own it, you have it for use for a period. If you follow the gardening analogy, you might come up with a structure of items something like this: a company has an entrepreneur which is the human capital; for every year you add another year-end around the entrepreneurs which is a customer database, an organisation structure, the brand image and things like that. That is the structural capital.
When we started to look at our units we found that the new ones had a lot of human help but those that were 10-15 years old had a lot of structural capital. Therefore, the statement that the human capital is the most important one is wrong. The most important asset in a company is the structural capital, because you can go to the bank, the financiers and owners and ask for financing of the structural capital. To go and borrow on the basis of good skills and good ideas is very difficult. The structural capital and the transformation is the critical ingredient here, and that is leadership. The very tangible part of this model is the cultural values because that is related to what you see, what you feel, and how you act. That is the very soft part of the human capital and if you have a lot of employees in your company who do not see the future - what will happen?
The agenda for the intellectual capital approach is related to these four steps: identify, capture, cultivate and channel, and capitalise leverage. You have to identify those small roots. You have to capture them in some small format that goes more or less into the intellectual properties. You have to cultivate the leadership issues and capitalise on them.
Related to the issue of performance measurement, you will come up with a new leadership agenda which is very much linked to Bob Eccles' question here. How should the board meeting be using its time? We have found out that the way to summarise this immense number of performance measurements is in four categories: the customer capital, the human capital, the financial capital and the structural capital. Under each heading you can have a number of ratios depending on whether you are an airline, or in the financial field as we are. Usually you see the traditional board meeting and traditional evaluation. I was very intrigued by Roger's presentation because you have a lot of focus on this one which we did not have when we started. We were much more focused on other things.
The way to handle them, as we see it, is in the number of dimensions. The way we look upon it is that we start by saying we have these numbers of accounts or customers. The interesting thing is not just having a statement of the number of customers, but also the changes, the dynamics, because that will show the growth. Then you have to relate it to the business values, because you have borrowed money from the bank or the owners. What are the returns on customers? Not just performance from the customer, but the relationship and the net business of each customer. What is the return on IT investment? Then you compare it with the strategic goals. These are the steps we have followed in the refinement of this.
We came up with a summary of ratios that are roughly described by this model. You focus on the shareholders, then you try to visualise the human capital related to the customer capital. The two most important ingredients in structural capital as we see it are IT and R&D. We spend 20% of our expenses on IT, which is about 2-3 times the average in the industry, and we spend about 50% more on R&D than traditional companies in our field. That is why the magnitude of these figures should be shown in the model and to the board meeting somehow. Therefore, you could say that the mission of this function is in the intersection between business development, how to capitalise, to leverage, human resources, and the use of IT to create a structure as well as spreading the knowledge. So we are relatively IT intensive, and it has to be shown what the return is on this.
We are struggling to describe our return on IT rather than our return on equity and working capital. As a result we have now developed a supplement to the traditional annual report showing the financial capital, performance ratios related to intellectual capital, customer capital and human capital. Then the re-engineering of the financial statement takes place, where you take the annual report statement and reshuffle some items to show the core business profitability. The structure is implied and used to describe things. What you see, for example, is the productivity measured as expenses in administration vs. gross income. The productivity ratio has improved about 40% in three years which is said to be very difficult to measure, but you can, and those are interesting figures for the shareholders.
I think Åke could now show some more detailed figures on how we are trying to apply this.
As Leif said we have grown very much within the last five years and this is our forecast for the year-end where we expect to be over SKR 10,000 million in premium revenue for 1993. I personally think it will be more like SKR 12,000 million. So we are looking at a growth this year of over 50% from last year. So we keep up to pace. The point here is the leverage on the structural capital. The main business centres are in the UK and the US. The US has grown rapidly; over 100% in the last three years, and will grow, I think, 150% this year. We also look at gross premium, which is our revenue, and net premium which is the risk premium. With traditional insurance companies this is very important and a lot of their profits are derived from the risk premium. We do not earn money on the risk premium, we earn money more on the administration and the fund management of the unit-linked life assurance that is our core business. On the balance sheet, we have total assets of almost SKR 32 billion, around three and a half billion UK pounds depending on the currency exchange.
I will now come to what is specific with AFS. Traditional insurance works like this: you get a premium, you invest it and then pay a claim in x years' time. You earn money on both the processing of the insurance and taking out charges from the customers, but also you earn money on the positive cash flow. For AFS's core business that is not true for two reasons: first of all we are very much in a growing stage, and also we sell life business with a surplus strain in the short run. It costs a lot to sell a policy in the first year but you get that back over the life of the policy. It is financially a very hard thing to do if you do not have a cash flow somewhere else to fund the business, or if you do not have within the company other businesses that have been established and which can provide funding. That, of course, creates problems for us if we look at our results or if we are looking at the traditional operating results for an insurance company. So what we regularly look at now internally are the statutory results which are based on Swedish accounting principles. We look at the internal result, which includes embedded value (which is a way of looking at the value of the portfolio of sold policies when we look at the reaped profits from that). For example, when you sell a ten-year policy you get a premium of 100, but it might cost you 200 to sell it; however, you get over the life of the policy 200 in income as a present value, and that is a result of working with models to look at the future value of the business we have in force.
As we see it, that is not doing enough for AFS because there are other things, as Leif has shown, apart from embedded value that comes into account here, especially for AFS where we are very intensive in investing in business development. We are trying to invest in our structural capital for the future, so what we look at are basically these three levels. We look at the statutory level which is the book value, and that is also important because that is where the money comes from to pay dividends to the shareholders. A main objective for the group as a whole is to have a dividend growth. Also we look at the internal, the management result, where we examine the market value fluctuations of assets and the embedded value of the life operations, which really looks at what the company is worth with the policies which we now have in force.
Another very important thing is to look at the appraisal value, which is really the items below the line: the value of the customer capital, the structure capital, and the human capital. That is where we have worked and tried to come up with some ideas on how to monitor this on an ongoing basis. Just to throw in some numbers here, Leif mentioned that the real value of Microsoft is about ten times its balance sheet value. Quite a lot of studies on this have been done for various reasons within AFS. At least three times the embedded value would be the appraisal value of AFS, because of the leverage we have in the investments we have done in the structure capital and human capital. I have a question mark here and I will come back to a suggestion of what can be done.
What we are trying to do is look at some kind of development of the value-added of the organisation. How much is the business conducted and the investments made in the business creating value for the future? The result of operations is derived from our insurance business or our investment business. Of statutory and value-added I have split the embedded value base here, and the result is basically that we have a contribution from the business and after that we invest in the structural capital, human capital, and the operation stands for intellectual assets or intangible assets. That in turn should be reflected in some kind of quantification and a database, where we evaluate the investments made in hitting the result and also capital investments that are hitting the result. They should be valued and given some kind of change in value here, and that should give a value-added of the operations. A unit manager should be obliged to make a return on his total value, not only on his financial value, because a unit with a lot of potential should produce more.
I have taken a tentative look at applying this model to some of our companies. You can see some very interesting results in relation to net asset value, our traditional performance measure which we now use. If we look at the structure of some of our companies and the total value-added in relation to the total value, you can get very interesting relations. One example is a very new sort of company that has invested a lot in the structure. They have managed to get a very good position in the market, get a very good goal, and they can see a very high leverage in the investments made. Here, the return traditionally would be negative but the total value-added would be a big positive number.
On the other hand, we have quite a well established company that has not done as much investment in the structure as one would have expected, and there you can see that the relations here are almost equal. On the other hand, there are also places where there has been a failure; where we have invested a lot but we have not been able to use it because we have, for example, spent a lot on IT, but we have not had the distribution to be able to go out with the products. Then really it has become a case of sunk costs.
What we see should be an agenda for the board meetings, and we have tried to look at the follow-up for our business as something where we still see the financial focus as the key, where we look at the return on equity, the return on net asset value and the possibility of giving dividends. We also look at Skandia to see what the critical foci are for our business to be successful, and all of these nine areas here we see as important. Some are less important for AFS, some are maybe less important for the investment division and so you can elaborate with that. In general, to look at the business and have indicators here will mean that we will have a much wider discussion during the board meetings.
The tradition for financial information is a regular part of a package that we present for the board and for the management group in our follow-up meetings. What we also have done is to take out some key ratios, which are called "productivity ratios", in relation to the more non-traditional measurements. We look at the customer capital, the development of the number of accounts we have, we look at the surrounding ratio which is the number of policies leaving us before the contracted term. This is a very good indicator of how we are doing in administration and how our fee structures are in relation to the market. This figure of the number of accounts is a tremendous shift from the industry viewpoint. Traditionally, the insurance industry measures at best the number of policies, but not the number of accounts, which is an example of how we are trying the change the language by coming up with new ratios. We look at the assets under management per employee, because employees are a high cost for us. A lot of our ongoing profits are derived from the assets and the management, so it is important to have a leverage there.
When you say number of accounts, do you mean number of policy holders?
Yes. We do this currently because the traditional accounting systems do not allow us to measure the number of customers, and that is the ultimate goal. We are stuck with the traditional investment in accounting systems. We could have and do have, for example, one Swedish policyholder having a policy in our Swiss subsidiary and also in our UK subsidiary. We would not be able to match those, so they would be double-counting here.
Basically the process for us is to be efficient in administration, to be able to have low expenses and to do flexible things for the lowest possible cost. We look at that in relation to gross premium and net premium and, of course, it is also interesting for us, especially because we have very fine numbers there to look at the development of business. The investments should give something in terms of development so there should be a correlation there.
There is one final one that shows the ultimate target. That is the transformation from IQ to ECU, from grey cells to hard currency.
Thank you very much.
Lord Butterworth
Thank you. Now we will have group discussion.
You laid quite heavy stress on value-added. I am a value-added enthusiast but I am not quite sure we are using the same definition of the term. Could you explain your definition?
Traditionally it is the result of the operation before personnel expenses and before investment in your structure. Perhaps we should rephrase that term because in this sense it is a sort of total company value growth.
You mentioned structural capital as a outer square in a diagram. What does that comprise? Is that the IT investment?
Structural capital is what you build in the extension of the human capital. One way to phrase it is to say that when the human capital leaves at 5.00 or 6.00 p.m. in the evening, what is left is the structural capital. That is a very interesting point when you build a company, because that is the thing you can finance if you go to the bank and it is also the thing that leverages the productivity. When you start the next morning and the staff are coming back, the quicker they can use the structural capital, the faster you grow and the higher productivity you will have. So the ratios in structural capital are among others: IT, customer structures, customer databases, organisational structures. We measure the number of people we have in the system rather than just the employees. We know today we have 12,000 active brokers working for us. We get 10 new brokers in the US each day. Then we have a number of passive brokers, but that is part of the structural capital even if it is not shown in the traditional accounting system. Or we could put it this way. We have the financial capital, the human capital, the customer capital, and the structural capital. The structural capital is IT, the distribution, trade mark, company name, special systems.
I do not really understand what you are doing. You have this notion of intellectual capital and a different language and this is quite a different way of looking at a company than the traditional way. The measures look pretty typical to me - mostly financial ratios of various kinds. If I was a financial economist and knew what I was talking about - which I am not but I will pretend I am for the sake of the question - I would say that I do not think you need most of that. The market value of your company is based upon an impressive growth rate, the expectations of the earnings that are going to be generated out of that growth rate, some characteristics of your balance sheet and the fact that you have a lot of variable costs through this broker network. A lot of the distinction between book value and market value will be accounted for by the structure of the organisation and by the growth rate and the profitability of it. These other things are distinctions which, I am sure inside make a difference to people, but I do not understand it because I do not see how those measures lead to decisions in a different way, the way I can with the things that Roger talked about. Now admitting that this is a gross generalisation, you are taking more of a balance sheet perspective in your presentation than Roger, who was looking more at flows in terms of the kind of data he talked about. I do not think I understand the essence of what is really going on there, and in particular how this notion of intellectual capital distinguishes between an evaluation, from a fairly traditional evaluation and a financial perspective that you would get out of terrific performance in a moribund industry. You are clearly on to something, but I do not know if it is the measures you are taking of the intellectual capital or just a very clever strategy being extremely well implemented.
You have a point, but I also think you started to answer the question yourself in the end by saying that you do not really know what is making us successful at AFS. We know. The record shows that we have a fantastic growth and that we have managed to do something with our transfer of human capital into structure and to exploit that in different markets. The market has told us that we are successful, and independent surveys show that. We have a limited sum of money and what we really want to know is where to invest it. We are doing this to find out why we are so successful. To describe the success of a company you could use traditional accounting systems, which show the history but do not actually describe why a company is successful. They show how you have used resources, but this is more of a management accounting approach, trying to grasp those very small things that are important or are fulfilling the strategy.
To give an example, we have shown more traditional financial figures here today because that is where we are right now. We do not have the accounting system for measuring the number of good ideas today, but we have an accounting system for measuring the number of employees, and we have a system for measuring the number of hours. Our ambition is to find those ratios that are important in the same way as Roger was describing. That is why we are seeking the interrelationship and what we have seen today in our system is that IT and R&D (or innovativeness) are probably the two most critical ones for continued speed. What we try to add is to systematise management and leadership on these things. The trick is probably to boil it down to very few ratios that are, from a leadership viewpoint, easier to use. Otherwise you will drown in the number of ratios.
The ratios that you look at make sense to me and the connection between looking at those things and what you are doing I think I understand. At the beginning you went through a fairly detailed description of a reasonably elaborate construction around intellectual capital and distinguished other things, but I do not see is why you need it quite frankly. You could say, "Listen, we have got a good strategy and it is a clever idea. We are implementing it well, and it is important to look at the number of accounts in a different way, along with R&D expenditures and IT expenditures. That is how we drive the business and that is fine". But this superstructure of an overall language system of intellectual capital - I just do not see what that is getting you. I see where the pieces are getting you.
Can I try an analogy and see whether I have failed to understand it as well. If you have got a machine producing a widget in one place and an identical machine in another place and the outputs are the same, then the return on the capital is going to be the same. But if, on the other hand, in one place you have got double the output, then prima facie you will have double the return on the capital invested. The issue is why have you got double the output? It may be the leadership, or it may be the air-conditioning. There is something in there that results in greater output and there are many things that may be the intangibles that are the cause of the better output. If you are going to try and leverage the trick then you have got to know what trick it is that you have pulled. So you have got to split up the possible causes into a number of written options and go and try to measure it, to know what it is that you are being successful at. That is what I think it is about.
Yes, I think it is a very good analogy. We are trying to develop a system to describe those things that are making us successful and we need that to describe the standard reports as well as the stock market. We are part of a parent company, and when the parent company is evaluated we are stuck by that evaluation from a standard report as well. Therefore, we have to clarify why we are sustainably successful. That is something you have to describe to the bank as well as to shareholders and rating institutions. Then you can apply the traditional balance sheet and we evaluate the book value. Some bankers and some financial people are asking more questions, and what we are trying to do is to simplify their work by showing that we have a measurement system that can help them to understand why we have performed well.
Has intellectual capital led your company to change the way it works?
One way it has changed is the clarification of the importance of having very few people on the payroll where we have 1/10th of all people working for us employed, rather than having a corporation concept. But usually if you describe a company that has 1/10th employed, the common perception of the company is that it is a small company. If you focus on the 1,200 employees, but know that it is 14,000 employees "working" for you, it is not that small any more.
Is that unusual in the insurance industry with all the different brokers that you have? Is it particularly unusual how your are operating in that context?
You can have your own sales force and your own branch network. In some markets the US for example, I would say you have no choice, at least not in the life market, because you have to go through an independent salesman. But in the UK, for example, you can make a selection. What you see (that has not been totally applied yet) is that relation with the ultimate customer, we have about 400,000 customers out there - it is the linkage with those people. Is it necessary to have 12,000 brokers in between, or could you use IT to come closer to these 400,000 people? That is going to change the structure of the organisation and that is why there is so much in IT. Actually, you would say we started as an insurance company, we turned into a financial company, and we might turn into an IT company rather than being left in the insurance field.
I found your structures very helpful for this reason. We have fooled around for the last 400-500 years believing that the accounting frameworks are in fact real. I think they were designed to be tools for thought, they are a way to help us think about financial transactions in a framework that is useful for certain purposes. One of the benefits of the focus you have introduced to us on intellectual capital, structural capital, and so on, is to create tools for thought for all the employees and perhaps for the agents as well, but certainly for the core group to understand why you are putting value on certain actions without necessarily there being an instant readout in the P&L. I would perhaps go along with Bob [Eccles] in saying that maybe that does not carry huge changes for the actual performance indicators, but I do think it carries a change in the way you think about how to use that information.
I think we can see a clear indication that it is changing the board meeting agenda by taking just a few slides and having them in our board presentation. By taking these things out and talking more about the critical success factors than just discussing the financial outcome - more discussion on the future that the past.
How external are you in your look? Some of the measures up there, such as the number of accounts, are an absolute amount, but look at market penetration and competitor analyses and you can see that it is cutting you out from the rest. This actually came over very much in Roger's presentation. Are you moving that way?
Roger mentioned the problem of aggregating the detailed level and the company level, the process level and the company level and the job level, and that is something that has struck me during the latest period; trying to work out the measurements and the concepts in our organisation. It is a problem of people on a detailed level wanting to see other things than on an aggregated level. Of course a lot of these market-related studies we do are on a company level or on a product level, but there is nothing we have yet on a consolidated level. We look at Benchmarking with our companies, our productivity, our process ratios. If you compare with banks, which we do, we have roughly twice as much per account as a traditional savings bank. That kind of benchmarking is coming up as a consequence, once you have identified what to measure.
That is very much a cultural thing. You are not looking at potential in the market place necessarily and what proportion you are taking?
Not at all.
Can I follow that up because I felt that both Roger and Leif in talking about the board agenda talked very much about being "customer-driven" and "process-driven", but as far as I know British Airways and possibly other companies pay quite a lot of attention to what their competitors do. That has not actually come out in the presentation. What are the market constraints? What is the relative perceived value? Your progress is done, presumably in relation to what others in the industry may or may not be doing.
We skipped that part, but there is a picture that follows that has to do with the virtual corporation concept that we should focus on the best in the class. What are we best at? We are not best at fund management because JP Morgan, Nemours and Deutsche Bank etc. are better than we are in fund management and therefore we have a number of fund managers in our structural capital working for us. We are not best in customer relationships and therefore we are using these 12,000 brokers. The rest is the process and that is the logistics. That is why ratios around the logistics are so important - the process ratios, and we compare them with other companies on whether we have a lower process cost than banks and other insurance companies. For the moment it looks like we are running on a level between 3% and 5%. The industry average is between 10% and 15%. We are running 1/3rd to 1/5th of the industry average on process efficiency.
Lord Butterworth
Roger - Is there anything you wish to add?
There are two aspects to competitors (if I could avoid saying anything I am not allowed to say at the moment about any impending court action). The whole area of marketplace performance has been very much driven by understanding what competitors are doing. I have seen ways in which we can satisfy customers or examples of how it can be done in different ways. So, our focus has been on the customers but we have seen the competitors as providing examples of how we can satisfy their needs. Apart from the financial pressure that competitors have provided, reducing costs and the actual competition for customers, so it has been an important part of our measures, particularly about how you can make these customer benefits come true.