January 2011

2011 outlook
Global Insurance Center

US life insurance outlook

Driving growth in a year of uncertainty
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 unprotable risks to drive bottom line earnings. The latter requires simplifying the business and product portfolio, improving operational efciency and squeezing earnings out of a stagnant revenue base, as the slowly growing economy makes it difcult 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. 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 not to mention possibly revised. These changes pose strategic and competitive challenges to life and annuity insurers. As insurers address these concerns, they must be cautious to preserve their nancial strength. Nevertheless, there are opportunities in deploying rebuilt capital to reposition and grow their businesses and improve future earnings. Ernst & Young has identied four issues that will inuence the US life and annuity insurance industry in 2011: 1. Responding to the changing regulatory environment 2. Establishing capital and risk management solutions post-crisis 3. Improving operational efciencies to control cost 4. 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 insurers 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 nancial reform package creates the potential for signicant regulatory changes, including deeper regulation at the federal level. There are several signicant 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. Securitizations will require an insurer to retain an economic interest in the security, i.e., to have some skin in the game. Finally, Dodd-Frank creates the Federal Insurance Ofce (FIO). The FIOs rst 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.

In addition, the National Association of Insurance Commissioners (NAIC) continues to move towards a principles-based approach to reserving. It is also evaluating requirements for risk-based capital. It is anticipated that C3 Phase 3 (C3 risk for life prots) will become effective 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 (risk-based capital) 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 nalizing their preparations for reporting under Solvency II, designed to ensure consistent capital adequacy across all insurers operating in the European Union by 2013. Solvency II is a major factor in the NAICs 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 IASBs Exposure Draft on Insurance Contracts (ED) in July 2010, the FASB released its Discussion Paper on its Preliminary Views on Insurance Contracts (DP) in September 2010. The insurance industry has not faced such signicant accounting change in more than 20 years. The proposals fundamentally alter the measurement basis for insurance contracts, and require increased disclosure and transparency regarding nancial 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 nancial 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, specically on asset/ liability management, in addition to signicant process redesign of valuation and reporting

US life insurance industry outlook

As insurers seek to reach new customers and maintain contacts with existing ones, strong distributor relationships and more efcient administration and improved customer service system interfaces are crucial.

processes, and technology considerations. The degree of impact will depend on the nature of a companys 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 nancial 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 or all insurers is to quickly grasp and respond to the regulatory and legislative challenges to support their future growth strategies. Formalizing the risk management function, and the trend toward establishing a chief risk ofcer 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 to risk limits. Boards, regulators and rating agencies are all expecting more in this area.

requirements for highly rated and nancially 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.

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 indicates that 28% of afliated producers listed technology as the single most critical support service. This was followed by back ofce 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 difcult environment, insurers have no choice but to control costs to achieve adequate prot 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.

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 efciently fund new business needs. A key challenge will be identifying the most cost-effective 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 benets embedded in the product.

The pending regulatory changes will affect risk management in two signicant 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 signicant challenges that a continued low interest rate environment presents, not to mention the risk of an unexpectedly rapid rise in rates. Second, the insurers that are not directly affected by DoddFrank and Solvency II will nonetheless have to cope with the emerging de facto standard for good risk governance and reporting. In addition, the NAICs 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 nancial services company, including its independence from risk-taking functions and its role in compensation structure oversight.

Improving operational efciencies to control cost

As insurers seek to reach new customers and maintain contacts with existing ones, strong distributor relationships and more efcient

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 nancial guaranty availability. Letters of credit of sufcient 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

Given a likely increase in nancial reporting and capital and risk management requirements from the emerging regulations, insurers may nd 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 efcient compliance with the regulatory and reporting requirements, while improving management information, distribution and risk management.

US life insurance industry outlook

Ernst & Young

Reinventing products and distribution to generate growth

not wreak havoc on the level and volatility of an insurers liabilities and capital.

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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. 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 proles of different businesses in light of the emerging regulatory and reporting requirements, thereby setting a course for continued success.

Generation Y is perhaps a more difcult 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 signicant 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 Internet-distribution 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.

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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 benet has begun to appear in the Dened Contribution benets 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 dened contribution market include guaranteed income purchase plans that incrementally buy xed income shares. Whether or not these products will drive signicant 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 signicant level of reserves and capital. For these markets, nding 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 benets, and participation mechanisms that will

US life insurance industry outlook