A decade ago, the UK’s life industry generated new business exceeding outflows, a positive situation that has reversed dramatically, throwing the industry’s in-force business into decline. While insurers have responded with cost-cutting strategies, there is a limit to how long this will compensate for a dearth of new business.
When assessing growth in the life insurance industry, premium income paints only half the picture. The other half is painted by outflows. In the case of the UK life industry, when this other half is added the completed picture becomes concerning. The Financial Services Authority (FSA) has been in the forefront of sounding this warning.
The FSA’s concern revolves around the life insurance industry’s aggregate net business flow which it defines as premium income less claims incurred as a percentage of claims incurred. In 2009, net business flow stood as high as a positive 40.5% but in subsequent years began an almost uninterrupted decline before turning negative in 2006.
Between 2006 and 2010, net business flow averaged a negative 23%. This five-year period included the boom years for premium income which reached a peak in terms of new domestic business of £92.74bn ($147bn) in 2007 according to the Association of British Insurers (ABI). In the same year, life premium income stood at a record 15.28% of the UK’s GDP, according to Swiss Re.
The FSA observes that the decline in net business flow partly reflects diminishing levels of new long-term savings from consumers, in particular lower contributions to pension arrangements. In part, adds the FSA, this is due to the effect of increasing amounts of money being withdrawn through maturities, surrenders and annuity payments not being reinvested in insurance products.
The FSA stresses: “The net flow is now very much away from the life industry and back into the hands of consumers.”
The FSA notes that a continuation of the current trend of net outflows will, if not countered by appropriate strategies, eventually place upward pressure on insurers’ unit costs and erode profitability. This is a reality many UK life insurers have come to terms with, with most of the larger ones having radically restructured their business models over the past two to three years.
Antonello Aquino, a vice-president and senior credit officer at rating agency Moody’s Investor Services, explained in a recent study that new business models are focused on maximising cash flow generation and minimising new business capital strain. To this end, insurers have been cutting costs and focusing on high margin products (annuities and protection), offering lower guarantees (so-called capital-light products) and reducing upfront commission paid to financial advisers.
Echoing the FSA’s concern, Aquino noted that the largest part of the cash flows generated by the life insurance industry are from what he terms the “monetisation” of the value of in force (VIF) business.
Aquino stressed: “The challenge for the industry is to ensure that the new generation of capital-light products is able to secure a solid cash flow pattern in the long term, and replenish the VIF monetised year after year by continuing to write appropriate levels of new business.”
Moody’s outlook for the UK life industry is negative.
Indicative of the underlying trend in the UK life industry, data from the ABI shows that between 2005 and 2010, total in-force individual business, including group pension schemes, fell by almost 8%, from £75.9bn to £69.9bn.
Arguably, investors’ relatively low expectations of the longer-term growth potential of business models being followed by many of the UK’s largest insurers is reflected in the rating of their shares on the London Stock Exchange. For example, Prudential is currently trading on a historic price-to-earnings (P:E) ratio of 9.9 and Legal & General on a 9.1 P:E. Both are below an already depressed average P:E of 10.6 for the benchmark FT100 Index as a whole.
While Aviva is afforded a far higher 12.4P:E rating it also offers the third-highest dividend yield of any FT100 company, namely 6.9% compared to the FT100’s average yield of 3.3%. Similarly, while Standard Life is trading on 12.4P:E it also offers a generous dividend yield of 5.8%, the ninth-highest of any FT100 company.
A tough sell
On paper there is an abundance of opportunity for life insurers to write new business in the UK. According to Swiss Re’s UK Term & Health Watch 2011 study, there is a £2.4trn life insurance protection gap in the UK, while Datamonitor’s Financial Services Consumer Insight Survey in June 2011 found that 56% of UK adults do not have life cover, almost 87% of people do not have critical illness cover and 90% do not have income protection. Notably, according to ABI data, total protection insurance premium income almost halved between 2000 and 2010, from £40bn to just over £20bn.
Adding further evidence of a vast potential market for the UK life industry, research from building society Nationwide reveals that 47% of parents in the UK do not have life insurance cover while 76% of parents do not have any critical illness cover in place.
In its latest Family Finances Report, insurer Aviva estimates that the number of families with protection insurance has fallen over the past 12 months.
Specifically, while families with life insurance was up from 39% in January 2011 to 40% in January 2012, the number with private health insurance fell from 15% to 12% over the same period, those with critical illness policies fell from 13% to 12% and those with income protection was down from 11% to 10%.
This trend is symptomatic of the harsh economic conditions being experienced in the UK. As the FSA notes, confidence among consumers is low and their disposable income is under pressure as a result of high levels of household debt, low earnings inflation and adverse investment market conditions.
In addition, unemployment in the UK has jumped. According to the Office for National Statistics, the unemployment rate in November 2011 stood at 8.4%, the highest level since January 1996. This represented 2.69m people unemployed, an increase of just over 1m since November 2007.
In its Family Finances Report, Aviva notes that while the average net monthly income of UK families increased by 7% since January 2011 to £2,066, the over-55 year old segment actually saw a decline of 4% in average income. This was against the background of retail price inflation of 5.4% in 2011.
Also of concern was that consumer debt increased at a significantly faster pace than incomes in 2011. Specifically, Aviva found that the typical family debt – excluding mortgages – increased by 48% from £5,360 in January 2011 to £7,944 in January 2012.
“This shows that families are building on their existing debts rather than clearing them,” notes Aviva.
In addition, Aviva found that of the 42% of families that are saving, the average monthly amount being saved fell from £22 in January 2011 to £21 in January 2012.
Aviva’s study also reveals that the typical person over 55 now has £11,153 in savings and investments, which is 27% lower than the £15,262 average in December 2010.
“This is partly because more people have found themselves dipping into funds to top up their income in order to meet day-to-day costs,” notes Aviva.
Among the over-55 segment Aviva found that the average level of accumulated pension savings was a meagre £26,940. However, on a positive note, the average house owned by the over-55s was worth £238,284 in December 2011 while the average amount of equity stood at £223,112.
Pointing to what could become a big growth area for insurers, Aviva commented: “It is likely we will see a more widespread take-up of equity release in the future.”
Time for a rethink
For UK life insurers serious about increasing the level of new business there is potential, it would appear. Drawing conclusions from a recent extensive survey of UK consumers, employers and savings industry experts, Swiss Re believes the life industry has an opportunity to boost its new business flows. What is now present, emphasises Swiss Re, is an environment in which consumers, shaken by years of financial uncertainty, are likely to be more amenable to buying protection and savings products.
“There is a marked change in consumer awareness,” says Russell Higginbotham, CEO of Swiss Re in the UK and Ireland. “We should build on this and help consumers address their uncertainty by offering straightforward advice and simple products which consumers will consider essential and bring them to buy financial protection and invest in pensions instead of the latest iPhone or other gadget.”
He continues: “We need to change the way we think about how protection is understood before we continue pushing the same old and rather tired propositions.
“Behavioural finance suggests that simple products would help consumers. People will not buy what they do not understand, but increasing understanding creates more confidence which will help people make more informed choices.”
Indicative of the change in consumer thinking, in 2009 Swiss Re found that the main reason people gave for not buying life insurance was that they did not think they needed cover. In its latest survey, the main responses were that they saw reducing their debt levels as a higher priority or that it was a matter of affordability.
Affordability – or the perception thereof – is a significant impediment to new business generation. In Swiss Re’s latest survey, when consumers who had not bought life insurance were asked why, 46% said they could not afford it.
Similarly, affordability was the main reason put forward by 47% of consumers for not buying critical illness and by 39% for not buying income protection. Only about 10% of consumers replied that they had not thought about buying cover.
Highlighting the need for more effective education of consumers on insurance matters, a recent survey by UK insurer Standard Life revealed that 48% of consumers do not know what an annuity is. Among the younger 35 to 44 year-old age group, an even higher 58% said they do not know what an annuity is. Overall, women (45%) are less likely to say they know what an annuity is compared with men (60%).
Of consumers who said they did know what an annuity is, 24% believe they offer poor value for money while 32% think there are more flexible retirement options available.
Distribution reform looms
Consumers under financial pressure or merely disinterested in life products are not the only problems insurers face. They also have to contend with looming reform of their primary distribution channel, the independent financial adviser (IFA).
Financial advice is free, the majority of consumers in the UK believe. From 31 December 2012 onwards, they will learn that is not the case when the FSA’s Retail Distribution Review (RDR) comes into force bringing with it a switch from a commission to a fee-based remuneration structure for financial advisers. Advisers will be obliged to tell consumers upfront how much their services cost and reach agreement on a fee. Consumers can also opt to have the cost deducted from their investment.
How the change will impact insurers remains to be seen. However, in a study, consultancy Accenture noted: “Once enacted, RDR will, at a stroke, remove commission as a competitive lever by which life insurers can control distribution.”
Adding uncertainty, a survey of financial advisers conducted on behalf of Zurich Financial Services in late-2011 found that almost half fear customers may not be prepared to pay a fee instead of commission for financial advice.
In an attempt to boost professionalism in the advisory sector, the FSA has also laid down qualification rules for advisers. To continue trading after January 2013, they will need to have obtained at the very least the diploma for financial advisers which, according to Scottish Life, is equivalent to the first-year of university study.
Despite the year-end 2012 deadline looming, there is still uncertainty on a number of issues related to the implementation of the RDR and to the impact that it will have on the IFA distribution channel.
Indeed, in July 2011, the parliamentary Treasury Select Committee (TSC) called for the RDR’s implementation to be delayed for 12 months. While in full agreement with the FSA on the abolition of commission, the TSC noted “the current timetable for reform risks putting large numbers of experienced financial advisers out of business”. The TSC noted that a 12-month delay would allow more advisers to meet the new qualification.
There is little love lost between the TSC and the FSA. Unsurprisingly, the FSA has not budged on its deadline for the RDR, development of which dates back to 2006 and which it estimates will cost between £1.4bn and £1.7bn during the first five years of its implementation.
How many IFAs will opt to leave the industry as a result of the RDR’s introduction is unclear but earlier fears that there would be a mass exodus appear to have been overly pessimistic.
According to Aviva’s Adviser Barometer study of November 2011, 89% of IFAs now say they expect to still be in business on 1 January 2013. An earlier survey conducted by Aviva about a year ago indicated that up to a quarter may leave the industry when the RDR takes effect.
Ultimately the FSA is unlikely to have anything to do with the RDR once it is implemented. Under the Financial Services Bill due to be promulgated early in 2012, regulation of the RDR will be the responsibility of the proposed Financial Conduct Authority (FCA).
The FCA was the subject of a report published by the TSC in December 2011. Commenting at the time of its publication, TSC chairman Andrew Tyrie, a member of parliament, left no doubts as to his opinion of the FSA.
“We need a fresh approach to regulation,” Tyrie said. “The plain fact is that the FSA did not succeed in protecting consumers from spectacular regulatory failures. The mis-selling of PPI [payment protection insurance] and endowment mortgages are just two examples.
“The FSA is not only expensive, for which the consumer always pays, but many have told us that it has also become bureaucratic and dominated by a box-ticking culture. The creation of the FCA is an opportunity to create something much better.”
What are not getting any better in the UK, it appears, are retirement prospects of workers. The defined benefit (DB) pension scheme is in terminal decline and although this offers significant business opportunity to insurers in the risk transfer game it offers cold comfort to workers.
The plight of the current workforce which is largely confined to defined contribution (DC) pension schemes is highlighted in a study by consulting actuaries Barnett Waddingham.
According to the firm, a member of a DB scheme who joined at age 20 and is retiring now at age 60 can expect to receive an annual pension of £21,070, based on a national average annual salary of £31,600. A member of a DC scheme over the same period on an 8% contribution of salary basis can expect a pension of £13,330.
Barnett Waddingham specifically chose an 8% of income contribution. This is because 8% is the minimum contribution under the new auto-enrolment rules laid down by the Pensions Act of 2008. Specifically, workers will contribute a minimum of 4% of their income, employers a minimum of 3% of a worker’s income, while tax relief will add a further 1%.
Auto-enrolment of workers into occupational DC schemes is due to begin a phasing-in process of some 10m workers in October 2012 and be completed in 2017. Employers can choose between their own pension scheme or the default scheme, the National Employment Savings Trust (NEST) while workers have the right to opt out of auto-enrolment.
Barnett Waddingham’s grim prognostication gets worse. The firm estimates that a 20 year old entering a DC scheme now can hope to receive an annual pension in current money terms of only £6,440, 40 years hence.
This far lower expected pension is the result of expected improvements in longevity (which equals lower annuity rates) and lower expected investment returns. Even if the member was to pay contributions for an extra five years and not draw pension until age 65, the projected pension in today’s money would only increase to £9,300.
Commenting on the study, Barnett Waddingham consultant Malcolm McLean says: “These figures show the stark reality of the pension divide between past and future generations.”
He stresses that there is more to the sorry story.
“I don’t think anyone should be in doubt about the extent of the pensions crisis we are facing. Millions of people are currently making no financial provision at all for their old age and seemingly have neither the ability nor the inclination to do so.”
Even auto-enrolment is unlikely to provide a complete answer and may also be “too little too late for many people”, says McClean.
“Everything seems to depend on a successful outcome for auto-enrolment which in turn depends rather unpredictably on the willingness of individuals to remain enrolled and not opt themselves out.”
He adds: “There are no equivalent plans, as far as I am aware, for the self-employed or those otherwise outside of employment.”
How auto-enrolment will affect insurers is unclear. Provided there is not an overwhelming preference for NEST or a mass opt-out, the potential in terms of business at least is significant. According to Aviva, 72% of family heads are not saving through a workplace pension scheme. However, 74% of the non-savers would be happy to join a scheme if their employer matched their savings.
“Auto-enrolment is going to mean big changes for many families in the UK,” notes Aviva.
On the NEST option, it is notable that life insurers do not feature among initial NEST fund managers. The selected managers are: UBS Global Asset Management, State Street Global Advisors UK and BlackRock UK Institutional Business.
Indicative of the potential opt-out rate, a survey of corporate advisers conducted by Aviva in November 2011 revealed that 20% of advisers believe that half of all employees will opt-out, a further 59% expect an opt-out rate of up to 30%, while only 2% expect there will be no drop out.
However, even if auto-enrolment was to be a complete success, the inadequacy of future pensions as reflected in Barnett Waddingham’s estimates would appear to present a further big opportunity for the life industry in the retirement savings arena.
Ultimately, a key determinant of the success of auto-enrolment and the UK life industry’s broader new business growth potential will be a resumption of solid economic growth and rising employment and disposable income. Chances of these drivers materialising in the immediate future appear slim.
Ominously, the National Institute of Economic and Social Research (NIESR) has declared the UK to be back in recession. The economic analysis think tank forecasts that the UK’s GDP will contract by 0.1% in 2012 and, providing the euro crisis is resolved, recover by 2.3% in 2013. Unemployment is predicted to rise to 9% in 2012 before easing to what the NIESR warns will still be an economically damaging 7% in 2014.