A Strategic Analysis of the US Life Insurance Industry
A Strategic Analysis of the U.S. Life Insurance Industry
A discussion of the state of competition within and the trends affecting the U.S. life insurance industry.
This is the third article in a four-part series. In this series of articles, we analyze the U.S. life insurance industry's customers, products, distribution system and regulatory and tax environment. We then proceed to discuss the competitive environment in which companies operate and outline a generic business model for a life insurance company. We conclude with a consideration of future trends and prospects.
Our 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.
In the first article, we examined the industry's retail customers and the trends in their need for the industry's traditional products. We discussed 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, as well as a broad shift from insurance toward savings products predicated on tax-advantages of annuities, again directed primarily toward affluent customers. We described the consequences of these trends and the responses to them.
In the second article, we considered trends in the industry's product offerings and the new risks and challenges posed by the newer product types. The structure of these products has significantly changed the customer value proposition and the sources of profit of life companies.
In this article, we examine the trends affecting the distribution system for the industry's products and the regulatory and tax environment in which life companies operate. We also look briefly at the state of competition in the industry.
Distribution
Trend Toward Independent Agents: Life insurance products are sold primarily by a traditional sales force, consisting of career or independent agents. However, there has been a shift from career agents toward independent agents. In the early 1980s, career agents accounted for about two-thirds of life insurance sales, with the remaining one-third sold by independent agents. Since then, there has been a steady decline in the share of sales by career agents. In 2003, independent agents accounted for over half of sales, career agents sold about 40 percent and the remaining 10 percent came from a number of newer channels including brokers, web sales and banks. Newer channels are growing their market share, but traditional agents are expected to dominate sales for the foreseeable future. However, there is need for improvement in agent productivity. High distribution cost and low productivity are major concerns for insurers.
Aging Sales Force: The traditional sales force is aging. The average age of an insurance agent has increased from 37 years in 1983 to 52 years in 2003. Due to low replacement during most of these 20 years, the size of the traditional sales force has declined. A large proportion of agents are close to retirement age. Their retirement over the next 10 years can create a serious problem for the industry.
Agent as Financial Planner: Recruiting, training and retaining life insurance agents has been difficult in an environment of declining demand. Life insurance is a "sold" product, it is a complex financial contract, and increasingly, the customer is sophisticated and affluent, with specialized financial planning needs. The traditional agent is transforming into a financial planning advisor, who needs to address a comprehensive range of financial planning needs. Hence, the agent needs to have a complete set of solutions in the arsenal–savings as well as protection products. To satisfy the wide range of investment risk appetites of customers, more agents are selling not only fixed annuities, but acquiring the securities licenses to sell variable annuities. These factors are part of the reason for the trend toward independent agents. The need to be a trusted advisor, an independent and credible ally of the customer, is more important when customers are sophisticated and their needs are complex. It is also difficult for one company to supply the full range of products the agent needs. Agents have a good chance of being equipped with the "hot" product design of the moment if they sell the products of several companies.
Due to problems with retention and productivity, some estimates put the cost of maintaining a career agency force as 30 percent higher than selling through independent agents. While policyholder lapses are likely to be lower in a career agency model, many companies have decided that the overall economics of the independent agency model are more favorable. Some companies that are still retaining a career agency system are allowing their agents to sell some products of other companies, particularly in areas where they lack a complete portfolio, in order to maintain satisfaction among agents and enable them to be more competitive in a difficult sales environment.
Power of Agents: Due to the trend toward independent agents and fewer agents overall, the bargaining power of agents is increasing. With the impending retirement of large numbers of agents, the power of agents is likely to be even greater in the future. A potential consequence is an increase in distribution cost and an increase in premium rates for life insurance. Independent agency systems are consolidating, increasing their power. They are seeking long-term relationships with fewer companies, making shelf space harder to obtain for others. They are asking for customized products, a greater role in product design, more marketing support, excellent systems integration and strong customer service. Quick application turnaround, streamlined underwriting processes and "hand-off" of customer support can reduce "not taken" rates. Seamless integration of the agent's computer system with the company's system can save time and reduce paperwork, increasing agent productivity. More than ever, responding to the needs of agents is a priority for insurance companies.
Newer Channels: Insurance sales by banks and securities firms were not permitted or at least severely restricted by federal law prior to the 1980s. Deregulation that lifted many of these restrictions has opened up new channels for the insurance industry. But these channels have not had much impact on life insurance sales, accounting for less than 10 percent of the market. However, these channels have had a profound effect on annuity sales. They are natural outlets for savings products, and these outlets have embraced annuities–with their investment guarantees and tax-preferred status, annuities play a valuable role in the overall investment plan for many customers. Access to affluent customers through these new channels has been a big factor in the impressive rate of growth in annuity sales and assets under management at insurance companies.
Newer distribution channels dominate in variable annuity sales. About 40 percent of sales are by securities brokers, 25 percent by affiliated agents, with other channels representing less than 10 percent each. Independent agents account for 40 percent of fixed annuity sales, banks for 35 percent and affiliated agents sell about 15 percent.
Regulation and Taxation
Life insurance products are complex and poorly understood by customers. The products are long-term financial contracts that provide financial security in the event of a catastrophe. Life insurers are financial intermediaries–major players in the asset markets and a vital component of the financial system of the country. As a result of these factors, the life insurance industry is highly regulated. One type of regulation protects the consumer, by standardizing contracts, promoting appropriate disclosure, restricting abusive sales practices, fostering suitability analysis and sometimes regulating prices. Another type of regulation promotes the financial strength of insurers by restricting investment in risky assets, requiring adequate levels of capital to weather unfavorable claim experience and establishing standards for recognition of policyholder liabilities.
State Regulation: The life industry is subject to a complex system of state regulation. Insurers need to be licensed state by state and obtain approval from each state to sell products in its jurisdiction. These requirements place a costly burden on the industry. Another result is the long time it takes to bring a product to market, inhibiting innovation and curtailing the benefits of creativity in product design. While regulators view the capital requirements as essential to ensure policyholder claims will be honored, these requirements increase the cost of the industry's products, particularly savings-oriented products, compared to those of other industries such as mutual funds and banks, which do not offer the type of investment guarantees contained in annuity products.
Federal Charter: From time to time, there is discussion about the potential advantages of federal regulation of the life industry. These proposals are resisted by states for obvious reasons, but also viewed with suspicion by some insurance companies. A federal charter will favor new companies, by lowering the barrier to entry and speeding up their ability to bring a product to market, while existing companies operating under state charter would need to go through 50 approvals (unless they convert to a federal charter). While regulatory cost may be lowered, the temporary effect could be an intensification of competition in the industry.
Securities Regulation: Variable products are considered "securities" and are subject to federal securities regulation governing registration, distribution and disclosure. Regulation of distribution, requiring education and licensing of agents and brokers under SEC rules, is perhaps the biggest barrier to more rapid growth of annuity sales. It is also a reason to seek distribution through brokerage firms that already have sales staff with the appropriate licenses.
Reserve and Capital Requirements: To promote the financial soundness of insurance companies, regulators require conservative reserve and capital levels. Currently, these calculations are performed using specified formulas, mortality tables and interest rates. However, using the same methodology and assumptions for all companies does not account for the differences in product design, underwriting techniques and financial risk across companies. Some new products are so complex that it has become very difficult to assess the adequacy of reserve and capital amounts for these products using the traditional approach.
A new approach, that relies more on the actuary's judgment and is based on "principles" rather than "rules," is being developed. If this change is implemented, it can have a profound impact on companies. The companies that practice effective risk management techniques to limit their risk exposure and are able to objectively justify lower liability and capital levels can see a substantial increase in their rate of return on capital. Other companies may be affected in the opposite way. Actuaries will play a significant role in determining the capital levels and ROE of insurance companies. They will need to have a solid foundation in new risk management techniques and the quantitative tools for the analysis and management of risk. The process of determining reserve and capital levels will become integrated with the enterprise-wide process of tracking risk exposure, measuring risk interactions, and managing and mitigating risk.
Taxation: To encourage the purchase of life insurance and enhance the financial security of the population, the federal government offers tax incentives to life insurance customers. Death benefits are received tax-free by the beneficiary. Investment returns on life insurance cash values are not taxed until withdrawn. Annuities also enjoy favorable tax treatment, similar to the treatment of life insurance cash values. This tax deferral is probably the most important reason why customers buy annuity contracts.
Recent tax law changes have been unfavorable to the life industry. When taxes on dividends and capital gains on stocks were lowered, the new lower rates were not extended to the equity sub-accounts of variable annuities. This makes annuities relatively less attractive. The long-term impact of this tax law change on the industry is not yet clear.
The phasing out and eventual elimination of the estate tax has had a profound negative effect on survivorship life sales. The law is subject to a sunset provision, but if made permanent, can further depress sales in this market. Recent IRS regulation relating to Corporate Owned Life Insurance (COLI), limits the potential for growth in this market as well.
In the view of taxing authorities, the individual insurance business is moving away from its roots of providing financial security for the broader population, which was the original "public interest" justification for favorable tax treatment. As the tax law continues to evolve, the industry needs to monitor developments. Improving the public image, by re-focusing on serving the needs of the middle class, will have a positive effect and can ensure continued favorable tax treatment over the long run.
Competition In The Life Insurance Industry
The elements are generally present for intense competition in the life insurance industry. There are low barriers to entry and high barriers to exit, so in an environment of slow growth for life insurance products, the industry suffers from over-capacity. Since capacity is easily removed in the distribution system, that has occurred. As a result, shelf space for the products of many companies has been reduced and the bargaining power of agency systems has increased. In spite of these trends, agent productivity continues to be an issue, with many companies forced to use an increasing number of agents of diminishing productivity to maintain overall premium growth.
Competing for Distribution Outlets: Generally, companies compete for the hearts and minds of agents and brokers. This increases the operational complexity of managing insurance companies. Managing a number of agency relationships can be cumbersome, but it affords a viable strategy for the survival of a large number of fairly big companies, rather than a few oligopolies as is common in many industries.
In industries where the end user continuously experiences the product and derives physical utility from it (such as breakfast cereal, shaving lotion or automobiles), building direct end-user loyalty is feasible, and brand development is critical for success. For insurance and savings products, there is relatively little consistent end-user experience–many customers buy these products once or twice in a lifetime. Hence, insurance companies need to continuously attract new customers, rather than rely on increasing sales to current customers or offering new value-added products targeted at current customers loyal to the brand. New customers, unfamiliar with insurance products, depend upon a trusted intermediary, i.e., the agent, to facilitate the purchase. Hence, competition for agents and brokers is the essence of competition in the life insurance industry.
Competition on Broader Financial Services: Faced with flat growth in traditional product lines like life insurance, insurance companies took the competition to new markets, directly competing with mutual funds and other financial institutions for savings dollars. This opened up new distribution opportunities for insurers, due to the sale of annuities through banks and securities brokers.
On the other hand, the elimination of certain barriers prohibiting banks and investment firms from selling insurance products or owning insurance companies had the potential to intensify competition in the insurance industry. If these financial institutions had acquired or chartered insurance companies and expanded insurance sales through the distribution system they controlled, that could have had a negative effect on insurers selling through traditional agents.
For the most part, these negative effects have not occurred. While some banks and securities-oriented firms own insurance comp- anies, broader financial services firms have moved slowly into the underwriting business, while most insurance companies that have chosen to distribute their products through the investment broker channels have been successful in accessing these outlets and have grown their business as a result. Overall, annuities have established themselves as a core component of the portfolio of savings products, giving insurance companies a solid presence in this market. Investment-oriented products have served the industry well, at a time when traditional insurance products have languished.
Our brief discussion here has touched on macro-competitive conditions in the industry, address- ing primarily interactions with related industries. A detailed analysis of macro-competitive condit- ions, including a consideration value chain issues, substitute products and regulatory effects, is beyond the scope of these overview articles. Discussions that pertain to micro-competition analysis are found throughout these articles, including the analysis of customers, products and distribution channels. In the next (and final) article in this series, we tie these discussions together by developing a generic business model for the life insurance business and consider the competitive strategies that companies can pursue.
Conclusion
Effective distribution has always been a cornerstone of the life insurance business. If the current trends in attrition continue and agents retire in large numbers over the next decade, the life agency force could become so small as to cause a distribution crisis. Unless alternative distribution systems are developed well enough to pick up the slack or agent productivity improves dramatically, compensation would have to increase in order to attract new agents to the sales force. The resulting rise in insurance premiums can further weaken the industry.
Regulatory costs, including conservative reserves and required capital and a complex regulatory system, add significantly to insurance company expenses. Efforts underway to simplify the system and foster "principles-based" capital and reserve requirements can change the equation, making the life industry's products more competitive compared to alternatives. High quality risk management is likely to be a requirement for a company to obtain capital relief and increase its ROE under the new approach.
The favorable tax treatment of insurance industry products has been a major factor in attracting customers. However, competing products now enjoy favorable tax treatment as well, though not to the same degree as annuities and life insurance. If this trend continues, future annuity and life insurance sales are likely to be impacted.
At a time when life insurance sales were weakening, annuity sales began to take off, providing a new growth product for the insurance industry that has sustained it for two decades. The competitive threats from broader financial services firms did not materialize–indeed the insurance industry has thrived by deploying the distribution systems of the investment and banking sectors to sell insurance industry products. At this time, the future is unclear. The prospects for the industry in the coming decades will depend on regulatory and tax policy and the ability of the industry to affordably distribute security products to underserved customers.
Narayan Shankar is currently a senior actuary at Allstate Financial.