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

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

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

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.