The insurance industry has evolved rapidly since the financial crisis. The next decade is shaping up to be every bit as transformative as firms grapple with a host of factors, most notably the unfolding regulatory framework, digital disruption and climate change.
A decade ago, governments and regulators around the world began instigating wide-ranging reforms of financial services in an effort to ensure there would be no repeat of the events that came close to devouring the developed world’s financial system.
Banks, having been at the epicentre of the financial crisis, have not surprisingly been the primary focus of efforts to curb risk taking and minimise systemic risks. But insurers have also been subjected to increasingly stiff regulatory regimes, designed to increase protection for policyholders. After all, the biggest US private sector casualty of the crisis was not a bank but an insurer: AIG took $68 billion from US taxpayers, $23 billion more than the biggest banking casualties – Bank of America and Citigroup. 1
However, whereas countries agreed a common international regulatory framework for banks, with the adoption of Basel III, the tightening of insurance regulations has been piecemeal. European insurers have seen the most sweeping changes following the introduction in 2016 of the European Union’s Solvency II directive. The rules take a risk-based approach to regulation: the riskier an insurer’s business, the more capital it requires. Perhaps most significantly, the shift to valuing both their assets and liabilities on a ‘mark-to-market’ basis when determining their regulatory capital position has meant the sensitivity of their assets to changes in interest rates has to be much more closely aligned with that of their liabilities.
Shifting to capital-lite
Consequently, some European insurers have made material changes to their asset allocations. Others have chosen to withdraw from activities no longer deemed sufficiently profitable given the new capital requirements, resulting in a wave of corporate activity as insurers adjust their business mix.
A number of companies have started splitting their activities into ‘capital-lite’ and ‘capital intensive’ units.
Iain Forrester, head of insurance investment strategy at Aviva Investors, believes corporate activity will stay brisk for the foreseeable future, partly because insurers cannot adjust their business models and shift unwanted risks off their balance sheets overnight.
“A number of companies have started splitting their activities into ‘capital-lite’ and ‘capital intensive’ units. While the new regulations have encouraged many to look to shrink the latter, firms have had to balance capital efficiency with the impact on short-term profitability and their distribution relationships,” he explains.
Paul Fulcher, a senior consultant to the life insurance industry with Milliman, a consultancy, agrees. “Some people took some very quick decisions after Solvency II, but it still feels like there are blocks of business sitting with people who don’t want to own them, so we’re likely to see quite a few legacy blocks being transferred between insurers,” he says.
Reinsurance and a move away from guarantees
The regulatory changes, when combined with low interest rates, have proved especially problematic for companies selling investment-linked products with guaranteed returns. Whereas insurers were previously prepared to provide long-term guarantees, the shift to mark-to-market valuations has made it much more expensive for them to offer these products.
The Geneva Association, an international insurance think tank, says insurers have made “significant progress” rebalancing their new business mix towards more sustainable products that are, “from both a policyholder and shareholder perspective, better adapted to the current low-interest-rate environment.”
Many have reduced their reliance on savings products with high interest-rate guarantees and replaced them with unit-linked and hybrid products
For example, it says many have reduced their reliance on savings products with high interest-rate guarantees and replaced them with unit-linked and hybrid products “that feature more sustainable guarantees”. 2
Other insurers have reacted by selling their portfolios of guaranteed business. In continental Europe, insurers such as Italy’s Generali have been busy offloading businesses to consolidation vehicles such as Athora and Monument Re. And, in a more fundamental shift, Standard Life Aberdeen in August 2018 completed the sale of its UK and European insurance business to Phoenix – a specialist consolidator of European life funds – to concentrate on investment management.3
With capital having flooded into the industry there has been no shortage of buyers. Reinsurance groups, private equity firms and specialist consolidation vehicles have all been eager to snap up insurance companies’ unwanted lines of business. For example, British insurer Prudential announced in March 2018 its intention to transfer 400,000 annuity policies to Rothesay Life, one of the earliest examples of a company established to manage blocks of annuities.4
According to the head of Ernst and Young’s Global Investment Advisory practice, Gareth Mee, UK annuities can offer long-term investors attractive returns relative to traditional asset classes. Moreover, the returns can be enhanced by shifting the longevity risk – the risk payments need to be made for longer because pensioners live to an older age than expected – to a softer regulatory regime.
“Under Solvency II, the amount of capital you have to set aside against the risk of someone living longer is very high. That is especially true when interest rates are so low. By contrast, you need to hold a lot less capital against that risk in Bermuda, or for that matter the US,” Mee says.
From the perspective of a US life insurer, taking on longevity risk from a group of UK individuals offers an additional attraction: the ability to hedge, albeit imperfectly, their exposure to US people living shorter lives.
Forrester says firms are also looking to shift the assets underpinning annuities to flexible regulatory regimes to improve the returns from their investment. “In Bermuda a scenario-based approach is used to assess asset-liability matching, which provides Bermudan insurers more investment freedom to generate returns than a European insurer subject to the more onerous rules of the Matching Adjustment under Solvency II,” he says.
Demand for private assets and alternatives
In both Bermuda and the US, insurers will allocate as much as 20 per cent of their investment portfolio to alternatives – with as much as half of that to hedge funds, private equity and other equity-like products. By contrast, in Europe, the capital implications of investing in these assets, particularly for an annuity business, can be high and hence insurers overwhelmingly avoid them.
Rather than selling off blocks of business, for other insurers the answer has been to shift towards higher-yielding assets. Long-term infrastructure has proved especially popular, both because it is treated favourably under the Solvency II regulations and offers a pick-up in yield due to its illiquidity.
Mee sees demand for infrastructure assets growing in the near term, particularly if companies continue to transfer their pension schemes to insurers as part of the trend toward buy-ins and buy-outs.
“While Sam Woods, the chief executive of the Prudential Regulation Authority (PRA), has talked about insurance companies trying to move towards a 40-50 per cent allocation to private credit (infrastructure), almost none of them are there yet,” he says.
However, Fulcher warns that while long-dated infrastructure assets are all the rage at present, the hunt for investments is in danger of becoming crowded. For instance, he says although Prudential’s decision to shrink its annuities business was taken mainly because its fast-growing Asian arm meant it had better use for its capital given the advent of Solvency II, it also appears like it spoke to its view of the attractiveness of the asset class.
“There’s a difference in perception as to how attractive these illiquid long-dated assets are. Some insurers may believe there is already too much money chasing too few of them,” he says.
Regulation: more change on the way
Looking ahead, ongoing changes in the regulatory environment seem assured. In Asia, for instance, several countries have implemented, or intend to implement, risk-based capital regimes similar to Solvency II. As in Europe, that looks set to drive changes in investment allocations and cause Asian insurers to change their product mix.
One challenge for the industry is that it is not always clear in which direction the regulations are heading. For example, in Europe, insurers are awaiting revisions to Solvency II next year. Perhaps not surprisingly, they are putting pressure on regulators to ease back, at least in terms of the capital treatment applied to certain types of investment.
Insurers are lobbying governments, telling them if they want help financing more infrastructure they need to align the regulatory treatment with the economic risk.
For instance, Fulcher says there is a potential argument for infrastructure equity to receive more favourable capital treatment. Pointing out that the Ontario Teachers' Pension Plan owns UK lottery operator Camelot, he says it is not obvious why European insurers should be encouraged to own the debt issued by infrastructure groups but penalised if owning the equity.
“Insurers are lobbying governments, telling them if they want help financing more infrastructure they need to align the regulatory treatment with the economic risk,” he says.
In the UK, the creation of so-called pension superfunds threatens further change. They are aiming to consolidate several corporate pension schemes and run them more cheaply and efficiently than the sponsoring companies. In effect, they are providing competition for insurance companies taking on company pension schemes via buy-ins or buy-outs.
Fulcher says it could make sense to have an intermediate stage between the more expensive option offered by insurers and the tiny fragmented pension funds that don’t have economies of scale and often rely on a sponsor covenant that can turn out to be weak, as demonstrated when British outsourcer Carillion collapsed in 2018.
Nonetheless, as Mee points out, differences in the regulations governing insurers and pension schemes could create an arbitrage opportunity.
“You’ve got pension consolidation vehicles and insurance companies that are both backed by private equity, and yet the regulations may be quite different for what are likely to be a very similar set of assets and liabilities,” he says.
The PRA is calling for consistency in the rules. Its head of insurance supervision recently warned against the dangers of unscrupulous owners and managers taking excessive risks or misusing policyholder funds.
“The risks faced by DB (defined benefit) consolidators are similar to those managed by insurance companies providing annuities… There may be unintended consequences if the two types of business are regulated differently,” said David Rule, executive director of insurance supervision at the regulator.5
In search of regulatory harmony
As for developments at the global level, the International Association of Insurance Supervisors (IAIS), which represents regulators from more than 200 jurisdictions, was tasked by the G20 with designing a framework to control systemic risk. It developed the global Insurance Capital Standard (ICS) which aims to measure the riskiness of insurers operating in different regimes in a comparable way. Such a set of rules ought to allow firms to operate more efficiently across borders, reducing costs and bringing benefits to consumers. As with banking, a common standard for insurance should promote co-operation between national authorities and limit the potential for regulatory arbitrage. However, much as the IAIS is keen for all countries to adhere to common standards, it is far from clear they will do so.
For example, there could be discretion over how insurers value their assets and liabilities. That could mean material differences and a lack of comparability.
While US authorities are accepting of the idea of capital being risk-based, they are far less keen on converging the way in which liabilities are valued. Forrester believes the outcome could be a global framework which is implemented differently by insurers in the US, and insurers across Asia and Europe.
“For example, there could be discretion over how insurers value their assets and liabilities. That could mean material differences and a lack of comparability,” he says.
So, while the notion of ICS has drawn a lot of attention, since there is little likelihood of the US adopting it the issue could prove to be of limited significance. Sweeping changes to accounting rules set to come in January 2022 are likely to be of more interest.
IFRS 17 aims to make it easier for investors and analysts to compare insurance companies. It is also designed to smooth out performance by forcing insurers to record profits from long-term policies over the life of the contract, rather than up front. However, some say it will introduce new costs but not a lot of extra clarity.
It appears as if few have thought through the business and investment implications of the new rules. “Insurers may continue to provide supplementary information to the market, and business decisions may not be driven by accounting measures. Nevertheless, I think some will decide running certain lines of business no longer makes sense on an IFRS 17 basis,” argues Fulcher.
The insurance landscape is being further revolutionised in a multitude of ways by the rapid pace of technological innovation. Increases in the volume of electronic data, the ubiquity of mobile interfaces, and the growing power of artificial intelligence (AI) are just some of the developments disrupting the industry.
Mee cites the example of Lemonade, a US ‘insurtech’ upstart that has used technology to break into an industry dominated by powerful, entrenched firms by offering cheap insurance to homeowners and renters.
Targeting a younger generation with an entirely app-based customer experience, the company claims it makes the insurance process as quick and painless as possible by having “bots instead of brokers and algorithms instead of paperwork”. Using Big Data to work out premiums and AI to evaluate claims, it boasts that it set the world record for settling a claim from approval to payout – three seconds.6
Lemonade, which charges a flat fee and vows to return money left over to charities chosen by its customers, recently raised $300 million in a funding round that reportedly valued the four-year-old company at more than $2 billion.7
Competition from the likes of Lemonade and Vitality in the UK is creating a wave of innovation as more companies look to use technology to create new products and drive better customer affinity. For example, technology is making it easier for insurance companies to monitor what their customers are doing.
This can not only help them price policies more accurately but also be used to advise customers how to avoid the sort of incident that might lead to a claim. Some have put boxes in customers’ cars that light up when the driver is driving badly. Others have installed leak-detection kits in their customers’ homes so that drips can be spotted before they turn into floods.
In health insurance, Vitality gives its customers advice on the best way to eat and exercise. It also measures their activity via connected devices such as Fitbits – people who sign up to the plan can receive discounts of up to 60 per cent on their life insurance.
Others are using new technologies to provide new services for customers. For instance, Aviva has created a Digital GP app to provide customers easier access to around 1,000 family doctors. The app enables them to book video consultations, receive remote diagnoses and obtain advice on simpler medical queries, via a live chat facility.
Looking to the future, Mee says initiatives by insurers to build-up their savings businesses will also need to be technology-led. As for Forrester, he expects new technologies to lead to growth in insurance-on-demand or pay-as-you-go type models. “If you’re an intermittent car driver or in a car club, if you want to drive the car today you flick a switch on your app. When you get home, flick it back and you’re not covered any more,” he says.
A treasure trove of data
New technologies are simultaneously transforming insurers’ investment activities. For example, social media networks such as Twitter and Facebook provide a vast potential treasure trove of information. Thanks to modern computing power, investment managers can quickly process and make sense of that information to decide whether to take investment decisions on the back of it.
Data analytics has the potential to suddenly give you an awful lot more information about your portfolio to hand, although it requires a considerable investment .
Furthermore, technology is providing insurers with an opportunity to manage their balance sheets with a level of precision previously unimaginable.
“Data analytics has the potential to suddenly give you an awful lot more information about your portfolio to hand, although it requires a considerable investment,” says Forrester.
While insurers have long held the ability to compare prospective returns from different investments or to assess how well different assets match liabilities, it is now possible to add a new layer of complexity into the equation by understanding the precise impact on their balance sheet of capital charges and different accounting treatments.
It is not all apple pie, though. Technological developments have brought with them a sharp rise in incidences of cyber crime. While this has provided a major growth opportunity for the insurance industry, regulators and other stakeholders rightly want to know insurers understand the risks they are underwriting.
However, technology could once again provide solutions. For example, AI can be used to search for security weaknesses and deploy solutions in real time, or to redirect attackers away from valuable data.
Climate change upheaval
Climate change, which Aviva Investors’ chief responsible investment officer Steve Waygood describes as the greatest collective risk facing mankind, is providing a third source of upheaval for the industry.
Faced with significant potential losses on both the risks they have underwritten and the assets in which they invest, insurers have begun to modify their behaviour. In part this is being driven by insurers themselves and their stakeholders (including customers looking to build a sustainable future), but also by regulators. This trend looks set to accelerate.
In December 2017, the Network for Greening the Financial System (NGFS) was formed by a group of central banks and supervisors. Arguing that climate change presents significant financial risks, the group is trying to mobilise mainstream finance to support the transition toward a sustainable economy.
In an April 2019 report, NGFS said: “Worldwide economic costs from natural disasters have exceeded the 30-year average of $140 billion per annum in seven of the last ten years”. It added that studies estimate the financial value at risk could be up to 17 per cent of global assets depending on the mean average temperature rise.8
The policymakers argue that the targets set in the Paris Agreement, and efforts by governments to limit the global rise in temperatures, will require a “massive reallocation of capital”.
Meanwhile, the IAIS in July 2018 warned climate risks present significant material challenges for the insurance sector, which are likely to grow over time. Since it is likely all insurance businesses will be directly or indirectly affected by climate risks over the long term, the IAIS said there was an “urgent imperative… for all insurers to consider their exposure to climate risks, regardless of size, specialty, domicile, or geographic reach, and seek to build resilience to such risks where appropriate”. 9
Forrester says insurers, which will shortly have to produce stress tests around climate risks, need to consider the assets in which they invest in conjunction with the risks they wish to underwrite. The longer-dated an insurer’s assets and liabilities, the more vigilant they need to be as their business will tend to be more vulnerable to the risks posed by climate change.
“Insurers are increasingly taking a holistic approach to assessing their exposure to climate risks. For instance, when weighing up whether to insure a coal-fired power station that decision needs to take account of your views on the merits of investing in energy firms with coal-fired power stations,” he says.
The US state of Rhode Island in July 2018 sued several major oil companies, including Exxon Mobil and Chevron, over the impact of fossil fuel emissions it claims have contributed to climate change, in turn damaging infrastructure and coastal communities in the state. The lawsuit follows similar action by US cities and local governments. 10
Interest in ESG exploding
As asset owners, insurers also have the power to make a difference. By working together, and encouraging action from policymakers and supervisors, the industry can help to collectively manage this existential risk.
The extent to which insurers are taking environmental, social and governance (ESG) factors into account when investing has exploded in the past year. “It’s increasingly driving equity and corporate bond allocations. The importance of being able to do ESG screening has increased immeasurably in no time,” says Mee.
He adds Ernst and Young recently approached European insurance companies to raise finance for a US shale producer. Even though the assets looked interesting, and in some senses aligned to other assets they buy, they were not prepared to invest in something so contrary to their ESG views. In contrast, when they worked work with another company looking to raise finance for a UK offshore wind farm, there was no shortage of insurers willing to invest.
“Even though they had never invested in offshore wind before, the asset was very aligned to their ESG views,” Mee says.
As the EU Commission considers whether to apply different capital charges for assets depending on how ‘green’ they are, Waygood warns the industry must do more to play its part in helping to meet the Paris commitment to keep the increase in global average temperature to well below 2°C above pre-industrial levels.
However, he draws encouragement from the fact that with growing evidence of the link between ESG standards and corporate performance, companies are paying ever more attention to these considerations. This trend is being reinforced by the shear weight of money flowing into responsible investments, which is forcing asset managers to take ESG criteria seriously.
According to a 2018 Bank of America Merrill Lynch research note, a “wall of money” is poised to flow into ESG strategies. The bank’s analysts claimed potential inflows from ‘millennials’ alone could drive $15-20 trillion of inflows into ESG-oriented strategies over the next two to three decades, roughly equivalent to the size of the S&P 500 index today. That would push ESG considerations further into the mainstream.11
“The insurance industry is more exposed than most to the destructive power of extreme weather,” says Waygood. “But as asset owners, insurers also have the power to make a difference. By working together, and encouraging action from policymakers and supervisors, the industry can help to collectively manage this existential risk.”
Amid much uncertainty, it seems insurers can be sure of one thing. Whether it is in adapting to the shifting regulatory environment, keeping ahead of the disruption caused by technological developments, or doing their part to help the world combat climate change, there is unlikely to be any let up in the pace at which they need to evolve.
- The Geneva Association Research Paper, The ‘Low for Long’ Challenge: Socio-economic implications and the life insurance industry's response, November 2017. https://www.genevaassociation.org/research-topics/financial-stability-and-regulation/low-long-challenge-socio-economic-implications
- Source: Phoenix Group website. https://www.thephoenixgroup.com/media/overview-of-the-strategic-partnership-between-phoenix-group-and-standard-life-aberdeen.aspx
- Source:Prudential PLC website. https://www.pru.co.uk/press-centre/transfer-of-annuity-policies-to-rothesay-life/
- An annuity is a very serious business: Part Two. Speech given by David Rule, Executive Director of Insurance Supervision, 10 April 2019. https://www.bankofengland.co.uk/-/media/boe/files/speech/2019/an-annuity-is-a-very-serious-business-part-two.pdf?la=en&hash=6BF86C21B2C85232A0A22D7D4D36344DF34B4610
- Source: Lemonade Insurance Company website. https://www.lemonade.com/
- Fintech Insurer Lemonade Valued At More Than $2 Billion After $300 Million Funding Deal. Forbes, 11 April 2019. https://www.forbes.com/sites/kristinstoller/2019/04/11/fintech-insurer-lemonade-valued-at-more-than-2-billion-after-300-million-funding-deal/#1626af2a2ee1
- A call for action Climate change as a source of financial risk, Network for Greening the Financial System, April 2019. https://www.banque-france.fr/sites/default/files/media/2019/04/17/ngfs_first_comprehensive_report_-_17042019_0.pdf
- IAIS and SIF Issues Paper on Climate Change Risks to the Insurance Sector, July 2018. https://www.iaisweb.org/page/supervisory-material/issues-papers/file/76026/sif-iais-issues-paper-on-climate-changes-risk
- Rhode Island sues major oil companies over climate change. Reuters, 2 July 2018. https://www.reuters.com/article/us-oil-climatechange-rhode-island/rhode-island-sues-major-oil-companies-over-climate-change-idUSKBN1JS28M
- The ABCs of ESG, Bank of America Merrill Lynch research note published 10 September 2018