US life insurers entered 2008 facing both opportunity and challenges. Opportunity lies in abundance in the rapidly expanding retirement market fuelled by millions of retiring baby boomers, while challenges include sweeping regulatory changes and increasingly complex risk management US life insurers will continue to experience modest growth in most lines of business in 2008, believes Doug French, an analyst at professional services firm Ernst & Young’s Global Insurance Center.
To support his view, French referred to total statutory net operating gains for the industry data published by consultancy Conning Research & Consulting (CR&C). According to CR&C, these fluctuated from $32.8 billion in 2005, to $27.4 billion in 2006, to $33.1billion in 2007 and will increase marginally to an estimated $33.5 billion in 2008. Between 2005 and 2008, this would represent a CAGR of 0.71 percent.
However, despite the overall modest growth prospects, there is one particular area that holds considerable potential for life insurers: the retirement market. “A new door opened for the life insurance industry when the first of the baby boomers applied for Social Security benefits in October 2007,” said French. He added that an estimated 10,000 people a day would become eligible for Social Security benefits over the next two decades.
In the US, the baby-boomer generation refers to the 76 million people born between 1946 and 1965. According to a study undertaken in 2006 by consultancy McKinsey & Company, by 2020 two-thirds of investable assets in the US will belong to retirees and soon-to-be retirees.
Focus on post-retirement
Combined with increased longevity, the burgeoning number of retirees and near-retirees means that investors are focused more than ever on the post-retirement phase, noted asset management company State Street Corporation (SSC) in a study published in late 2007. “As this enormous group of people prepares to retire at a time when a corporate pension is no longer a sure thing, baby boomers will require products that reflect a shift in goals consistent with the de-accumulation phase such as income and principal protection,” said SSC.
SSC explained that placed in the broader perspective of a complete post-retirement picture, new products for baby boomers must look beyond simply solving the income stream issue. Products that deliver income and manage risk are likely to be the most successful. In this context, post-retirement financial products include annuities, long-term care, fixed and variable investments and other life insurance vehicles.
“The most significant opportunity for organic growth in the insurance industry is represented by the 35 million middle-wealth baby boomers facing the realities of retirement,” said French. “As they shift their defined contribution plans, they will seek predictable low-cost income-producing financial products.” French defined middle-wealth baby boomers as those with investable assets of between $250,000 and $750,000.
No room for complacency
But for all the attractions of the fast-growing retirement market, insurers cannot afford to be complacent. “It is clear that insurers are no longer guaranteed a seat at the income planning table simply because they are currently the only writers of payout annuity products,” warned French. “Insurers need to take a more aggressive stance since mutual funds, asset management firms and other financial services institutions are aggressively competing for the same dollars, and will build approaches that minimise the need for insurance products.”
He continued that the financial protection that will be demanded by the retiring baby boomers will transform savings products and distribution systems on which life insurers have relied for years. “This will require an approach that not only manages financial risk, but also manages overall health risks, including disability coverage for senior citizens who remain in the work force,” said French. However, he cautioned: “It is not clear whether insurance companies will be able to innovate quickly enough to establish an early competitive advantage.”
On a more optimistic note, SSC noted that there is a need for transparent and customised products that are both upfront about investment costs and that can be tailored to an individual’s investment horizon and income needs. “Insurance companies, with their expertise in risk management, are well positioned to answer these needs,” said SSC.
Life insurers in the US are already developing products that offer income stream solutions, such as reverse mortgage products and longevity insurance, continued SSC. Principal protected products are also receiving renewed attention.
Wealth management and estate planning goals will also factor into the creation of new products for the de-accumulation phase, added SSC. “For instance, some insurers are already imagining products that combine annuities with disability or critical-care insurance,” said SSC. The ultimate goal of these products is to create a hedge against rising health care costs.
SSC believes that long-term care insurance is a product range that has a bright future. “Although it has seen lukewarm sales to date, long-term care insurance is a product poised for success with baby boomers,” predicted SSC. The Pension Protection Act of 2006 (PPA) “breathed new life” into this product by enabling a tax-free exchange between annuity or life insurance contracts and long-term-care insurance contracts, explained SSC.
The PPA also clarifies that amounts withdrawn from certain life insurance and annuity contracts to pay for qualified, long-term-care insurance will not count as taxable income for the policyholder, continued SSC. While the PPA does not become effective until 1 January 2010, several insurers are already selling annuities that include a long-term-care feature alongside an annuity, added SSC.
Adapting to a changing customer landscape is not the only challenge US life insurers face. Also looming on the horizon are regulatory changes that are likely to revolutionise the way in which insurers manage risk. In particular, noted SSC, the National Association of Insurance Commissioners, the organisation to which all US state insurance regulators belong, has proposed changes similar to those under Europe’s Solvency II regulations that are due for introduction in 2012.
Principles-based risk management
For US insurers, adoption of an approach similar to Solvency II would entail moving from a formulaic risk management approach to a principles-based approach. A key element of Solvency II is that while minimum capital requirements will still pertain, insurers will be required to assess their own capital needs in light of all risks pertaining to their business.
And while the Solvency II 2012 deadline is viewed by many European insurers as tight, US insurers may face an even tighter deadline. French believes US life insurers may become subject to new principles-based regulatory regime “in the next year or two”, well ahead of the Solvency II timetable.
Fortunately, US insurers appear to be taking a proactive approach to a principles-based regulatory regime, reveals a survey of North American chief financial officers published by the Tillinghast insurance practice of consultancy Towers Perrin in December 2007.
According to Tillinghast, respondents reported a new level of familiarity with principles-based regulation of reserves and capital. “Fully 92 percent of respondents indicate that they understand the basics of new principles-based regulation, up dramatically from only 40 percent a year earlier,” said Tillinghast. In addition, said Tillinghast, no respondents in its latest survey selected the comments “I am not at all familiar with the new framework” or “I know very little about the new framework”. This compared with 42 percent of respondents who selected either of these two responses a year earlier.
Tillinghast also found that while most CFOs do not expect full implementation of the new regulatory framework until 2010 or later, more than one-half reported that they are “actively preparing” for it. “This, too, is a marked change from a year earlier, when most companies were in a wait-and-see mode,” said Tillinghast.
However, despite encouraging indications from CFOs, Tillinghast added that the survey’s results indicated that shifting to principles-based regulation would not be easy. “Cost is one obvious hurdle, and the benefits are not all that clear, “said Tillinghast. Other points raised by CFOs included the need to dedicate significant resources to improve modelling capabilities (79 percent of CFOs), a need to develop hedging programmes (87 percent) and concern that the new regulation would lead to a lack of comparability of results across companies (80 percent).
Challenge of fair value accounting
A parallel challenge facing life insurers is the possibility of the introduction of a new fair value accounting standard, both in the US and Europe. The TIAA-CREF Institute (TCI), the research unit of US financial service company TIAA-CREF, defines fair value accounting as an approach that uses market or estimated market-based values for each asset and liability on a company’s balance sheet. This differs from the current accounting approach used by life insurers which relies on an amortised cost approach to valuing assets and liabilities. “This is a profound departure from existing accounting systems in use by life insurance companies,” noted the TCI in a study.
“The message is clear, a major, fundamental change in financial reporting for insurers is now on the horizon,” said French. He added that the International Accounting Standards Board (IASB) issued a Phase II Discussion Paper on accounting for insurance contracts in May 2007 and invited comments to be submitted by November 2007. The IASB expects to issue an exposure draft on the subject in 2009.
French stressed that although the date for implementation of a fair value accounting standard has been delayed (the original deadline was 2007), it is not too soon for US insurers to begin examining the impact of the preliminary views set out in the IASB’s discussion paper on their financial systems and statements. “The implementation effort required for insurers is expected to be enormous,” said French. “Companies should begin developing a plan that includes steps to assess the impact of the proposals on their financial statements, educate key employees and constituents, and evaluate the readiness of their organisation for implementation.”
Of concern, however, is that Tillinghast’s survey revealed only 8 percent of CFOs polled are “very knowledgeable” about the IASB’s discussion paper on insurance contracts. “We believe this is cause for concern, given the ongoing drive for convergence in global accounting standards,” said Tillinghast.
SSC noted that adoption of fair value accounting rules in many other regions has already altered the insurance business significantly. In particular, in their approach to asset management, insurers have been driven toward broader portfolio diversification.
Indeed, French noted that broader portfolio diversification by US insurers is already the order of the day, according to data from Citigroup Investment Research (CIR), a unit of US bank Citi. According to CIR, over the past five years there has been an increase in alternative asset investment, with these asset classes now representing almost 22 percent of the life insurance industry’s asset composition. “Where life insurance traditionally relied on high-quality corporate bonds and mortgage-backed securities, there is now greater emphasis on aggressively structured asset-backed securities, hedge funds, private equity, real estate and other related classes,” said French.
With diversification of this nature has come the need for far more sophisticated risk management, the importance of which was illustrated by recent credit market turmoil. However, it is becoming more difficult to understand the underlying risks because credit risk has become more opaque and uncertain, said French. “Organisations which have the people, systems and processes to capture and truly understand and manage the risks from these new asset classes will have a competitive advantage,” he concluded.