Chris Gentle, Roy O'Neil and Michael Ricks look at the growing trend of putting business functions and processes into low-cost jurisdictions.

Few would argue that offshoring - the relocation of business functions and processes to a lower-cost location on a long-term basis - is an emerging major trend in the financial services industry. For many financial institutions, the potential of offshoring to reduce operating costs significantly has made it an increasingly appealing strategic option.

But lately offshoring has begun to undergo an important metamorphosis, transitioning from 'something to consider' to 'something that must be done'. What has caused this change?

Enormous industry pressures, such as depressed equity markets and increased competition in mature financial product markets, are demanding that companies find new ways to improve profit margins. These pressures, coupled with the attention-grabbing success of offshoring pioneers such as AIG, Citigroup and HSBC, strongly suggest that offshoring will soon become a prerequisite among financially healthy institutions.

But the case for offshoring does not stop there. In addition to the obvious benefit of cost savings, relocating to less expensive locations also offers organisational advantages:

- it upgrades delivery quality;

- it builds organisational resilience;

- it enables the organisation to react to competitive pressures; and

- it provides business continuity.

These factors, taken together, have enabled offshoring to capture the attention of the financial markets. Consequently, re/insurance companies that choose to proceed without developing coherent offshoring strategies do so at their peril. Soon, the lack of such a strategy could send a financial institution's share price spinning, as financial markets perceive that such organisations will be left at a significant competitive disadvantage.

Deloitte Research estimates that $356bn of cost for the global financial services industry will be relocated offshore through either outsourced or captive models within the next five years. As offshoring gains momentum, financial institutions will likely move a broader range of functions to lower-cost locations. Currently, the majority of offshore moves involve establishing small IT shops - in India, for example - for the development of software. It is likely that within two years, this figure will become inverted, with a new majority of offshore moves encompassing all types of business processes - IT (applications development, coding and programming), operations (finance and accounting, processing and administration, and operations) and contact functions (call centres and contact support).

Those institutions currently offshore - primarily banks and insurers - will lead the shift to full-service outsourcing, as they anticipate the proportion of cost savings will rise as they scale their operations.

The expectations are that in the next two years, the average number of functions is likely to increase from less than two to more than four.

This move is likely to be accompanied by growth in the average size of offshore locations from less than 500 to closer to 1,000.

Location ... location ... location

Although many companies relocate offshore for cost, they stay for quality.

Contrary to popular belief, moving to a lower-cost location does not necessarily precipitate a drop in the quality of inputs or customer service. Indeed, many companies, both financial and non-financial, often encounter a pleasant surprise; not only do costs drop for many business processes, but the efficiency and effectiveness also improve.

To date, India - which is recognised for both low cost and quality service - has dominated the early market for offshore processing, particularly in the IT and software development areas. A recent survey by Deloitte Research suggests that India is likely to continue as the key offshore destination in the near term. The survey reports that nearly half the financial institutions planning offshore moves are considering at least two locations, with India being one of them. In the future, offshore activity is expected to extend around the Indian Ocean Rim, encompassing markets in South Africa, Malaysia, Australia, China and Singapore. Nonetheless, the hub market will be India, potentially accounting for as many as one million new positions from offshored financial services.

In assessing future locations, it would seem that a city-based approach, rather than a country-based one, is most effective. A detailed analysis of cities around the Indian Ocean Rim - which should be part of any offshore planning work - can help you understand which cities may be suitable to host specific functions.

Achieving a model blend

Another crucial issue in ensuring future offshoring success involves selecting the most appropriate ownership model. But like a comfortable pair of shoes, one size doesn't fit all. The correct blend of in-house, partnership and outsourced activities is needed to put the offshore business on a solid foundation, and there are six factors that drive the selection of a specific ownership vehicle.

1) Operational risk versus cost savings - any offshore arrangement, whether captive or outsourced, adds a degree of operational risk. In selecting an ownership model, this risk must be weighed against the potential cost savings. For instance, an insurance company may find it easier and less risky to offshore business related to 'closed book' as opposed to underwriting capability.

2) Desired degree of control - a third-party contractor will always be more accountable to their own structural shells than they will be to you. This factor often fuels the decision to build an offshore facility. Cultural issues also come into play. In some instances, a company may wish to maintain control by using a captive model that is more compatible with its internal culture.

3) Flexibility requirements - captive, outsource and joint venture models must all be evaluated in terms of the flexibility they provide in managing the processes that might be offshored. Also, it is important to consider how a second, or even a third, offshore location will impact the organisation within the constraints of a given model. For instance, will it provide greater scope around labour arbitrage, business continuity provisioning, and/or economy of scale building?

4) Speed of execution - typically, it is faster to implement an outsourced option than a captive one.

5) Cultural alignment - with successful offshoring initiatives, there is usually a close alignment between an organisation's culture and that of the selected offshore model. For instance, if the organisation doesn't typically use outsourcing services, then it might be more difficult to implement a successful outsourcing model.

6) In-depth local knowledge - it is crucial to understand the cultural differences, such as pricing policies, among various outsourcers. A good understanding of local law also helps. The legal and tax differences between establishing a captive within India in comparison to South Africa, for example, are dramatic. Further, understanding the needs and concerns of the local workforce is also critical to making offshoring work. For example, captive facilities in Indian cities are often located on the periphery.

Staff members have to travel relatively long distances between home and work, so it is important to maintain a fleet of buses to shuttle employees back and forth.

Ongoing management

Adequate preparation and planning accelerate offshoring efforts and mitigate many risks by the time the transition begins. This includes establishment of a well-structured governance model, which should provide the framework for ongoing management. But even with these proven structural elements, remote management remains difficult under the best of circumstances. That's why continuous vigilance is crucial. This can be partially accomplished by monitoring appropriate metrics and service level agreements, although close working relationships with offshore staff members are still a must.

Experience suggests that a rigorous management approach to offshoring can yield other benefits. First, by developing a business case for offshoring, companies achieve a greater understanding of possible cost savings and efficiencies. Many companies find this to be a logical intermediate step prior to outsourcing. Through the lower cost base and better understanding of cost and efficiency attained through offshoring, companies have a much stronger point of departure for negotiating an outsourcing deal.

Second, resources performing a given function tend to receive seniority-based pay increases and become more qualified through experience. The functions performed, however, become neither more valuable nor more complex.

Offshoring allows a recalibration of the workforce, with the associated costs of having only the required skill and seniority level for a particular function. Factor in a lower wage location, and real cost savings between 60% and 80% are within reach.

Third, the best offshoring arrangements enhance strategic flexibility.

Operations are crafted with the flexibility to increase or decrease the level of control, change geography or revise legal structure to reflect future changes in the strategic importance of a function.

Other key success factors in ongoing management include:

- execute according to a detailed, highly structured and well-understood transition plan;

- establish a project office that usually evolves into a permanent management structure;

- continue refining and adjusting the governance model and all accompanying processes;

- manage ongoing communication and expectations;

- create mechanisms for weekly reporting and issue resolution;

- conduct ongoing progress/program/relationship review; and

- establish some management presence in the offshore location.

Get it right the first time

Reflecting the current environment, every major financial institution should be evaluating what offshoring could deliver for their business.

Most have begun this journey and have established trial operations in some instances. As offshoring transitions from a trend to an imperative, it is essential to catch the wave before your organisation is left behind.

Nevertheless, re/insurers must move cautiously in this space. Research shows that those financial institutions that moved offshore too quickly are operating on a sub-optimal basis. If an offshoring arrangement fails to produce expected returns, the organisation loses trust in the process and it becomes much more difficult to try again. The lesson is succinct: get it right the first time. Those that can may be able to ride the offshoring wave to an unprecedented level of competitive advantage.

COVER FOR OUTSOURCED OPERATIONS

In December 2003, Aon Ltd placed the first cover in the Lloyd's market to reimburse the cost of relocating outsourced operations.

The company stated that by seeking to outsource sections of their core operations to offshore locations, including call centres and claims handling, companies were exposing themselves to a whole new range of risks, including terrorism, political instability and civil unrest.

The benefits of choosing to relocate operations offshore can easily be lost should such operations be closed down due to circumstances entirely beyond the company's control, such as a trade embargo between a company's home country and the country where its outsourced operations are based.

To combat such a threat, Aon's counter terrorism & political risk (CTPR) division developed a new policy to cover the cost of shutting down an offshore outsourcing operation and re-establishing it in another country.

The policy covers relocation costs in the event of war, terrorism, trade embargo, strike, supplier insolvency and expropriation by the host government, but can also include more traditional and natural perils.

Charles Keville, director of CTPR, who was responsible for arranging the policy, said "With so many companies these days looking to cut costs by 'offshoring' significant parts of their operations, the speed at which they are able to relocate those operations should disaster strike is paramount in protecting both their revenues and their reputation."

- Chris Gentle is Director of Research and Roy O'Neil a Partner in the London offices of Deloitte. Michael Ricks is a Partner based in Deloitte's Munich operation.