A Strategic Analysis of the US Life Insurance Industry Part 1 Customers
A Strategic Analysis of the US Life Insurance Industry Part 1 Customers
by Narayan Shankar
An in-depth look at the U.S. life insurance industry.
This is the first article in a four-part series. In this series of articles, analysis of the U.S. life insurance industry's customers, products, distribution system and regulatory and tax environment will be given. Then, a discussion of a generic business model for a life insurance company and the competitive environment in which companies operate will follow, concluding with a consideration of future trends and prospects.
The analysis is purely strategic and avoids consideration of technical or actuarial issues. The goal is to provide a flavor of what the industry looks like, stripped of the intricate details of actuarial modeling and accounting issues. We look at the issues that business leaders without a technical background think about and see the issues as they appear to business strategists and decision-makers. These are the considerations that inform the decisions that set direction for insurance companies and shape the industry.
The U.S. life insurance industry includes more than two hundred groups of companies. These companies provide a broad range of life, health and annuity products to a market that consists of individual customers as well as employers, pension trusts and associations. Historically, the industry's primary role has been to provide financial security to its policyholders, by reducing the adverse impact of the premature death or disability of a breadwinner or the catastrophic costs of major medical expenses. However, the industry is also a major financial intermediary, rivaling banks and investment firms in this regard as shown on Table 1. Policyholder premiums received in advance are invested to earn a spread. More recently, the industry has been offering products with primarily a savings orientation and relatively little mortality or morbidity risk. These savings products are often offered with investment return guarantees.
Part I of this series examines the industry's customers. A good starting point in industry analysis is a careful look at the needs of customers and the factors that shape demand for the industry's products. We'll focus on the retail customer rather than the institutional market for the life industry's products.
Historically, the main value proposition for the life industry customer has been that of income protection. For the young wage earner dying prematurely, life insurance can create an estate, serving as an income source for dependent survivors. Disability insurance provides monthly income in case of disability. For seniors, income annuities provide protection against outliving one's assets. The industry has also played a role in protecting customers against catastrophic medical or chronic care expenses. However, there is an ongoing shift in the private insurance needs of individuals, due to demographic and secular trends as well as the increasing role of group and social insurance. This has resulted in significant changes in whom the industry serves and the needs served. We will describe these trends, after first examining the life cycle of the life insurance industry to this point in time.
Life Insurance Industry Life Cycle
The glory years of the industry coincided with the steady increase in population and prosperity in America during the industrial age. As the middle class expanded, incomes became stable and people realized their "American Dream," the need arose to protect this stability and the future of loved ones. At a time when families depended heavily on one wage earner, demand for life insurance grew organically. Death of young and middle-aged adults was not an uncommon occurrence around the year 1900, when life expectancy was 49 years.
The most popular product was whole life insurance, which served two purposes. First, it protected young dependents in case of premature death of the policyholder. Second, it served as a "retirement plan" for the spouse in old age. Wives usually survived husbands by 10 or more years. At a time when private pensions were uncommon and social security did not exist, the death benefit from life insurance, often annuitized through a supplementary contract, was a critical source of income for the widow.
During the era of organic expansion, the life insurance industry grew almost without effort. Over almost a century, there was little or no change in the basic life insurance product or its method of sale, except that gradually, contracts became standardized with the consumer protection features we take for granted today, such as cash values and the non-contestability clause. It was the period of agency building, resulting in the creation of a comprehensive network of life insurance salesmen spanning the entire country, and the proverbial kitchen table sale of life insurance occurred in every neighborhood in every corner of America.
The industry prospered by serving a fundamental need of the population, i.e., enhanced financial security. Several factors contributed to the financial well-being of life insurers, including improving mortality, standardization of underwriting processes and risk classification, stable lapse experience and a stable investment environment.
Over time, a high level of penetration of the Middle American market was achieved. At the end of this growth period, the industry had reached a mature phase in its life cycle. However, around the middle of the 20th century, trends that were to adversely impact the life insurance product had begun to emerge.
Secular Trends Affecting Life Insurance
The number of individual life policies sold declined steadily over the last two decades, from about 18 million policies in 1984 to about 11 million policies in 2002. However, over the same period, the total face amount of new sales increased from about 800 billion to about 1.6 trillion. Thus, the average face amount increased from about $45,000 to about $150,000 during this period.
The most fundamental industry trend is the declining demand for life insurance among middle income Americans, resulting in an industry shift in pursuit of the affluent market for specialized needs in life insurance as well as savings. This narrows the customer base of the industry, exposes it to regulatory and legislative changes, and compresses its distribution force.
The second major trend is the change in customer expectations and buying habits that coincided with the dawn of the "marketing era" as explained below. This trend has resulted in product complexity and channel diversity, compressed the product life cycle and increased the overall risk profile of the typical insurer. While many other industries have experienced the impact of the "marketing era," the effects have been exacerbated and accelerated in the life insurance industry due to the weakening demand conditions.
As a result of these trends and the industry's responses to them, there is increased disintermediation risk, marketing risk, mortality risk, investment portfolio risk and regulatory risk compared to a generation ago. Hence there is greater (mis-) management risk as well. These are powerful effects, highlighting the profound importance of demand conditions, customer expectations and buying habits on the health of an industry.
First, an explanation of the "marketing era,"and then an investigation of the forces that have caused the decline in organic demand for life insurance among the middle-income population.
The Marketing Era
Economists have classified the period prior to 1960 as the "manufacturing or product era." During this period, most traditional industries experienced organic growth for the same reasons described above for the life industry. The business model for success in this era was to focus on the manufacturing process, improving productivity, streamlining products and pursuing scale economies. Relatively simple mass-market products, reasonably priced and of reliable quality, were assured of a market. When most families did not have a refrigerator, bells and whistles did not matter–a basic refrigerator that was affordably priced would attract customers. You just had to make them well, and the products would sell. Once traditional industries reach maturity and high market penetration, they enter the "marketing era." Simple mass-market products are no longer adequate. "One size fits all" is not a viable growth strategy. When everyone has a refrigerator, customers look for specific features based on their prior experience with the product. A company cannot decide what it will produce based on process efficiency and technical feasibility alone, without reference to the needs of the customer. It becomes necessary to segment the market into groups with similar needs and preferences, listen to customers to understand these needs and preferences and provide what they want.
Like other industries, it became necessary for the life industry to respond to these new expectations of customers. Intensifying competition in a mature market forced companies to respond creatively. One important effect of this shift toward the "marketing era" has been the variety of new insurance product designs seen in recent decades. We will discuss these new product designs in the next article in this series.
We now turn to the causes of the weakening organic demand for individual life insurance. These causes are primarily demographic, secular and other environmental trends. In aggregate, the effect of these trends has been a gradual decline in the need for income protection through the private insurance mechanism.
Lower Financial Vulnerability of the Population
As women entered the workforce in increasing numbers, the two-income household became common, reducing dependence on the primary breadwinner. The decline in fertility in the post-baby boom period resulted in fewer children per family. The increase in life expectancy has nearly eliminated the possibility of dying prior to age 50 except from lifestyle-related causes, to the extent that few people expect to die at a younger age or know someone who did. Lower mortality suppresses the motivation to purchase life insurance. It also reduces premiums, putting pressure on the revenue from a unit of sale.
Alternative sources of income protection have reduced the need for individual life insurance. These substitutes include the social security survivor benefit, which provides a monthly income to the surviving spouse and children. Some private pension plans also offer survivor income. Employers routinely provide a death benefit through group life insurance, with the option to purchase additional amounts on a voluntary basis. These purchases are easy, usually without underwriting and through convenient payroll deduction.
These trends have suppressed middle market demand for individual life insurance. As a result, life insurers have generally turned their marketing efforts away from income protection to other needs. In the 1980s and 1990s, these needs increasingly centered on the role of life insurance in estate planning and as a tax-preferred savings vehicle–which meant that the industry focused its attention not on the vast middle class, but on affluent Americans and the corporate market.
When wealthy individuals die, their estates are subject to a federal tax. In some instances, this tax liability can necessitate the liquidation of all or a portion of the estate in order to pay the tax in cash. This can present a significant problem, especially if the estate is held in the form of illiquid assets. Life insurance benefits pass on to heirs tax-free. This opens up two possibilities: (1) Leave a legacy for heirs in the form of life insurance benefits, avoiding the estate tax. (2) Use the life insurance benefit as a liquidity source for payment of the estate tax on the rest of the estate.
Tax Preferred Savings
Whether or not in the context of estate planning, life insurance has potential as a tax-advantaged investment vehicle. If a death benefit is paid, the investment return is earned completely tax-free. If the policy is surrendered for its cash value, taxes are due on the investment return, but have been deferred to a later period. The cash value can be utilized as a policy loan, with possible tax benefits.
Life insurance products specifically designed to meet estate-planning needs grew rapidly in the 1990s. Single premium life insurance, limited pay life insurance and survivorship life insurance policies were introduced for estate planning purposes and to take maximum advantage of the favorable tax treatment accorded to the savings component of life insurance. Corporate-owned life insurance also uses the tax-preferred status of life insurance in advantageous ways. As we will describe later, recent tax law changes have already impacted these new markets. Further changes to the tax law are possible. As an illustration of the impact of tax law changes, Table 2 shows the recent growth rates in survivorship sales.
Customer Demographics and Product Trends
The trend toward the affluent market and the emphasis on new uses of life insurance such as estate planning and tax-preferred savings have resulted in the industry's pursuit of an older demographic–one that has estate planning needs and the funds to utilize the tax advantages. How about younger customers and middle-income customers? Increasingly, they are purchasing term insurance rather than whole life. There are two reasons for this trend.
First, the "tax-advantage" motivation for the purchase of whole life insurance does not apply to most middle-income people. They now have a variety of tax-preferred savings options, including 401(k), IRA, college savings and other vehicles. There is more than enough capacity in 401(k) and college savings plans to absorb all the savings dollars of most middle-income earners. The prevailing wisdom is to "buy term and invest the difference."
Second, the "retirement plan" motivation for the purchase of whole life insurance is no longer relevant to most people. Life insurance is now viewed as protection needed primarily in the pre-retirement years, with an emphasis on the financial security of young children. Private pensions and social security as well as Medicare have vastly reduced the need for a husband to create a "retirement" estate for an elderly widow. Hence the trend toward the pure insurance protection of term life insurance.
The trends affecting life insurance merited lengthy discussion due to the long history of this product and the complex forces that are affecting this market. The discussion on annuities will be shorter. There is currently a small market for income annuities, which is expected to grow in the coming decades, as will be discussed in a later article in this series. Most annuities sold today are deferred annuities.
Deferred annuities mainly operate on the value proposition of serving as a tax-advantaged savings vehicle that offers investment guarantees. Due to the existence of other tax- advantaged savings vehicles that are easily accessed by most people, and the relatively large initial investment required to buy an annuity contract, they are not targeted at the middle-income mass market. Annuities are appropriate for those who have exhausted other tax-advantaged options such as IRAs and pension contributions. They may also be appropriate for small business owners and self-employed people with relatively high incomes, who may have less easy access to such things as 401(k) plans. They are also used by retirees who have accumulated pension and other savings, and need some tax-preferred means of investing these funds in their retirement years, subject to minimum withdrawal rules. The guarantees in annuities may have a strong appeal in this market segment–while the average age of the variable annuity buyer is under 50, the average age of the fixed annuity buyer is over 60. Overall, individual annuities are sold to a relatively small slice of the U.S. population.
There is a trend in the life insurance industry from income protection products to savings products. As individuals go through their stages of the life cycle, the savings phase ends around the time of retirement. Thereafter, asset protection becomes a primary consideration. Income annuities can play a role in this phase, as well as deferred annuities with investment guarantees, as described in the previous paragraph. A growing issue is protection of assets, primarily housing, from the consequences of catastrophic health care expenses. Long-term care insurance has stepped in to provide this protection. While still a small part of the industry's overall revenues, it is a key growth area.
This concludes our discussion of the life insurance industry's retail customers and the trends in their need for the industry's traditional products. We also examined the industry's response to these trends, i.e., the change in focus toward a narrower base of affluent customers with new products that satisfy specialized financial needs rather than middle-market income protection needs, as well as a broad shift from insurance toward savings products predicated on tax-advantages of annuities, again directed primarily toward affluent customers.
We noted the consequences of the narrowing of the customer base of the industry; the growing complexity of products; and the reliance on secondary financial needs (such as tax shelters) rather than primary, self-arising and intrinsic human needs (such as income security) to support the industry's growth. These consequences include increased exposure to regulatory and legislative changes, and the compression of the industry's distribution force. The overall risk profile of the typical insurer is now greater than in the past, due to increased disintermediation risk (policyholder options), marketing risk (channel investments, channel diversity and shorter product cycle), mortality risk (finer risk classes), investment portfolio risk and regulatory risk. These are powerful effects, highlighting the profound importance of demand conditions, customer expectations and buying habits on the health of an industry.
Narayan Shankar is SOA staff fellow (life) for the Society of Acturies. He can be contacted at: Nshankar@soa.org.
Part II of this article will be published in the June/July issue of The Actuary.