Creating Breakthrough Innovations in Life Insurance and Annuities

June 2007 Confidential Working Paper Copyright 2007 McKinsey & Company Marla Capozzi Matt Hemsley A.J. Peak Tim Welsh

Contents
3 3 4 5 7 7 8 Introduction The case for innovation Four ways to innovate New distribution models Annuity underwriting and pricing Operations-led innovations in term life insurance A new approach to product development

Introduction
Is now the time for breakthrough innovation in the life insurance industry? The answer is emphatically and urgently yes. The retirement of the babyboom generation presents life insurers with an opportunity that is unprecedented in its size and scope. By making radical innovations in products and distribution models, life insurers can capture potentially hundreds of billions of dollars in assets and tens of millions of new customers in the U.S. But they must move quickly to seize these opportunities, as competitors from every segment of financial services and health care are aggressively piloting initiatives in a space that has been historically the domain of life insurers: namely, longevity and death protection. Although the life insurance industry faces intense competition, it is uniquely positioned to manage the longevity risk associated with products designed to address middle-income retirees concerns that they will outlive their savings. This gives life insurers a distinct advantage over other financial services and health-care players in the quest to serve this significant market. In addition, the same innovations that allow life insurers to better serve the retirement market will also enable them to create products that better meet the needs of young middle-income families. In so doing, the industry can improve the lagging penetration rates of its products and reverse the slow growth and declining returns it has experienced over the past two decades. We have identified four ways in which life insurers can innovate to capture these opportunities: First, insurers can create new distribution models that

position them for the changing demographics in the U.S. Second, as the market for annuities grows, insurers can manage their risk and speed the sales process by purchasing customers health information, readily available in electronic form, rather than relying on traditional underwriting methods. Third, insurers can substantially lower their costs for term life insurance and increase the number of people with access to the product by establishing a direct sales force in low-cost offshore locations and investing the savings in targeted advertising. Finally, insurers can accelerate the process of product development and reduce their costs by implementing a design-to-cost process that allows multiple products to be created from a single platform. Innovations such as these will drive growth by helping the industry meet the needs of many consumers who lack access to its products today. (In the box on p. 6, we present examples of how these radical innovations could address the needs of two quite different consumers.) By focusing on consumer needs and developing new products, distribution approaches, and operating models, the industry can achieve a step change in its performance. Ultimately, the question is not whether companies will implement radical innovations such as these to seize the enormous opportunity, but who will act fast enough to capture it an incumbent or an attacker from outside the industry.

The case for innovation

Considering that the stocks of some life insurance companies have recently hit all-time highs, one might argue that the industry does not need to pursue radical innovation. However, an analysis of the 20-year performance of the life insurance industry relative to other financial services paints a different picture. For more than two decades, the life insurance industry has struggled with a combination of slow growth (i.e., only slightly higher than GDP) and declining returns (returns only slightly in excess of the cost of capital). This performance stands in stark contrast to other segments of financial services (e.g., mutual funds, credit cards),

which have experienced substantial growth and generated consistently attractive returns over the same period. Asset-management firms, for example, have maintained margins above 20% even through the worst bear market in 60 years and have enjoyed roughly double the growth rate of the life insurance industry.

Since the late 1980s, retail banking has outgrown the life insurance industry
$ bn

Exhibit 1

REVENUE GROWTH
Life insurers Retail banks
GR wth CA gro % % 1 7. 23.1 2

434.4

CA ro The life insurance industrys poor % %g 4.5 1.4 284.3 performance has contributed to its 11 becoming substantially less relevant both in the broader financial 134.4 134.5 services context and to consumers. For example, the annual profits of the top 10 carriers combined are the same as Citigroups 1988 2005 1988 2005 profits of about $25 billion. This large-scale gap is substantially difSources: CompuStat; publicly available information; McKinsey team analysis ferent from the industrys historistrategy to capture it. While all segments of financal position. In 1988, the revenues of the top 20 life cial services stand to benefit, life insurers are insurers approximated those of the top 20 retail uniquely positioned to respond to one critical banks; today, the revenues of the top 20 life insuropportunity: providing products that address coners are about 35% lower than those of their counsumers concerns that they will outlive their retireterparts in retail banking (Exhibit 1). ment savings or not have sufficient assets to maintain their independence. No other segment of Underscoring this decreased relevancy are low the financial services industry is as well positioned ownership rates with core life insurance products. to manage the longevity risk that is, to estimate For example, fewer than 10% of households own how long people will live and to manage their curan annuity, despite its being one of the industrys rent assets so they have enough money throughcore products and a potentially critical element of out their lifetime. the retirement strategy for middle-income Americans. In fact, this is one of the lowest ownership rates of any financial services product in the U.S. The industry is even failing to serve potential customers of life insurance, as fewer than half of U.S. consumers own a life policy. After analyzing successful innovations in other industries, we identified four priority innovation Even those in the industry not motivated to puropportunities for life insurers: new distribution sue radical innovation to redress this underperformodels, a new approach to underwriting annuities, mance surely must take notice of the opportunity a new operating model for term life insurance, and presented by the retirement of the baby-boom a new approach to product design. To implement generation over the next 20 years. Indeed, this the kinds of innovations we describe, many life shift is among the most significant opportunities insurance companies will have to hone their leadin the history of financial services, and radical ership capabilities, develop customer insights, and innovation will be a critical component of any improve innovation processes (see box on p. 9).

GR wth

Four ways to innovate

NEW DISTRIBUTION MODELS

Life insurers have historically distributed insurance and annuities in face-to-face interactions to consumers; for the most part they still follow this approach. In nearly every aspect of commerce, however, distribution systems have evolved substantially over the last 20 years. ATMs, call centers, and Internet distribution have been widely deployed by financial services companies. Even gas stations have evolved from simply purveyors of fuel to retailers of convenience items targeted to specific segments of customers. These innovations in distribution have developed from insights into how and where consumers want to purchase different products. Life and annuity distribution must evolve in the same way. The old conception of these

as push products is simply not sufficient when millions of Americans even affluent ones lack access to the industrys products. As the U.S. population has grown and shifted over the past 20 years, the locations of life insurance agents and the places where consumers actually live are no longer in alignment. Across the country, the counties growing most rapidly in both population and wealth are substantially underrepresented by life agents, who tend to be concentrated in the Northeast and Midwest, rather than the South and West. Consumers in Las Vegas, for example, are 50% less likely to come into contact with a life insurance representative than their counterparts in Chicago (Exhibit 2).

Distribution innovation: Create alternative distribution model for underserved markets

2006
UNDERSERVED
Clark County, NV (Las Vegas) 409 10.9 514 16.9 People per agent
$ mn

Exhibit 2

2011E*
People per agent Income per agent
$ mn

Income per agent

OVERSERVED
Cook County, IL (Chicago) 199 5.6 201 6.9

-51%

-49%

-61%

-59%

* Assumes current 2006 number of licensed life insurance agents applied to projected population Sources: ESRI demographic data; InfoUSA data for licensed life insurance agents; McKinsey team analysis

INNOVATION IN ACTION
Maria, a young middle-income woman with a young family, lives in Texas. A life insurance agent has never visited her and, given her location and income, one is not likely to. At a community fair, she notices a billboard advertisement for term life insurance, which piques her interest since she is a new mother. A few weeks later, while surfing the Web for childrens products, she comes across an ad offering term life insurance protection for her family for $10 a month. Maria clicks on the ad, and rather than being taken to another Web site, she is connected to a live salesperson who explains to her how she can protect her family for $10 a month. After a brief but convincing description of the product, Maria decides to purchase a policy, which is automatically underwritten using electronic health information. A few years later, Maria begins thinking about saving for her childrens college educations. The company that sold her the online term life policy contacts her about a product called a college savings plan, which is similar to an annuity. Because the company has gotten to know more about Marias purchasing behavior and her familys needs, they are able to offer her the right life-stage products at the right time. Maria purchases a plan under which, in exchange for monthly payments of $100, she is guaranteed to receive a check for $5,000 at the beginning of each school year once a child begins attending college. By the time Marias children reach college age, she will be a great prospect for a financial advisor from the life insurance company who can help her and her husband think about how to manage their savings for retirement. Bill, a married 55-year-old with $200,000 of savings, lives in Cleveland. As he gets closer to retirement, he has become concerned that his savings will run out during his lifetime. While driving through a commercial district, he notices a retirement store owned by a life insurance company. Because Bill is not comfortable accessing insurance and financial information via the Internet, he drops by one evening and discusses his situation with a salesperson. The face-to-face interaction and the fact that a salesperson is getting to know his personal needs gives Bill a feeling of confidence about the company and the transaction. In the course of the discussion, the salesperson, with Bills permission, accesses his electronic health information. Because Bills family has a history of heart disease, the salesperson offers not only an annuity that guarantees income for life but also discusses with Bill a life insurance policy so that Bills wife will have money if he predeceases her. In a short time, the salesperson is able to understand Bills needs, give him a quote on the cost of these policies, and explain how they will work. Bill decides to purchase both an annuity and a life insurance policy, thereby addressing his most significant concerns.

To redress this imbalance, a business-as-usual approach would dictate simply recruiting more agents for Sun Belt locations. However, looking at the problem through the lens of innovation reveals an opportunity to pursue new distribution models, particularly to serve the needs of the retirement market. For example, in locations that are underserved by agents, insurers could open a point-ofservice location similar to a retail bank branch. Such a retirement store could be staffed by a sales

force that is not paid by commission, but rather based on a new compensation model that provides incentives for the appropriate sales to different customer segments. In addition, insurers should consider Internet- or phone-based distribution for their products. We discuss this option below, for term life insurance. Some in the industry have already questioned the effectiveness of such distribution models on the

ground that life insurance must be sold, not bought that an agent must explain to a consumer why he or she needs the product. Indeed, some experiments with placing agents in bank branches and expecting customers to seek them out have failed. But retirement products respond to a fundamentally different need than life insurance: People in their fifties and sixties do not need to be persuaded to address their retirement needs. Even if they did not recognize this need on their own, they have already been bombarded by a barrage of advertisements that have created the requisite awareness. Life insurers can build on this awareness to pursue new distribution approaches that align better with population trends and serve consumer needs more effectively than face-to-face life insurance distribution.

lions of Americans is readily available in electronic format. Life insurers can purchase medical information about most consumers from major health insurers and pharmacy benefit managers and use it in the annuity underwriting process to determine how to price the risk appropriately and how quickly they can underwrite the annuity. For example, if a customer visits one of the new retirement stores we have described to purchase an annuity, a salesperson could access the customers medical history (with his or her permission) and submit the history to an underwriting engine for an initial screening to determine the risk and pricing of the annuity. The results of this screening would allow the salesperson to discuss products that are appropriately priced given the customers health risk and increase the speed of the overall underwriting process. As in every other risk-taking industry, such innovations in underwriting and pricing are likely to facilitate a radical expansion of the market while improving the accuracy and speed of pricing the risks.

ANNUITY UNDERWRITING AND PRICING

The underwriting and pricing of annuities, a product well-positioned to address the retirement needs of baby boomers, presents another opportunity for innovation. In other financial services, such as auto insurance and credit cards, the availability of data and the sophistication of risk pricing models have driven a revolution in underwriting over the past 20 years. However, life insurers do not tend to underwrite annuities, the prices of which do not generally differentiate between the risks of the annuitant dying at age 90 or at age 60. The significant economic difference associated with the variance in outcomes means that the growth in annuities sales to baby boomers, and their subsequent annuitization, will add a tremendous risk to the balance sheets of life insurers. To develop an underwriting methodology for annuities, the most apparent solution would be to use the approach the industry already uses for life insurance, which entails collecting blood and urine samples. However, this approach is far too invasive and time-consuming for the sale of annuities, because consumers expect to purchase these as easily and quickly as any other investment product. To find an innovative solution, the industry must look no further than the computer on an annuity salespersons desk: health information about mil-

OPERATIONS-LED INNOVATIONS IN TERM LIFE INSURANCE

Operations represent 45% to 50% of a life insurance companys costs, but they have rarely been viewed as strategic as reflected in the fact that few CEOs have come from the operations side of the business. However, many personal financial services companies have realized significant value from being more aggressive in pursuing operational efficiencies and from developing new operating platforms to support new distribution channels. A prime target for operations-led innovation is term life insurance. Although often not considered a leading source of net income for insurers, term life insurance accounts for approximately 40% of applications and 25% of premiums across the industry. The product is attractive to a large segment of Americans, particularly to young people who cannot afford other life insurance products to provide coverage for their families. However, term life is currently not readily available to many consumers because it is sold almost exclusively through agents, who, as we have discussed, often

are not accessible. In addition, it is not worthwhile for agents to sell an inexpensive term life insurance product because it does not generate a large enough commission. To make affordable term life insurance accessible to many more consumers, life insurers can develop an offshore operating model for the product an approach already used successfully throughout financial services. By establishing a direct sales force at a low-cost offshore location and implementing an automated underwriting engine, insurers can increase the profitability of term life insurance by approximately 30% to 50% and improve operating margins by approximately three to five percentage points (Exhibit 3). This savings could be reinvested

into marketing and new forms of distribution targeted at specific types of consumers likely to buy term life, such as young families. In an extreme scenario, companies could sell term life insurance through the Internet and call centers, supported by aggressive advertising through a variety of media to generate consumer interest.

A NEW APPROACH TO PRODUCT DEVELOPMENT

Life insurance products are typically developed over two to three years, a long period if the industry is trying to respond rapidly to consumers changing needs. This long development period is due in part to the economic and IT complexity of
(continued on p. 10)

Build a direct offshored term life insurance model

Average profitability for a term life business1
% of net premium
Offshoreable expense

Exhibit 3

100

56

12

13 8 132

30% ~
11
Baseline operating margin (pre-tax)

n 0% i to 5
35

c r ea

se

~16
Adjusted operating margin (pre-tax)

Net Net investment, premiums death benefit payout, changes in reserves

Commissions

Expenses

Other

Net cost savings3

1 Based on the weighted average of the top 15 term life companies whose 2005 term face amounts represented >80% of their total face amounts issued (e.g., coverage amount) 2 According to the financials, 40%60% of the expenses consist of FTE and real estate; experience suggests 45%55% of FTE and real estate expense can be offshored 3 Experience suggests a 45%55% net savings on offshored expenses, assuming only 50% of the commissions savings is captured with the remaining 50% being reinvested into incremental market spend

Sources: 2005 AM Best results; used individual life P&Ls to calculate profitability, which does not include some non-term life sales

THREE CHARACTERISTICS OF SUCCESSFUL INNOVATORS

We examined companies in industries known for innovation and identified three key characteristics that life insurance companies must develop to encourage the kinds of innovations we describe while mitigating the risks associated with change. Life insurers that develop these attributes will be well positioned to become the industrys leading innovators. Distinctive leadership. Breakthrough innovation comes from the top: The leadership at life insurance companies must launch the innovation journey by demonstrating commitment through their own action. Across industries, senior leaders of top innovators consistently demonstrate distinctiveness by creating a compelling reason for innovation, giving it a sense of purpose and urgency, and actively managing the process. Specifically, senior leadership dedicates time and attention to innovation (e.g., it is on their regular agenda) and establishes clear, actionable metrics and targets. They also allocate and protect funding while tracking the innovation portfolio to prioritize ideas most likely to have the highest impact. For example, the top team of a leading specialty retailer spends two hours every other week personally reviewing the innovation portfolio and rebalancing it as necessary. Consumer insights. Developing an understanding of consumers needs and behaviors is often a completely new capability for an organization. Building this capability typically requires new talent and techniques (e.g., using ethnographical and anthropological traits as an overlay to customer segmentation), as well as external partnerships, to provide a source of new ideas. Consumer products companies have realized the value of consumer insights for years, in many cases making them the driver of all innovation decision making. Indeed, at high-performer innovators, these insights are the foundation of the organizations culture, working approach, and go-to-market strategy. Processes and structure. Lastly, life insurance companies must create processes and structures through which to identify and pursue ideas such as those we describe. A disciplined innovation process and structure, balanced with creativity, is one of the most important drivers of innovation performance and provides the foundation on which to build broader capabilities. In a recent McKinsey survey, most life insurance and financial services executives described their organizations as having pockets of innovation that lacked adequate scale and processes to commercialize good ideas.1 In addition, approximately 50% said their organizations lack a formal process to align resources and talent, and lack formal mechanisms (e.g., dedicated resources or an innovation unit that focuses on generating breakthrough ideas) to manage ideas from start to finish. In contrast, high-performing innovators use, for example, a pipeline-filtering model to select ideas and a stage-gate process to make funding decisions. Such processes enable distinctive capabilities in pruning the weeds to eliminate 75% of ideas before concept testing, and allow these companies to avoid an overreliance on incremental innovation. Companies that optimize their process and structure also outperform in the other areas, such as idea generation and commercialization.
1 The McKinsey Quarterly conducted the survey in January 2007 and received responses from 322 executives; 85 were from the United States, 145 from Europe, and 92 from the rest of the world. Of the respondents, 112 held C-level positions.

10

insurance products and to a challenging regulatory environment. But it is also attributable to insurers longstanding desire to create distinctive, if not unique, products. Other industries (automotive manufacturing, for example) approach product design from a different perspective, referred to as design to cost. They pursue products they can design quickly and at lower cost and they create platforms from which variations of a standard product can be built readily. Product developers seek to maximize the number of component parts used across different products, and thereby avoid building products from scratch. The same approach could be applied to life insurance and annuities and has the potential to accelerate the process of product development and to substantially reduce costs. For example, the core annuity product, designed to provide a guaranteed income stream over a lifetime, could serve as the platform for various prod-

ucts designed to meet the needs of many different markets. A college savings plan designed to provide specific guaranteed payments at the start of each college term is one example of a product built from the same platform as a guaranteed lifetime annuity but positioned to appeal to a different market. * * * To begin the journey to breakthrough innovations, a life insurance company must consider several threshold questions: What is the size and scope of the opportunity available to the company? What unique advantages does the company possess that it could leverage in this environment? Does the company have the strategic vision, organizational structure, capabilities, processes, culture, and leadership commitment to enable maximum impact with minimal risk? Companies that answer these questions and act promptly to address the issues raised will be well positioned to win the race to capture the enormous opportunity.

Marla Capozzi is a consultant in the Boston office, Matt Hemsley is a consultant in the Minneapolis office, A.J. Peak is a consultant in the Cleveland office, and Tim Welsh is a director in the Minneapolis office. Contact for distribution: Cristina Sanchez Phone: +1 (212) 446-8965 Email: cristina_sanchez@mckinsey.com