Windows of Opportunity - 2011 global insurance outlook by Remon Houweling

Windows of opportunity 2011 global insurance outlook

Contents Executive Summary ................................. 1 Asia-Pacific ............................................. 3 Europe .................................................... 13 US life ..................................................... 23 US property/casualty ............................... 29

Windows of opportunity: 2011 global insurance outlook

Executive Summary Ernst & Young’s global insurance outlook explores the issues confronting global insurance organizations in 2011. In this report, we offer our perspective on the insurance markets in Asia-Pacific and Europe, as well as the US life and US property/casualty sectors. The key themes for 2011 are:

Asia-Pacific

US life

• Adjusting and expanding distribution strategies amid shifting demographics and consumer buying patterns

• Responding to the changing regulatory environment

• Developing strategies to shape and comply with the heightened pace of local and global regulatory and accounting developments

• Improving operational efficiencies to control cost

• Developing dependable capital sources required to support accelerating business growth • Operational improvements, takaful opportunities and regional hubs

Europe • Manage critical capital and risk challenges • Develop distribution flexibility and support systems • Improve process efficiency and develop new markets

• Establishing capital and risk management solutions post-crisis

• Reinventing products and distribution to energize growth

US property/casualty • Operating in a sluggish US economy • Enduring the soft underwriting cycle • Leveraging analytics to drive the growth agenda • Effectively transitioning to the new accounting standards • Anticipating regulatory and legislative developments • Analyzing opportunities for managing excess capital

• Focus on non-life loss control • Optimize corporate structure and domicile

Windows of opportunity: 2011 global insurance outlook

Asia-Pacific

Executive summary As insurance companies seek growth opportunities in the Asia-Pacific region, they confront significant opportunities. Domestic insurance markets in much of the region have improved, as a growing number of consumers seek to purchase insurance. Additionally, the regulatory systems across much of the region have become more sophisticated.

Some challenges, of course, remain. Since Asia-Pacific is a highly diverse super-region with respect to different countriesâ&#x20AC;&#x2122; economic development and insurance penetration, the rate and drivers of growth vary on a marketby-market basis. Mature markets, for example, are more saturated insofar as insurance penetration. Developing and emerging markets, on the other hand, offer greater growth opportunities for companies prepared to invest for the long haul.

Windows of opportunity: 2011 global insurance outlook

Ernst & Young anticipates further regional evolution, but not revolution, in AsiaPacific markets in 2011. Each insurerâ&#x20AC;&#x2122;s strategic prioritization and response to the opportunities presented may reap significant rewards. Early movers may especially benefit by their immediate actions, while the insurers who wait to discern the short-term mistakes of others may similarly attain valuable traction. Indefinitely postponing a response to the current market opportunities seems illadvised, given the chief attraction of the

By 2015, approximately 39% of the world’s economy is predicted to be in Asia-Pacific (see Figure 2). Ernst & Young has identified three key issues that will influence insurers looking to share in this growth in 2011: • Adjusting and expanding distribution strategies amid shifting demographics and consumer buying patterns • Developing strategies to shape and comply with the heightened pace of local and global regulatory and accounting developments

Figure 1: Average insurance growth rates by region 1999 – 2009 25 Annual average growth rate 1999-2009

Asia-Pacific market—its remarkable growth rate, the world’s fastest, as Figure 1 illustrates. This alone helps explain why many multinational insurers are either preparing plans for further investment in the region, or are in the thick of implementing them.

Category

Markets

Mature

Australia

World

• Developing dependable capital sources required to support accelerating business growth Within this outlook, economies have been classified as mature, developing or emerging markets. For the purpose of this outlook, we have broadly classified the various markets as follows:

South and East Asia Latin America and Caribbean Western Europe North America

0 Lif e

Non-lif e

Source: Swiss Re Sigma No 2/2010, Ernst & Young analysis

Figure 2: Predicted GDP by region 85

Hong Kong Japan Korea New Zealand Asia

Singapore Taiwan Developing

Emerging

Oceania

China

South America

India

Africa

Malaysia

Europe

Thailand

North America

Indonesia Philippines Vietnam

0 1980

1990

2000

2010F

2015F

Source: International Monetary Fund, Swiss Re Sigma 2005, United Nations statistics division, World Wealth Report, United Nations Population study, Ernst & Young analysis.

Adjusting and expanding distribution strategies amid shifting demographics and consumer buying patterns The traditional agency distribution model for selling life and health insurance in the Asia-Pacific region is increasingly challenged by the development of alternative sales channels. The insurers that take advantage of many customers’ willingness to buy insurance outside the established agency and independent financial advisor channels (in some markets) can both increase production volumes and more effectively manage expenses. This will require some insurers to retool their existing distribution models, adopting more flexible sales approaches that leverage new or rapidly shifting technologies. Certainly, the high cost of recruiting and training new agents and retaining existing ones is a factor in considering such alternative distribution channels. Another is the possibility of utilizing the alternative channels for non-life sales down the line. Examples of successful alternative distribution mechanisms include bancassurance, Internetbased sales and telemarketing, and sales via mobile phones. Not all the alternative models are without risk—telemarketing, for instance, has endured recent setbacks in the region from growing consumer privacy concerns. In response, many jurisdictions are considering an approach where consumers opt to be contacted, as opposed to the insurer initiating contact. Shifts also are underway in some of these distribution strategies to improve sales metrics. Bancassurers, for example, are seeking to expand their distribution networks beyond sales at bank branches, and are beginning to make headway selling products through ATMs, online banking systems and call centers. The investments make sense: whereas bank-insurer relationships are under pressure in most parts of the world, in AsiaPacific the bancassurance model continues to grow in acceptance and importance. A factor is the emergence of an ultra-wealthy class,

leading many of the regions’ major banks to make substantial investments in private banking and wealth platforms to access this market. Internet distribution methodologies also continue to grow in popularity in the region, primarily as an insurance research tool but increasingly as a source of new business. More than 60% of insurance customers throughout Asia-Pacific now use the Internet as their primary channel for researching insurance products. The evolution in both traditional and alternative distribution channels has encouraged a sharper focus on customer segmentation strategies. Many multinational insurers are investing in sophisticated analytical tools to better understand their customers. By clarifying these customers’ expectations, they hope to craft a more efficient delivery mechanism in each defined customer segment. These trends appear to be accelerating. Now let’s glimpse these macro changes across the different market types.

Mature markets In more mature markets like Hong Kong and Australia, market concentration is becoming a key challenge. Bancassurance also has become increasingly important as banks leverage their infrastructures to pursue cross-selling opportunities. In Hong Kong, for example, bancassurance has been a successful strategy, with companies like BOC Group Life, China Life, Hang Seng Life and HSBC Life now owning a commanding market share. Australia also has strong bancassurance sales for life insurance products, with all four of the biggest banks—including ANZ and Westpac—now owning a 43% market share. Recently, the joint venture between ING and ANZ was dissolved, with ANZ acquiring ING’s 51% share of the joint venture.

Significant bancassurance opportunities exist in all mature markets, as no location in Asia-Pacific has bancassurance market levels approaching some European countries, which are well above 60%. In many of these markets, direct distribution of general insurance is an established theme. Nevertheless, the expectation is for accelerated market entry by Internetbased insurers like Youi in Australia, as well as increased development of direct life insurance platforms like AvivaDirect in Singapore and Realinsurance in Australia.

Developing markets In 2010, China reported a 44% increase in premiums from bancassurance sales compared to the same period in the prior year. This contrasts sharply with premiums from agency sales, which increased by only 17% over the same duration. Insurance premiums from Internet sales in China similarly grew, surpassing the US$1 billion mark (7.8 billion renmimbi) in 2009. Although it is difficult to predict whether this channel will see the same growth in China as it has in other markets, it is clearly now a permanent facet of the market. In Malaysia, bancassurance is growing strongly and is estimated to have a market share of around 45%. Thailand also enjoys robust bancassurance sales of around 30%. In India, several insurers have all announced linkages with banks to sell both life and nonlife insurance. Promoting these developments are comments by India’s Ministry of Finance urging banks to enter the insurance market. At the same time, the traditional agency channel in the country has been under pressure, following a review of unit-linked commission structures by the industry regulator, IRDA, during the year.

In Singapore and Taiwan, bancassurance market share is estimated at 27% and 7%, respectively. The trend suggests that these percentages will increase significantly over the next few years. Both Korea and Japan offer huge bancassurance potential, given the relaxation of restrictions around bancassurance in these markets in recent years. Windows of opportunity: 2011 global insurance outlook

Emerging markets Bancassurance also continues to perform strongly in emerging Asia-Pacific markets. In Indonesia, for example, bancassurance now accounts for 22% of premiums. AXA has a long-standing arrangement with the largest bank for life insurance. In some markets like Vietnam, however, the take-up has been slow. Banks and insurers are struggling to develop an appropriate model; moreover, a small percentage of the population currently has a bank account. New market entrants and even insurers that take the long view can establish a bancassurance brand today, positioning the companies when bancassurance gains acceptance. As yet, there have been no meaningful attempts at online sales models or direct sales of insurance in these markets.

Developing strategies to shape and comply with the heightened pace of local and global regulatory and accounting developments

and experience. Depending on the country, some of these entities have also been subject to more advanced IFRS reporting requirements. Their use provides an opportunity for local regulators to evaluate the value-added benefit of moving towards more global solvency and accounting frameworks.

During 2011, regulations will continue to evolve in the wake of the global financial crisis. These emerging regulations also may quickly change because of subsequent economic and political factors. Additionally, the growing involvement of local regulators in global initiatives may play a larger role in affecting insurance regulations. Consequently, it remains crucial for insurers in the coming year to stay abreast of proposed changes to local or regional regulations. Insurers must quickly identify the potential business impact of prospective regulations and alter their strategies accordingly.

In the near term, widespread adoption of Solvency II is unlikely in the region because of the long lead time involved in preparing necessary resources and calibrating the risk factors for local countries. Nevertheless, all Asia-Pacific regulators will look towards the Solvency II framework to guide their thinking in areas like enterprise risk management (ERM) and internal models, activities that will continue in the medium term.

Many Western European insurers have established a presence in Asia-Pacific. These companies bring to their Asia-Pacific operations valuable Solvency II requirements

Regulatory frameworks within the region are at different stages of development, and are subject to rapid change. These frameworks are illustrated in Figure 3.

Several markets have implemented RBC frameworks, and others are following suit. Some markets are moving in this direction gradually for pragmatic reasons, and are slowly building up the requirements. Hong Kong, for example, announced in November 2010 that it plans to move to RBC and will conduct a formal study on the subject in the second half of 2011. The shift towards RBC may lead some insurers to seek new capital infusions, reduce growth rates, seek a merger, or possibly even close their operations. IFRS adoption or alignment is either widespread or in progress in the region. This enhances the ability to compare the financial statements of companies within the Asia-Pacific region with their counterparts in Europe, Canada and, in the near future, the United States. In a real way, IFRS represents the emergence of a global financial reporting language, which can help lower the compliance costs for companies seeking capital from different markets. It also facilitates comparison of a companyâ&#x20AC;&#x2122;s performance across jurisdictions. A new insurance standard is expected later in 2011, with implementation in 2013-2014. It is important to understand the linkages between IFRS and Solvency II, not to mention potential conflictsâ&#x20AC;&#x201D;the key differences in their

Figure 3: Assessment of the regulatory environment within the region Mature countries Developing countries

Transparency and disclosure

Emerging countries

VT CN

Lower

SG Higher

Medium HK

Rules rather than principles

AU MY

TH IN

SG AU

Rules

Principles HK

Risk based capital

NZ TH

PH CN

Not applicable

AU KR

JP Embedded in business

Recently established TW

Regulatory maturity (based on above)

VT PH

JP MY

AU SG

Immature

respective measurement, risk margin, entity and reporting requirements. Insurers also need to closely monitor reporting and capital differences between US-based and European organizations in their product treatment. At present, the European approach generally seems to be more influential to regulators in Asia-Pacific; consequently, it will be interesting to see how insurers with US reporting obligations approach areas of significant divergence. Let’s look at these global regulatory and accounting issues across the different market types.

Mature markets Japan’s Financial Services Agency has overhauled its inspection approach to ensure the financial stability and stronger risk management of insurance companies. The new requirements are expected to include stricter standards for capital adequacy and will align with pending changes to the

Mature

calculation of insurers’ solvency margin ratios and the application of IFRS to listed companies, with an early voluntary adoption permitted for the fiscal year ending in or after March 2010, followed by a decision in 2012 on whether to make adoption mandatory starting in 2015 or 2016. The Monetary Authority of Singapore has recently issued new guidelines on Corporate Governance for direct insurers and other financial institutions, with an increased focus on the importance of the Board and the need for directors to have appropriate skills and a commitment to oversee the insurers’ operations. In Australia, the regulator, APRA, expects to release draft capital standards for life and general insurers in early 2011, to take effect in 2012. The proposed framework is based on a three pillar approach to capital supervision, similar to Solvency II. Early indications are that additional levels of capital may be required, although this is not the regulatory intent.

Windows of opportunity: 2011 global insurance outlook

Developing markets China fully adopted the IFRS insurance Phase 2 concepts in 2009. Over time, the experiences of Chinese insurers may be valuable for overseas IFRS insurers, which are likely to adopt IFRS in the future. China’s Insurance Regulatory Commission (CIRC) has increased its focus on solvency by requiring companies to maintain at least 100% of actual capital to required statutory minimum capital, with 150% gauged as the recommended level. This has led some insurers to raise subordinated debt and expectations of additional capital. At the end of June 2010, nine insurers did not meet the CIRC’s new solvency standard. India issued new regulations relating to unit linked-life insurance products, setting minimum returns at 4.5%, increasing the holding period and establishing higher capital requirements.

Regulators in other countries continue to review regulations concerning the percentage for foreign ownership of local insurers.

Emerging markets Vietnam is considering amendments and supplements to its Business Insurance Law to heighten the supervisory power of regulators, while Indonesia continues to scale up the levels of RBC that insurers must meet, following delays to the original timetable.

Developing dependable capital sources required to support accelerating business growth Given expected strong growth of AsiaPacific insurance markets in 2011, with some experts predicting double-digit annual premium increases, insurers will need access to dependable supplies of capital to comply with solvency requirements, support organic growth, and for some players, seize merger opportunities. Many insurers also may need

to invest in the development of back-office systems, develop new branch offices and hire staff, among other business activities. The strain on capital from these investments is in addition to the liabilities assumed from the issuance of new policies. While a key use of capital is to support organic growth, insurers in some markets may have opportunities to acquire competitors or expand into new geographic markets. In some markets like China, both large and small insurers are competing in a relatively underpenetrated market. Given more stringent solvency requirements, some smaller insurers may seek to exit the market, offering other insurers an acquisition opportunity. In part, merger and acquisition opportunities appear driven by a renewed focus on return on capital measures, and a perceived need to extract value from different areas of the business. The dealmakers consequently will need significant internal capital or access to credit and/or equity markets to raise funds to close transactions.

Companies seeking expansion in the region confront many challenges. Within Asia-Pacific are extremes of protectionist policies, from 0% foreign ownership to 100% foreign ownership to more intermediate allowances. In China and India, foreign insurers have made only limited inroads in the local market, attaining insignificant market share. Stiff restrictions in both countries limit foreign insurersâ&#x20AC;&#x2122; access to important business lines and freedom of reinsurance. Nevertheless, India and China are perceived to represent the worldâ&#x20AC;&#x2122;s greatest growth opportunities, collectively accounting for 37% of the global population. The challenge is to achieve a regulatory milieu in which domestic and international insurers can coexist and equally benefit. The desire to acquire Asia-Pacific operations far exceeds the supply, however. Furthermore, some large local insurers are now looking to expand offshore to achieve growth that has been difficult to attain in saturated markets. European and North American insurers are competing with these large local insurers, as well as domestic insurers in many markets. In time, Chinaâ&#x20AC;&#x2122;s giant insurers may also seek

to expand regionally. If multinational insurers are serious about Asia-Pacific expansion, they must have a strong organic growth strategy. In 2011, the challenge facing local and/or international insurers will be identifying the combination of capital sources that best fits their needs. Some insurers will seek capital through the initial public offering (IPO) market. Others may turn to reinsurance to reduce the amount of risk held on their balance sheets. This, in turn, lowers their minimum capital requirements, although these requirements are narrowing as accounting and solvency rules become more sophisticated. Further eroding the use of reinsurance as a capital source is increasing awareness by regulators of the possible misuse of reinsurance to manipulate solvency margins. In a continued low interest rate environment, issuing debt also remains an option to access capital. Yet another possibility is securing capital from abroad, given the liberalization of regulations governing foreign ownership percentages. Investors may have reservations about the ability to extract profits and capital from some Asia-Pacific jurisdictions, however.

The challenge for Asia-Pacific insurers is evaluating their choices, and implementing appropriate solutions once these choices have been made.

Mature markets The IPO of AIA in Hong Kong raised approximately US$20.5 billion in October 2010. Korea Life also launched an IPO in March 2010 to raise capital to fund development in its domestic market. Many Japanese insurers are currently investigating expansion opportunities, particularly in China and Indonesia. While the country looks for new opportunities, the Japanese market has consolidated with the formation of the NKSJ and MS&AD groupings. The Australian market continues to experience significant merger and acquisition activity, mainly by companies seeking to improve their distribution models and/or market share. Additional activity in life, health and general insurance is expected in 2011, albeit not on the same scale.

Windows of opportunity: 2011 global insurance outlook

Developing markets In China, despite many years of unprofitable operation, foreign insurers have managed to capture only 1.8% of the Chinese nonlife insurance market and 4.8% of the life and health insurance market. The paltry percentages are partly a consequence of the restrictions that foreign-invested insurers are subject to, restrictions that domestic Chinese insurers evade. In India, the foreign ownership cap of 26% is a significant impediment, limiting foreign investorsâ&#x20AC;&#x2122; leverage over local management. Other countries in the region do not erect such daunting ownership obstacles and permit a more level playing field. Malaysia, for instance, now allows 70% foreign ownership, although entering the market still remains difficult. Meanwhile, the maximum allowable ownership in Thailand has increased from 25% to 49%. Over the long term, expect the larger Chinese companies, now among the worldâ&#x20AC;&#x2122;s largest, to expand internationally, both within and outside the Asia-Pacific region.

Emerging markets In the Philippines and Vietnam, several insurers are 100% owned by foreigners, and Indonesia permits 80% foreign ownership. Of all the countries in the region, Indonesia now appears to be the one in which global insurers are most interested in penetrating in the years ahead.

Other issues Operational improvements In 2011, new and emerging regulations will pressure insurers in developing markets, and relatively new insurers in mature markets to upgrade their information technology technical expertise. To more effectively manage costs and support strong levels of growth, improvements are likely to be necessary in insurers’ data management, IT platforms, advanced technology solutions and actuarial and accounting skills. Asia-Pacific insurers further need to consider upgrading employee skill sets, recruiting and developing key talent to process the volume of data created by rapid business growth. In well-developed markets like Hong Kong and Singapore, more advanced insurers are looking to Europe for best practices. International players with Asia-Pacific headquarters are implementing IT systems that consolidate figures from different countries’ operations to prepare group financial results. Such large IT system and infrastructure investments are expected to continue in mature and developing markets. In all areas (but in developing markets especially), an efficient IT system that supports the distribution of products will be a future market trend, one that should be more closely evaluated in 2011. Significant growth potential is possible through mobile banking and tele-insurance distribution channels, given the large numbers of consumers with mobile phones.

Natural catastrophe cover Whereas natural disasters in emerging markets have not significantly influenced the insurance markets—because of low insurance penetration and economic levels—in some areas this picture is rapidly changing. Other than in Japan historically, natural catastrophes have exacted heavy tolls in human life in Asia-Pacific, but relatively low insured losses. This is in sharp contrast to events of similar magnitude in developed areas, where the reverse generally holds true. In 2009, more than 60% of deaths from global natural catastrophes were in AsiaPacific, and the percentage was even higher in 2008. Recent earthquakes (China, Indonesia and New Zealand), typhoons (Taiwan and the Philippines), storms (China and Australia), droughts (India and Australia), flooding (India and Australia), and bushfires (Australia) are reminders that significant natural hazards do exist in Asia-Pacific, and that low insured losses to date do not necessarily reflect the loss potential in the future. Due to the increased volume of natural disasters, reinsurers are likely to revisit their risk profiles for the region, particularly with respect to countries that have experienced a recent catastrophe. At a minimum, reinsurers will tighten underwriting and begin to differentiate between insurers that can provide detailed information on their exposures, and those that cannot. While this will not entirely manifest in 2011, insurers nonetheless have an opportunity to differentiate in the medium term. As insurance penetration in Asia-Pacific increases and the concept of liability insurance gains hold, exposure to liabilities stemming from natural disasters also will grow. Among the tragic discoveries in the wake of earthquakes, for instance, were buildings and schools not built to code that thereby contributed to the death toll. The growth of liability insurance, combined with higher economic standards, indicates that Western-style litigation following a natural catastrophe will surface in Asia-Pacific, creating exposures and risk correlation issues for both insurers and reinsurers. Business interruption is another exposure to consider post-disaster.

Takaful opportunities Takaful is a form of insurance based on Islamic principles. Foreign insurers are exploring securing licenses in strong takaful jurisdictions such as Malaysia and Indonesia. The strong growth in both business volume and customer acceptance of takaful products suggests that this model is poised to grow further. Now that takaful has achieved acceptance as a business model several challenges must be addressed, including overcoming talent shortages, given the limited number of Islamic scholars experienced in finance and insurance; competition with conventional insurance for skilled resources; resolving differences between Islamic schools of thought; and the restricted but growing availability of re-takaful.

Regional hubs Some mature markets like Singapore, Hong Kong and Australia are seeking to become regional hubs for the Asia-Pacific region. Governments are looking to offer generous incentives such as tax concessions and salary subsidies, which are likely to fuel even greater interest in the region. The insurance markets within Asia-Pacific are changing rapidly. Long-overdue improvements in some domestic markets and growing signs of more sophisticated regulation are both underway, although the pace of these activities differs country-to-country. While domestic concerns have distracted the attention and the capital needs of both European and American multinational insurers, there appears to be renewed interest and activity by these companies in Asia-Pacific. These factors bode well for a change in the profile of the market. Consequently, there may be significant rewards for insurers that are first movers, not to mention watchful insurers that learn from the mistakes others have made or explore niches that remain unexploited.

Windows of opportunity: 2011 global insurance outlook

Europe

Executive summary The European insurance industry enters 2011 financially stronger than it was at the beginning of 2010. Strengthening of the credit and equity markets, combined with reductions in claims frequency in 2009 and 2010, have improved the industryâ&#x20AC;&#x2122;s capitalization, solvency and profitability. Efforts to maintain and increase capital will continue in 2011, as insurers prepare for the impending implementation of Solvency II and Basel III.

Macroeconomic conditions indicate that 2011 will likely be another year in Europe of low GDP growth, low interest rates and moderate equity market performance. Ernst & Youngâ&#x20AC;&#x2122;s baseline Eurozone Economic Forecast for 2011, published in December 2010, projects a moderate slowdown over the year, with GDP falling to 1.4% in 2011 from 1.7% in 2010, and inflation forecast to remain steady at 1.5% to 1.6%. At these levels, inflation poses no immediate threat to growth. Even if the economic recovery continues, insurers may find that the assets underpinning their balance sheets Windows of opportunity: 2011 global insurance outlook

have decreased in value. Questions concerning the impact of the European sovereign debt crisis also remain, albeit the effect may vary for individual countries. Certainly, the macroeconomic conditions will challenge the skills and resources of insurers to generate superior investment returns and maintain balance sheet strength. The sluggish economy and low interest rate environment challenge all segments of the European insurance industry to achieve superior growth. Non-life premiums across the region were poor in 2010, while profitability in both the non-life and reinsurance sectors will 14

continue to be challenged by the soft market, the need for continuing expense reductions and the end of loss reserve releases supporting profitability. Business demand for traditional non-life products will remain especially listless in 2011 due to the slow business growth. At the same time, risks relating to continued advancements in technology and catastrophic weather events, as well as fraud and litigation exposure, are increasing. A key question is how catastrophic losses in 2010 might affect pricing this year. On the life side, premiums improved modestly in 2010. As Europe’s population ages and the countries grapple with demographic challenges to their social welfare systems, especially those parts related to retirement benefits, it creates opportunities for insurers to provide products and services in the retirement space. The downside is the low interest rate environment, which reduces profitability of guaranteed products. Continued high unemployment also makes it difficult financially for many individuals to purchase new products. A key question facing life insurers is whether the emerging capital requirements will hinder their ability to meet consumer needs. With this in mind, Ernst & Young identified five risks and opportunities for European insurers in 2011 as they encounter uncertain economic and regulatory conditions in their pursuit of growth: • Manage critical capital and risk challenges • Develop distribution flexibility and support systems • Improve process efficiency and develop new markets • Focus on non-life loss control • Optimize corporate structure and domicile

Manage critical capital and risk challenges The foundation of profitable growth in the European life and non-life insurance segments is superior management of capital and risk. Complicating this efficient management, at present, are changes in several factors, including accounting and regulatory regimes, anemic economic conditions and low interest rates. In 2011, insurers will continue to seek solutions to better manage capital and risk, despite these complications.

For European life insurers, effective capital and risk management is stymied by looming regulatory changes increasing their capital requirements, as well as low interest rates that reduce the profitability of savings and investment products. Efforts to derisk products and protect against economic uncertainty will continue, although insurers need to be cognizant of the related costs and operational risks. In 2009 through early 2010, consumers concerned about the safety of investments in stocks and bonds flocked to guaranteed savings and investment products. Under Solvency II, however, these products will absorb more life insurer capital. Although some consumers will shift towards unitlinked products, the growing opportunity in an aging Europe to provide guaranteed retirement income products, particularly as equity markets recover, remains strong. Nevertheless, life insurers must effectively evaluate and manage the capital strains caused by Solvency II. To minimize the capital impact of Solvency II, some insurers may redesign their guaranteed products in 2011 to be either less capitalintensive or to require policyholders to assume a greater proportion of the risk. Insurers also will seek to reduce their business risk exposures to strengthen their balance sheets. Managing this derisking without increasing the level of other risks is challenging, since complex risk management solutions can foster increases in costs and operational risks. The use of complex hedging programs, for example, raises the amount of operational risk. Such programs also increase the basis risk for unit-linked products. As life insurers examine how to reduce the capital strains caused by guaranteed products, the prolonged low interest rate environment will depress the yields for new cash flow and maturing bonds. Consequently, spread compression is emerging as a significant risk issue in 2011, as insurers complete their testing and analysis of the impact of Solvency II on their capital structures. Some life insurers may use this time to consider testing the potential of a “Japan Scenario” on capital requirements and profitability.

Non-life companies do not currently face similar capital strains, although their profitability will likely erode following the end of loss reserve releases from prior years. Nonlife insurers have historically suffered the most existentially threatening shocks from new and unanticipated exposures having no prior loss history. Examples include asbestos, the US liability crisis, the LMX spiral and the 11 September disaster. Each event bankrupted several insurers. Systemic damage to large parts of the industry was barely avoided. Managing the capital impact from similar events cannot be actuarially estimated. Consequently, there is a need for structural solutions that limit aggregate liability. The development of contingent capital solutions is another prudent element of a successful risk management culture, as is the diligent and continuous monitoring of emerging trends and implications. Owing to the RBC charges under Solvency II, non-life insurers will be motivated to purchase more reinsurance, both as a risk mitigation technique and a tool to achieve solvency capital relief. In 2011, reinsurers appear strongly capitalized to accept this potential increase in demand. The use of captive reinsurance structures may be a viable option for some large insurers, as it may allow them to shift liabilities from their operating companies to improve their RBC or Solvency II ratios. Captives provide structural access to capital and are an efficient mechanism to pool risks across organizational structures. In some cases, this may facilitate risk sharing with corporate or group customers. The Isle of Man continues to experience growth in the number of captives domiciled under its jurisdiction. While there are some concerns about the treatment of European Union-domiciled captives under Solvency II, the potential to utilize other jurisdictions is possible and may continue to attract insurer interest. Capital management efforts by both life and non-life insurers may encourage some companies to consider raising additional capital, especially in the low interest rate environment. For the insurers that choose this path, the implementation of IFRS 4 Phase 2 may present a challenge. The standard alters insurer financial statements, possibly

making it difficult for investors to evaluate the financial statements against previous statements. The change may also limit investor ability to compare different insurance companies. Consequently, some investors may be less willing to commit capital to the insurance industry. With that in mind, 2011 may be a year when insurers consider how to improve the transparency of their financial statements and business models.

Develop distribution flexibility and support systems At its core, continued financial strength for European insurers depends on sales, and sales depend on access to distribution. In 2011, insurers will continue to develop increased flexibility in their distributor relationships to respond to both regulatory challenges and market opportunities. To achieve such flexibility, insurers must address their legacy systems and processes, which in many cases hinder the ability to access customers via the Internet and to establish new distributor relationships.

The importance of each channel varies according to the type of product, consumer preferences and national legislation and legacy infrastructure. In the non-life segment, agents and brokers have traditionally been the major distributors. In 2008, the latest data available from CEA (the European insurance and reinsurance federation) indicates that agents had an average market share of 42%. Broker market share was 25%, while direct sales accounted for 18%, bancassurance 12% and other distribution channels 3%. With regard to life insurance, brokers and bancassurers are the two largest distributors, averaging 32% and 30%, respectively, in 2008. Agents were a close third with a market share of 26%, and direct distribution was 11%. Over the medium-term, both life and nonlife insurers are preparing for a shift away from tied agents towards direct sales. For life insurers, regulatory changes challenge traditional distribution channels and encourage new distribution opportunities. In 2011, the European Commissionâ&#x20AC;&#x2122;s Packaged Retail Investment Products, or PRIPs, framework will begin to take form. Efforts are

Windows of opportunity: 2011 global insurance outlook

also underway, most noticeably in the UKâ&#x20AC;&#x2122;s Retail Distribution Review, to ban the use of commissions on savings and investment products and to pay agents or brokers instead, beginning in 2012. Basel IIIâ&#x20AC;&#x2122;s impact on bancassurers also affects life insurance distribution. Under the proposed new capital requirements, some bancassurers may decide that moving to a distributiononly business model, in which the products of several different insurers are marketed and sold, may be a more effective use of capital. At the same time, local and Europeanlevel efforts to restrict or ban the tying and bundling of bank and insurance products may reduce sales in this key channel. Considerable investments in the development of physical branch offices pressure banks to increase revenues from these facilities.

Ernst & Young has identified three key challenges for bancassurers from the changing regulations:

continues to challenge the commercial viability of selling complex savings and investment products without face-to-face interactions.

according to Cisco Systems. Obviously, the potential to increase non-life sales through direct distribution is significant.

• In an era of low spreads on traditional banking products, commission and fee income becomes more important. The favorable treatment of commission income under Basel III and Solvency II, which could increase bancassurance distribution of insurance, augments this importance.

Life insurers need to remain engaged with regulators in shaping these and any other emerging sales compliance regulations, which may reduce their ability to compensate agents and brokers. The regulations also may reduce the churning of contracts and policies by removing the financial incentives to replace them. This could improve insurer profitability, if the products are priced to remain on the books.

In 2011, insurers will continue to develop and implement direct distribution models. However, the legacy administration and distribution systems insurers have in place may prove a hindrance in increasing the amount of business conducted online and via mobile phones. These legacy systems and processes may further inhibit the ability to integrate operations with non-direct distributors, such as bancassurers. These frictional effects should not be dismissed, given the complications and costs of integrating new distributors into existing systems. Insurers that understand how to effectively address the challenges of their legacy systems and processes to take advantage of new distribution opportunities may achieve a competitive advantage in 2011.

• Unbundling of bank and insurance products may require banks to offer more competitive insurance products. • Increasing pressure from European governments to break up larger banks may prompt the sale of underlying insurance assets. These insurers could then establish new distribution relationships. As these factors play out in 2011, insurers need to be aware of emerging opportunities to establish new distribution relationships with bancassurers. If regulations hinder the ability of life insurers to compensate agents and brokers, and require greater simplification of sales material, insurers may increasingly turn to distributing more commoditized products over the Internet. Regulatory pressure also

For non-life insurers, the market opportunity to increase sales via direct distribution to customers is driving some away from tied agents and brokers. In the UK automotive market, for example, so-called “distance selling” increased from a market share of 33% in 2001 to 44% in 2006, according to CEA. The main reasons were further development of the Internet and of aggregators that compare different insurers’ products and prices. Nearly 418 million people logged onto the Internet in Europe in March 2010, an increase of 298% over the previous ten years,

Improve process efficiency and develop new markets

countries in Western Europe, presenting the opportunity for improved process efficiency.

Improvement in process efficiency and information scope is critical to both life and non-life insurers, if increased margins and top-line growth are to be achieved. Both sectors are under pressure to modernize their systems, from the front end to the back end, to improve their product innovation and consumer service, better address information demands and accommodate accounting and regulatory changes. Since many European markets are concentrated, thereby limiting robust organic growth, it may encourage insurers to consider expanding into these markets. If they take the plunge, the investments in process efficiency may provide a stronger foundation for this expansion.

Many insurers, however, operate legacy systems that may not be ideally suited to outsourcing. In addition, the continued demands for increased risk modeling and reporting presented by Solvency II, Basel III and IFRS 4, as well as more robust ERM, add pressure on the processing ability, availability and quality of data from legacy systems. As a result, insurers will continue to undertake gargantuan efforts to consolidate and modernize diverse administration systems in 2011.

An option some insurers will consider is outsourcing back-office operations to regions like Eastern Europe, which offers the advantages of proximity, relatively high educational attainment and adept language skills. Eastern European governments are increasingly promoting the region as an outsourcing destination to neighboring

Given the concentration of the European insurance market, more efficient and dynamic systems may prove advantageous for insurers considering entering new markets. In 2009, the largest markets in Europe were the UK, France, Germany and Italy, which together account for nearly 75% of European life premiums, according to CEA. The top four non-life insurance markets in Europe– Germany, the UK, France and the Netherlands– together account for more than 60% of European non-life premiums.

Windows of opportunity: 2011 global insurance outlook

Faced with limited organic growth prospects at home, European insurers must consider opportunities in emerging or other markets where recent premium growth has been a multiple of European growth. Examples of these markets include: • Southeast and East Asia, which experienced annual premium growth in recent years exceeding 20% for life and 10% for non-life • Latin America, where life premium growth was more than 8% and non-life premium growth exceeded 6% over the past decade • China and India, the two largest potential markets, although regulatory concerns continue to thwart foreign insurers accessing near-term growth potential in both • Brazil and Southeast Asia, where several foreign insurers have achieved success The potential for stricter solvency standards in Southeast Asia offers opportunities to foreign entrants. There is great demand for insurance support to expand infrastructure development and for new products, such as microinsurance and takaful. Both may be additional avenues for innovation and growth.

Defining and pursuing new markets will be critical in breaking away from the constrained growth of traditional markets. Insurers will need to consider how their investment in process efficiency not only improves their current operating results, but positions them for new market growth as well.

rates, underwriting losses and a potential rise in fraud. Combined ratios in many lines are being pushed to more than 100%, depending on the line of business. These trends highlight the need for non-life insurers to invest in their claims management systems to improve their control of losses.

Focus on non-life loss control

Underwriting performance for property insurance is under pressure across Europe due to the impact of severe weather in 2010. Deteriorating results in UK personal lines, â&#x20AC;&#x201C; as well as in automotive in the UK, Ireland and Italy, challenge European insurer results. Flat or declining rates in commercial lines, and mild increases in some of the hardest-hit lines (like automotive in the UK), are insufficient to counteract the rising claims costs.

Seeking top-line growth in the non-life market may prove problematic for insurers in a sluggish and uncertain economic environment. Business concerns about the strength of a recovery may hinder their desire for increased insurance coverage, e.g., reduced purchasing power lowers the need for additional motor and property coverage. Fraud also tends to increase when economic conditions remain stagnant. These challenges may impair nonlife insurance profitability. Reserve releases over the past few years bolstered the results of European non-life insurers, but as these insurers enter 2011, the continuation of such high-magnitude releases seem unlikely. Among the factors abetting this development are competitive pressure on

Casualty lines are also under pressure, due in large part to concerns over broadening legal liability. Legal trends in Italy are already causing loss ratios to deteriorate in medical malpractice lines. Though still not approaching US levels, increasing litigiousness and the heightened coordination of collective redress schemes may adversely affect European casualty insurer results.

The phenomenon of insurance fraud remains a serious issue across Europe. Fraud is pressuring the automotive line in the UK, Ireland and Italy. In the Italian market, for instance, fraudulent claims are estimated to represent well over 10% of all automotive claims. Clearly, insurers need to consider in 2011 investments in claims systems that improve the detection of fraud. These investments in claims systems also offer the opportunity to enhance service and pare costs. A recent Ernst & Young survey indicates that clientsâ&#x20AC;&#x2122; perception of insurer claims service affects their satisfaction, loyalty, retention and the advocacy of that insurer. Process efficiencies also can be gained through investments in claims systems, particularly for motor vehicle insurers that incur high claims administrative expenses. Non-life insurers may also reduce claims expenses through improved integration of claims with core administration systems, and implementing one-shot claims for straightforward losses. Consequently, in 2011 non-life insurers should consider decisions that address rates, claims leakage and fraud.

Optimize corporate structure and domicile Pending regulatory changes, combined with limited organic growth potential, creates pressure for European life and non-life insurers to re-evaluate their core business structures. The capital impact of Solvency II and Basel III adds to the motivation to re-evaluate current organizational relationships. In 2011, two possibilities may prove more attractive than these avenues. Consolidation of insurers can accomplish the twin goal of boosting capital and achieving top-line growth. Redomestication—the relocation of corporate headquarters—can advance capital efficiency by opening access to favorable tax regimes, while facilitating capital movement across entities. European insurer consolidation has slowed since the high levels following deregulation a decade ago, but it is likely to accelerate again. Potential acquirers have focused on maintaining rebuilt capital levels, as they awaited greater clarity on the impact on capital from Solvency II, in addition to

opportunities in emerging markets. The pace of consolidation among Europe’s 5,000+ insurance companies may increase in 2011 in response to the higher capital requirements mandated by Solvency II regulations. Smaller and mutual insurers with a limited product range are deemed most likely to be required to maintain higher capital levels. Larger European insurers will look to spin off underperforming units or products making inefficient uses of capital. Under Basel III, the bancassurers’ ability to treat insurance capital as part of overall capital may require banks to maintain additional capital. At the same time, bancassurers and joint venture partners that are narrowly focused on a set of similar products may be unable to tap the risk diversification benefit under Solvency II, leading to increased capital requirements for their insurer operations. This could foster a shift in a bank’s ownership structure or a move towards a distributiononly model that utilizes branch networks to reach customers.

Windows of opportunity: 2011 global insurance outlook

Some insurers may decide to spin off segments or downsize their business, both difficult decisions. Each incurs a set of challenges beyond the impact to capital. Executives need to clearly and effectively communicate the strategic advantages gained by their decisions to customers, government regulators and labor, as well as the capital markets. As a result, insurers that pursue consolidation or acquisitions in 2011 should consider how to improve the effectiveness of their financial and strategic communications. In addition to consolidation or acquisitions, some insurers are considering redomestication—hence the recent flurry of insurers and reinsurers relocating their group headquarters which is likely to continue in 2011. Companies engaged in restructuring initiatives to streamline their legacy group structures should consider redomestication as part of these efforts. Taxation continues to be a primary factor in choosing a domicile. Corporate tax regimes differ across European jurisdictions. Companies can arbitrage these differences by choosing headquarter locations that

offer advantageous tax regimes. Beyond the corporate tax rate, insurance companies must consider other contributors to the effective tax rate, including treatment of losses, insurance premium tax, excise tax and double taxation treaties. A key consideration is taxation of income from branches in a distributed corporate structure under group headquarters. Recent moves by insurers and insurer units from the UK to continental locations underscore the importance of the treatment of taxation of overseas branches of UK-headquartered companies. The UK Treasury is considering changing this policy, which is potentially included in the 2011 Finance Bill. While taxation and regulation remain the driving considerations in regional and domiciliary restructuring, insurers should also consider competitive and operational issues in their analysis of domicile and structure. Regulatory considerations are other important drivers. The optimization of branch versus subsidiary networks needs to be evaluated in the context of both Solvency II regulations and potential national regulations governing minimum domestic capital requirements. Even though the capital requirements following Solvency II are not finalized, some companies are pre-emptively moving from local subsidiaries to a branch structure. This may provide greater fungibility of capital to allow a more nimble response to changing conditions. The ability to “passport” across the continent is an advantage for establishing or maintaining a headquarters in Europe, in comparison with other regions. Passporting permits European insurers to access business in numerous countries under the supervision and rules of a single regulator. Non-European insurers with European branches are not allowed to passport across Europe, and may be subject to multiple regulatory jurisdictions. The recent focus in the Eurozone has been on Ireland as it accepts a substantial bailout from other European countries. For businesses wishing to relocate their operations to Ireland, the current Eurozone crisis presents opportunities and challenges. Ireland’s export sector performed well during the recession. Despite the intensifying crisis, its service exports grew faster in the first half of 2010 than service exports at other developed

economies. For inbound businesses, the government’s continued commitment to its low corporate tax rate is encouraging. It also seeks to attract new businesses to offset part of the impact of the austerity program. Such businesses are likely to benefit from an enhanced pool of skilled people with experience in financial services and a willingness to accept lower wages than in the boom years, plus other competitive costs such as lower office rents. The out-migration of skills, however, may make it harder to import skills, given the crisis. In the insurance sector, which the Dublin International Insurance & Management Association says employs more than 2,000 people and paid more than €150m in taxes in 2008, the low corporate tax rate and the availability of skilled labor are not the only attractions. Indeed, the Financial Times recently noted that Ireland is attracting insurance companies from low-tax countries. Attracting such businesses is Ireland’s membership in the EU, which means that insurers must comply with Solvency II capital rules. Additionally, lower tax jurisdictions previously used for headquarters are likely to become less attractive. Outside of the tax and regulatory drivers behind redomestication, companies need also to consider the human factors attendant to alternative locations. Availability of suitable staff the cost of living, and the ability to attract qualified managers and underwriters all may affect operational soundness and shape the reputation of the company. Accessibility of work visas and office space, and other qualityof-life considerations contributed to recent moves from Bermuda to European locations. As the impact of Solvency II becomes clearer in 2011, and competing jurisdictions take actions regarding equivalency, redomestication in Europe will continue to be a top-line agenda item. An outstanding question is whether significant movements by large, well-managed and capitalized insurers into smaller countries is viable in an era where regulators and governments are aware of the risks to national taxpayers of a disproportionate financial sector.

Windows of opportunity: 2011 global insurance outlook

US life

Executive summary The US life and annuity insurance industry enters 2011 with a stronger balance sheet, reasonable earnings momentum and slightly rising direct premiums, albeit at the expense of a declining base. Going forward, the industry confronts a climate of broad regulatory and economic uncertainty in the coming year and beyond. In this environment, insurers will need to create new products and services and leverage distribution channels to increase top-line

growth, while paring costs and unprofitable risks to drive bottom line earnings. The latter requires simplifying the business and product portfolio, improving operational efficiency and squeezing earnings out of a stagnant revenue base, as the slowly growing economy makes it difficult to attract new customers and retain existing ones. Low interest rate conditions compound these problems, challenging life and annuity insurers to generate competitive product returns. Companies that clearly understand these issues and react quickly and prudently in their strategic core businesses will gain a competitive advantage. Windows of opportunity: 2011 global insurance outlook

Looming regulatory changes such as those posed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) are still in the process of being interpreted and implemented窶馬ot to mention possibly revised. These changes pose strategic and competitive challenges to life and annuity insurers. As insurers address these concerns, they must be careful to preserve their financial strength. Nevertheless, there are opportunities in deploying rebuilt capital to reposition and grow their businesses and improve future earnings.

Ernst & Young has identified four issues that will influence the US life and annuity insurance industry in 2011:

Securitizations will require an insurer to retain an economic interest in the security, i.e., to have some “skin in the game.”

• Responding to the changing regulatory environment

Finally, Dodd-Frank creates the Federal Insurance Office (FIO). The FIO’s first task will be the completion of a study on how to modernize and improve the regulation of insurance. This study is to address issues ranging from capital standards to regulatory gaps to the international coordination of insurance regulation. This study may lead to higher capital standards, more protection for consumers or group level supervision. It may also require uniform product approvals or single and common accounting rules across all states.

• Establishing capital and risk management solutions post-crisis • Improving operational efficiencies to control cost • Reinventing products and distribution to energize growth

Responding to the changing regulatory environment New legislation and regulations in the United States raise the potential of altering the growth trajectory of the life and annuity insurance industry and the companies that comprise it. As yet, the continuing development of these new rules creates uncertainty in terms of their future implications, such as their impact on an insurer’s strategy, products and capital. The insurers that seize the opportunity to respond to the new rules will gain an advantage. Among the new and ongoing regulations of importance to the industry are Dodd-Frank, the recently created Financial Stability Oversight Council (FSOC), various initiatives undertaken by the National Association of Insurance Commissioners (NAIC) and ongoing accounting changes driven by the International Accounting Standards Board (IASB) and the Financial Accounting Standards Board (FASB). Solvency II will also impact the US insurance market. The Dodd-Frank financial reform package creates the potential for significant regulatory changes, including deeper regulation at the federal level. There are several significant ways Dodd-Frank can impact insurance companies. Insurance companies that own banks or thrifts will be regulated at the federal level, in addition to those insurance companies that are deemed “systemic.” Derivative trading will be regulated, with the degree of regulation depending on whether the insurer is an “end user” or a “major swap participant.”

In addition, the NAIC continues to move towards a principles-based approach to reserving. It is also evaluating requirements for RBC. It is anticipated that C3 Phase 3 (C3 risk for life profits) will become effective later in 2011. This initiative will be challenging, particularly for smaller companies that may not have modeling expertise and systems in place to undertake the stochastic projections. C3 Phase 3 will further complicate the RBC process, which is not entirely factor based. There may also be revisions to AG-43 as the NAIC deliberates these issues. At the same time, the US-based subsidiaries of European insurers are finalizing their preparations for reporting under Solvency II, designed to ensure consistent capital adequacy across all insurers operating in the EU by 2013. Solvency II is a major factor in the NAIC’s own Solvency Modernization Initiative, as US state insurance regulators ultimately seek a degree of equivalency with their European regulatory counterparts. All of these potential changes will be implemented in the next few years, and will require study during 2011 and 2012. Following the release of the IASB’s exposure draft, Insurance Contracts (ED), in July 2010, the FASB released its discussion paper, Preliminary Views on Insurance Contracts (DP), in September 2010. The insurance industry has not faced such significant accounting change in more than

20 years. The proposals fundamentally alter the measurement basis for insurance contracts and require increased disclosure and transparency regarding financial statements. The likely impact of these accounting changes is greater earnings volatility and possibly increased capital pressure. This new accounting standard has implications well beyond financial reporting and investor relations. The proposed changes could fundamentally alter how insurers design and price new products, in response to the impact of guarantees/options and volatility on earnings. There could also be broad-based risk management implications, specifically on asset/liability management, in addition to significant process redesign of valuation and reporting processes, and technology considerations. The degree of impact will depend on the nature of a company’s insurance contracts and the complexity of its organizational structure. It is clear, however, that a range of functions and operations will be affected. Senior executives should assess a broad range of business strategies to mitigate the challenges created by the proposed changes, such as future earnings volatility. These various legislative and regulatory “known unknowns” will consume management focus and company financial resources. The changes also may compel some insurers to exit particular lines of business. Certainly, the new regulatory environment will affect different insurers’ competitive abilities differently, with larger insurers, for instance, having the resources to leverage their internal capabilities. The challenge—and opportunity — of all insurers is to quickly grasp and respond to the regulatory and legislative challenges to support their future growth strategies.

Establishing capital and risk management solutions post-crisis As the industry returns to pre-crisis levels of new business and seeks further growth, capital will require careful management to efficiently fund new business needs. A key challenge will be identifying the most costeffective capital solutions to support strategic growth initiatives.

The redundant regulatory reserve requirements will continue to be an issue that insurers need to address as they sell term life insurance and certain universal life contracts. Similarly, insurers selling annuity products will need to seek solutions that manage the risk and mitigate the reserves required to support the guaranteed benefits embedded in the product. Cost-effective capital solutions will continue to be a challenge. For example, the ability to securitize reserves is compromised by the lack of investor interest and financial guaranty availability. Letters of credit of sufficient duration are less available and more expensive than pre-crisis levels, and while reinsurers’ balance sheets are recovering, they have not regained their appetite for assuming large amounts of this risk. Regulatory developments to lower collateral requirements for highly rated and financially sound foreign reinsurers should be carefully monitored as a partial solution. Insurers should also pay close attention to developments in the domestic captive arena, although these may not offer a long-term solution.

unexpectedly rapid rise in rates. Second, the insurers that are not directly affected by Dodd-Frank and Solvency II will nonetheless have to cope with the emerging de facto standard for good risk governance and reporting. In addition, the NAIC’s Solvency Modernization Initiative is expected to sharpen the regulatory focus on how companies “risk manage” their businesses. The regulations will set clear expectations for the role that risk management needs to play in a financial services company, including its independence from risk-taking functions and its role in compensation structure oversight.

Formalizing the risk management function, and the trend toward establishing a chief risk officer position (if none now exists), will continue. Quantifying risks through some form of economic capital modeling has become the norm among larger insurers. Enhancements are anticipated in that sector, including more emphasis on model validation. Middle and smaller size insurers will also need to undertake this modeling, especially if their product portfolios include more complex risk products such as variable annuities. A strong theme in 2011 will be the development of a risk appetite that is connected to risk-taking capacity (available capital) and risk limits. Boards, regulators and rating agencies are all expecting more in this area.

Improving operational efficiencies to control cost

The pending regulatory changes will affect risk management in two significant ways. First, the new accounting standards will make any mismatch between asset and liability duration more evident, necessitating more precise interest rate risk management. This will only add to the significant challenges that a continued low interest rate environment presents, not to mention the risk of an

As insurers seek to reach new customers and maintain contacts with existing ones, strong distributor relationships and more efficient administration and improved customer service system interfaces are crucial. These interfaces offer insurers the opportunity to competitively distinguish themselves beyond basic product features and commission rates. A LIMRA (a US-based association) survey of distributors

Windows of opportunity: 2011 global insurance outlook

indicates that 28% of affiliated producers listed “technology” as the single most critical support service. This was followed by “back office support” (23%) and “business development” (20%). Not surprisingly, insurers are making substantial efforts to offer websites and technology to their producers to issue business faster and otherwise increase their satisfaction levels. Faced with continued economic uncertainty, along with pressure to increase earnings in a difficult environment, insurers have no choice but to control costs to achieve adequate profit levels and protect the balance sheet. This must be balanced against the investments needed to enhance systems and processes and improve the underlying data to deepen distributor penetration and improve productivity. Increasing the ease of doing business through investments in technology and streamlining processes not only heightens productivity for insurers and distributors, it can assist with greater market penetration. For example, newer distribution methods leveraging the Internet and social media can improve longterm business growth by attracting younger consumers and improving “win-loss” ratios. Look for companies to escalate their efforts to improve productivity by simplifying and reducing complexity, replacing legacy systems and lowering their resource costs through shared services, offshore captives and outsourcing. Given a likely increase in financial reporting and capital and risk management requirements from the emerging regulations, insurers may find themselves struggling to fund the investments needed to comply in a timely manner. Making the right investments in technology, process improvements and data management will enable more efficient compliance with the regulatory and reporting requirements, while improving management information, distribution and risk management.

Reinventing products and distribution to generate growth Although the life and annuity insurance industry enters 2011 with strengthened capital, questions abound about how best to deploy this capital to achieve long-term growth. With life insurance ownership in the United States at a 50-year low, according to LIMRA, insurers may want to invest in the development of new products. As they do so, insurers are wise to address the “barbell” demographic of consumer markets. Baby boomers have become acutely aware of the looming retirement challenges and the risk of market losses, and are beginning to clamor for meaningful guarantees. Meanwhile, Generation Y (individuals born between the early 1980s and the early 1990s) have reached an age where they should be forming households, yet the weak employment environment has compelled them to remain single in record numbers. If the economy remains stagnant, it could suppress both their desire for savings and life insurance products and their ability to pay for them. At present, products in the retirement income sphere are focused on solutions providing baby boomers with guaranteed income for life. There are several examples of recent product innovation in the retirement plans area. For example, the guaranteed lifetime withdrawal benefit has begun to appear in the defined contribution benefits market as either an embedded feature in hybrid target date funds, or as an explicit wrapper around a menu of investment options (proprietary or not), including target-date funds. Other approaches to reaching the defined contribution market include guaranteed income purchase plans that incrementally buy fixed income shares. Whether or not these products will drive significant top-line growth is still up for debate, as success stories to date have been modest, at best. In the retail business, much of the recent innovation in the market has been dialed back, as companies reassess their willingness to provide guarantees that may require significant level of reserves and capital. For these markets, finding the right balance between customer choice and company restrictions is a delicate matter. For example, it may require information about the

end customer that a company does not have, which can make a difference between hitting a home run and striking out. More creativity is needed to generate true market growth. This may require the development of products that combine income with accumulation or health benefits, and participation mechanisms that will not wreak havoc on the level and volatility of an insurer’s liabilities and capital. Generation Y is perhaps a more difficult market to penetrate given the low ownership of life insurance in this age demographic and their very different buying behaviors compared to previous generations. To generate growth in this segment will require life insurers to make significant investment in innovative product and distribution systems. For instance, younger consumers may respond to relatively simpler and less expensive entry-level products such as term insurance, particularly through enhanced Internetdistribution programs targeted to their age demographic. One example of such a term life insurance program involves streamlined underwriting processes using customer analytic techniques to instantly issue a policy with a meaningful face amount. In addition to focusing on barbell demographics in 2011, carriers will increase their activity around the middle-market customer base. Look for multi-line agents, bank distribution channels and enhanced Internet sales strategies to make strides in serving this market in the coming year. Success will come to those carriers that are able to leverage sales experiences across their product portfolios, developing simpler solutions to deliver their products more quickly than the competition. Fundamentally, 2011 will be a key year for insurers to assess their companies’ competitive positions and to examine the risk-return profiles of different businesses in light of the emerging regulatory and reporting requirements, thereby setting a course for continued success.

Windows of opportunity: 2011 global insurance outlook

US property/ casualty

Executive summary The outlook for the property/casualty industry in the United States in 2011 is one of continuing competitive challenges for individual insurers. Many of the same factors that fostered the soft market conditions in recent years remain in play. The industry is financially strong, thanks to an abundance of capital amassed in 2009 and 2010. Capital positions are at or near an all-time high and continue to drive price competition in the property/casualty insurance industry.

Three other factors are conspiring to maintain the competitive market through at least 2011—a recovery in the value of the industry’s assets, access to relatively inexpensive capital and adequate loss reserves to address claim costs. These generally positive factors are contrasted with the industry’s ongoing underwriting and investment income pressures. The slow economic recovery, years of price competition and generally low investment returns have compressed the industry’s profit margins, and are expected to further squeeze individual carrier operating

Windows of opportunity: 2011 global insurance outlook

margins. The key performance driver for insurers in this environment is superior underwriting—and a number of leading insurers are using advanced analytics to gain a competitive advantage. Ernst & Young has identified six issues that will influence the property/casualty industry in 2011: • Operating in a sluggish US economy • Enduring the soft underwriting cycle • Leveraging analytics to drive the growth agenda

Figure 4 Change in net premium written and average investment yield*

20%

Total All Lines

15%

5.5% 5.0%

10% 5%

4.5%

4.0%

-5%

3.5%

-10%

3.0%

-15% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010E

*Total investment income, excluding capital gains and losses, relative to average cash and invested assets Source: Insurer statutory filings, Conning Research & Consulting analysis

â&#x20AC;˘ Effectively transitioning to the new accounting standards â&#x20AC;˘ Anticipating regulatory and legislative developments â&#x20AC;˘ Analyzing opportunities for managing excess capital

Operating in a sluggish US economy The tightening of purse strings by businesses and consumers in the slow-to-heal US economy has had the effect of reducing net premiums for property/casualty insurers, fostering declines in industry revenues and earnings. As Figure 4 indicates, premium income has fallen in the industry in three of the past four years. This has not occurred before; 2005 was the first time in 50 years that the industry experienced a decline in premiums.

Other than a slight increase in property premiums in the aftermath of Hurricanes Katrina, Wilma and Rita in 2005, net premiums declined each successive year by a larger amount until 2010. Commercial lines incurred the largest net premium decreases, and fell by US$33 billion or 14% from the end of 2006 to the end of 2010. Commercial premium growth is expected to remain stunted in 2011.

The decreases in net premiums have been accompanied by decreases in average investment yields, which have shrunk steadily since 2005. Average portfolio book yields have declined by 100 basis points from 2000 to 2010. Three-year Treasury note yields alone have fallen more than 350 basis points from 2006 to 2010, while AAA corporate bond yields have decreased nearly 200 basis points.

Figure 5 The widening performance gap of the 100 largest property/casualty insurers Quintile

2006 average operating ratio

2009 average operating ratio

Top 20%

62.5%

70.1%

Bottom 20%

81.5%

120.7%

Performance gap

19 pts.

51 pts.

The low investment yields, coupled with the significant declines in net premiums, is compressing the industry’s operating margins, which increases the risk that insurers will delay needed or advantageous investments in substantive infrastructure improvements in underwriting, marketing and customer service. Current efforts include increased advertising spending, improvements in underwriting and claims systems, and support services to customer-focused methodologies to increase policy renewal retentions and identify subsegments with higher expected premium growth. Astute investments in infrastructure enhancements also will prepare insurers to respond to the eventual return of a growth economy. The insurers that have strategically invested in infrastructure improvements have achieved lower combined ratios—even in this era of continued declines in net premiums and rising expense loads.

Enduring the soft underwriting cycle By better understanding the dynamics of the industry’s underwriting cycle, individual insurers can separate their performance from the pack. Figure 5 illustrates how the performance gap of the 100 largest property/casualty insurers widened from 2006 to 2009, as the industry experienced increasing financial pain from the recurring soft market conditions. Overperformers have a firmer grasp on pricing trends by a more thorough monitoring of the factors contributing to the industry’s cyclicality. These insurers analyze all cyclical indicators available to them to develop their pricing outlook, including underwriting cash flow, loss reserve adequacy, reinsurance capacity, catastrophe losses, policy terms and conditions, loss retentions and other data. Monitoring cyclical trends by line of insurance is crucial in responding to a pricing turn. For instance, the medical professional liability line currently is achieving near-record profits, including both underwriting and operating profits, while workers’ compensation combined ratios are above 110%. Sophisticated insurers that understand the various factors pointing to a turn in the underwriting cycle go beyond pricing tactics to position their companies advantageously throughout the cycle. Entering

and exiting market segments and redeploying capital, where possible, can lead to wider profit margins and stronger competitive positions.

Leveraging analytics to drive the growth agenda In the price-competitive property/casualty market, insurers that have strategically collected, analyzed and modeled both legacy and new data streams are turning this information to their competitive advantage. The vast supply of digital information is guiding new sources of economic value and providing fresh insight into markets, customers, suppliers, partners and the enterprise itself. Insurers spent much of the past decade mining their own disparate data streams, cleaning formerly unusable data and finding new data sources. The latter includes data from such relatively new digital devices as smart phones, laptops, personal sensors and onboard monitoring devices that generate additional streams of new information. There is also a vast array of data to be mined from new customer touch points provided through social networking media. Applications can sift through or “scrape” massive aggregations of data to predict customer behaviors in more refined ways than just a decade ago. This process is far from complete, and the challenge is to transform the wealth of data into actionable information. Predictive modeling has been effectively employed in personal lines underwriting, where variables such as credit scoring have proven their predictive value. Underwriting applications to commercial markets have shown promise, but are less mature in their development. While these powerful technical tools are a new strategic building block to drive growth, they require senior managers of property/casualty insurers to develop greater literacy in their use. For example, with new business growth a challenge in the soft market environment, many insurers are sharpening their focus on client retention strategies. Predictive data modeling can provide a deeper understanding of existing customers to minimize client attrition.

Windows of opportunity: 2011 global insurance outlook

To do this will require investments by property/ casualty insurers in next-generation predictive analytics that identify target clients, profitable markets and superior distribution partners. It also requires the commitment of senior executives to a new level of literacy in this discipline–or ill-designed applications will serve to worsen the soft market.

Effectively transitioning to the new accounting standards The likely development of new accounting standards for insurance creates both risks and opportunities for property/casualty companies. While many insurers will treat the transition to the new standards as a compliance exercise, others will leverage the opportunity to reorganize and refine their systems, reporting and risk controls to position the company for success in the new environment. Following the release of the IASB’s ED in July 2010, the FASB released its DP in September 2010. The insurance industry has not faced such significant accounting changes in more than 20 years. The proposals fundamentally alter the measurement basis for insurance contracts and require greater increased disclosure. The likely impact of these accounting changes is greater earnings volatility and possibly increased capital pressure. This new draft accounting standard has implications well beyond financial reporting and investor relations. The proposed changes could fundamentally alter how insurers design and price new products, in response to the impact of volatility on earnings. There could also be broad-based risk management implications, specifically on asset/liability management, in addition to significant process redesign of valuation and reporting processes, and technology considerations. The degree of impact will depend on the nature of a company’s insurance contracts and the complexity of its organizational structure. It is clear, however, that a range of functions and operations will be affected. Senior executives should assess a broad range of business strategies to mitigate the challenges created by the proposed changes, such as future earnings volatility. These accounting changes will consume management focus and company financial resources.

Anticipating regulatory and legislative developments New national and international laws pose possible unintended consequences for US property/casualty insurers in 2011 and beyond. In the United States, the impact of two recent pieces of legislation—Dodd-Frank and The Patient Protection and Affordable Care Act—remains unclear from a regulatory standpoint, as the supporting regulatory structure is yet to be erected. For insurers with European operations, adding to the regulatory pressures is the updated Solvency II regulations, designed to ensure consistent capital adequacy across all insurers operating in the EU by 2013. In the US, the Dodd-Frank legislation and the restructuring of the health care sector create both impositions and opportunities for property/casualty insurers. While the target of Dodd-Frank was not the property/casualty industry, the legislation does have elements affecting insurer operations. These include streamlined reinsurance regulations and the creation of a uniform system for non-admitted insurance premium tax collection and regulatory oversight. The consequences of other elements of the legislation remain unclear and therefore difficult to navigate. For example, the legislation creates two new regulatory bodies to ensure greater stability of the nation’s financial system—the FSOC and the Office of Financial Research. Each is granted extensive data-gathering authority, which may affect the reporting requirements and workflows of US-based property/casualty insurers. The legislation also creates a federal insurance office with powers to assess the effectiveness of the state insurance regulatory system, which may have important implications down the line. Finally, an insurer deemed a “systemic risk” will confront additional regulatory restrictions, and larger insurers may be affected by new regulations governing derivatives transactions. The Patient Protection and Affordable Care Act affects every organization conducting business within the health care system, including property/casualty insurers. Insurers experience a double impact—as employers and as businesses with operations linked to the

health care system. The legislation also poses the possibility of increased cost shifting from the health care system to insurers of workers’ compensation and automobile liability. Rather than simply react to the legislative and regulatory changes, US property/casualty insurers can monitor them closely and interact with regulators to help shape their eventual outcome.

Analyzing opportunities for managing excess capital US property/casualty insurers struggling with sluggish organic growth because of the soft pricing environment and the weak economy can deploy their excess capital by expanding their businesses and making share repurchases. Many insurers enjoy significant capital funding opportunities from their respective policyholder surplus. As Figure 6 indicates, premium-to-surplus ratios in the US property/ casualty industry have been on a downward trend, decreasing to 85% in 2009 from nearly 120% in 2003. Given the slow premium growth outlook and the industry’s adequate reserve levels, these ratios are expected to continue the downward trend in 2011, with surplus growing faster than premium.

By and large, the insurers that have implemented acquisitions are seeking to drive expansion in one or more of three areas — enhancing their product offerings or underwriting teams, improving economies of scale and data collection activities, or adding runoff operations to leverage stronger balance sheets and claims settlement capabilities. We expect M&A activity to continue in 2011 at a moderate pace. Other insurers may benefit by deploying their excess capital into technology and infrastructure improvements. Such investments present sustainable long-term benefits in improved claims handling, service to agents and pricing segmentation strategies. If most insurers continue to trade below book value, our outlook is that, increasingly, insurers will deploy their excess capital into share repurchases, which can be accretive to earnings and book value per share. Long-term winners will be the insurers with a holistic approach to capital management. As the slower-growth environment continues into 2011, insurers must look for ways to maximize capital returns, and find options that balance these returns with the risks they present.

For some insurers, acquisitions have proved a viable option. In 2010, the number of acquisitions in the industry increased from 2009 levels, although the average deal size remains small because of economic uncertainty, credit availability issues and questions regarding stock valuations.

Figure 6 Property/Casualty industry premium-to-surplus ratios 118% 109% 98%

95% 89% 84%

2003

2004

2005

2006

2007

Source: Insurer statutory filings, Conning Research & Consulting analysis

2008

85%

83%

2009

2010E

Windows of opportunity: 2011 global insurance outlook

Ernst & Young Assurance | Tax | Transactions | Advisory

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