A Strategic Analysis of the U.S. Life Insurance Industry Part IV: Life Insurance Company Business Model and Future Prospects
A Strategic Analysis of the US Life Insurance Industry Part IV: Life Insurance Company Business Model and Future Prospects
This is the final article in a four-part series. Previous articles analyzed the U.S. life insurance industry's customers, products, distribution system, regulation, taxation and the competitive environment in which companies operate. This article outlines a generic business model for a life insurance company and concludes with a consideration of future trends and prospects.
Analysis in this article 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 consequences of these trends and the industry's 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 the third article, we described the importance of regulation and taxation in shaping insurance company product design, the attractiveness of products to the customer and the profitability of insurance companies relative to other financial services firms. We looked at the central role played by distribution systems, the trends affecting these systems and resulting impact on the industry. We also touched briefly on the state of competition in the industry.
Life Insurance Company Business Model
Like any other business, the key question for a life insurance company is how to get a reasonable return on invested capital. Invested capital takes three main forms: solvency capital, operating capital and acquisition costs.
Solvency Capital: To provide assurance to policyholders (and regulators) that a company can meet its claim obligations even in the face of adverse experience, investors are required to contribute funds to the company. Solvency capital also arises indirectly due to conservative reserving practices, which require a company to post liabilities in excess of best-estimate levels. Solvency capital is usually held in the form of marketable securities (fixed income, real estate or stocks). While these securities earn a return, the level of return is not adequate to compensate for the fact that solvency capital is "at risk," i.e., the funds may need to be drawn upon to pay claims. Hence, the company needs to earn a margin on its operating revenues to augment the return on the solvency capital. The "risk" to the insurer arises due to adverse outcomes on mortality, morbidity and interest yields. Appropriate spreads on these factors will generate the margins needed to produce an adequate return on capital. Solvency capital is a significant component of total capital.
Operating Capital: Typically, insurance companies do not need to invest significantly in property, plant or equipment to conduct business. There are ongoing administrative, marketing and loss adjustment expenses associated with doing business, which are covered by expense charges built into the premium. These ongoing costs are not regarded as an "upfront" investment that forms a base on which a return (net of depreciation) needs to be earned. However, the capital mix in some companies may include large investments in technology and distribution infrastructure, on which a return would be expected.
Acquisition Costs: A major component of total capital is the money spent to acquire business. A large initial expense, in the form of underwriting costs and/or first-year commissions, is incurred in order to put the business on the books. The heart of the economics of the insurance business rests with the recovery of these expenses through margins in renewal premiums or interest spreads. Early termination of the contract can result in a loss to the company, if the acquisition cost is not recovered. Surrender charges, conservative cash values and other approaches are used to mitigate this loss.
Insurance and annuity contracts are usually multi-year contracts that are expected to generate margins throughout the life of the contract. For insurance, premiums are usually paid each year. For annuities, first year premium is the dominant component of revenue, but the annuity deposit earns interest each year for the company, generally a higher yield than the rate credited by the insurer on account balances.
Generic Operating Strategy
The basic operating strategy for life insurance companies is as follows:
- Use underwriting rules and procedures that result in mortality experience that matches the pricing assumption. Use pricing assumptions that result in a competitive price while not causing an abnormal fraction of applicants to be turned down for insurance–inconsistent or excessively stringent underwriting really upsets agents.
- Offer competitive sales commissions. Build a network of productive agents.
- Maintain adequate financial strength, so that agents can feel confident recommending the company to customers–if the company has financial problems, the agents can lose many customers who are the source of their livelihood.
- Target an optimal capital structure, to minimize the cost of capital.
- If possible, promote the company's name through mass media, so that customers are familiar with the company's name and believe in its reputation–it is easier to sell products of a company already known to the customer. This strategy is normally applicable only to the largest companies, which can afford the high cost of "brand" development.
- Offer products with "selling points," i.e., features that appeal at some basic level to customers. These selling points usually have something to do with guarantees, security or upside potential on investment returns. The "selling point" of the moment varies and a company needs to stay on top of what is currently popular. Historically, there has been little advantage to being an "innovator" in product design, but "fast followers" can reap big rewards.
- Invest in a portfolio that achieves target returns while bearing a pre-determined level of investment risk. If the liability portfolio is interest sensitive, the asset portfolio should be appropriately matched to limit disintermediation risk. Maintain adequate liquidity.
- Manage the company's overall risk profile by establishing risk tolerance limits and appropriate use of reinsurance and other risk mitigation techniques.
- Offer appropriate incentives to agents and customers to promote policy persistency, so that acquisition costs can be recovered and spreads can continue to be earned–older policies are generally the most profitable.
- Keep operating costs at target levels. Use technology and a trained workforce effectively to provide good customer service–application processing, policy issue, billing, collection, fund transfers, account statements, claim settlement, telephone response, etc.
The above steps might sound easy, but to survive, a company needs to grow its revenue base and do all of the above to remain profitable.
Sustainable Competitive Advantage
What aspects of the generic strategy outlined above can be used to build a sustainable competitive advantage?
There are only a few generic techniques to build sustainable competitive advantage. These techniques center around one of the following concepts:
- Build a legal barrier to competition through patents. To sustain this advantage, a company needs to pursue a strategy of continuous innovation, so that it always has a strong portfolio of patent-protected products. Generally, companies in the technology and pharmaceutical industries pursue this strategy.
- Achieve strong competencies in hard-to-perform processes, particularly where these processes involve economies of scale. In industries with complex technical processes and substantial scale economies, a large company that performs excellently can be hard to compete against, on both cost and quality dimensions. The biggest threat to these market leaders would be a transformation in technology that makes their current process obsolete.
- Develop a wide network of relationships of trust and mutual benefit. These relationships take time to build and can be hard to duplicate, particularly if there are substantial switching costs serving as a barrier to selecting new partners. Brand development and product differentiation fall in this general category, as well as building a complex network of agency relationships for insurance sales.
- In products with network externalities, a customer's ability to get utility from a product depends on other customers using the same product. By having the largest installed base, a company can achieve monopoly power. An example is Microsoft in the area of personal computing software.
Competitive Advantage in Insurance Industry
How do the above techniques for achieving competitive advantage apply in the insurance industry?
Patents: Until recently, insurance products have not been granted patent protection. Product innovation may offer a temporary advantage, but it would not be sustainable, since it can be easily copied. However, a company that develops an effective process to be a "fast follower" can achieve a sustainable competitive advantage. This involves continuously monitoring the market environment, the tastes and needs of customers and the product designs of competitors to identify "winners." Once the opportunity is identified, it needs to be followed up with "speed to market." i.e., the company needs to have a smooth engine to crank out and file contract forms, generate premium scales, create marketing materials, train agents and update administration systems to accommodate the new sales.
Scale Economies on Functional Processes: The core functional processes in the insurance business consist of underwriting, record-keeping/ customer service and investment management. Few companies attempt to achieve superior margins through underwriting gains or differentiate themselves on their underwriting superiority. Basic competency in underwriting is not hard to develop, but achieving excellence can be formidable. With the processes currently utilized, there do not appear to be significant economies of scale in underwriting. On the negative side, aggressive pursuit of underwriting superiority can result in depressed sales due to the perception of excessive selectivity. However, a streamlined, consistent and responsive underwriting process will increase agent satisfaction.
Record-keeping and investment management are processes with scale economies. However, these processes are separable from other core functions of insurance companies. As a result, there is a vendor market for these services that effectively eliminates them as avenues for pursuit of sustainable competitive advantage.
Network Externalities: This does not apply to the insurance industry, since the utility a customer derives from owning an insurance contract does not depend on other customers owning the contract as well. (Note the subtle difference between the concept of a network externality and the concepts of economies of scale and the law of large numbers, which do apply in the insurance business).
Pursuit of Trust and Relationships: Strong capitalization, agency relationships and brand development fall into this category. Generally, companies do not attempt to build a competitive advantage through high capitalization levels, since the cost of doing so is prohibitive and the strategy is not adequately appreciated by agents or customers. Companies that enjoy very high ratings from the major rating agencies generally achieve those ratings due to business performance, market strength and future growth/profitability prospects rather than exclusively due to high capital ratios.
For the largest companies, brand development is a powerful tool to achieve a competitive advantage. Generally, companies in that size-range promote their brand in the mass media. However, medium-sized companies can be successful in the life insurance industry by pursuing a strategy of agency relationships. The heart of the matter for companies of all sizes and in all market segments would appear to be maintaining and growing distribution strength and agent loyalty, through competitive compensation and sales support. This includes creating and nurturing a top-notch process for maintaining a comprehensive product portfolio that is continuously "fresh" with attractive product features. This approach will engender sustained sales growth together with strong renewal persistency, leading to above-normal revenue growth and profitability.
Probably the most important characteristic of the life insurance industry is that its products are difficult to sell–very bluntly, customers would rather not buy them, except for certain savings-oriented products. It should be no surprise that in such an industry, companies that are superior in moving their products would have a consistent advantage. Many companies are attempting to pursue a route to sustainable competitive advantage by strengthening their distribution capabilities and agency relationships as described in the previous paragraph. Companies that perform competently in this area can hang on and survive. Those that outperform the competition in this area without selling at unprofitably low prices can grow to dominate the industry.
Future Trends and Prospects
Demand: It is likely that demand for insurance products will remain consistent with current trends for the foreseeable future. The factors suppressing middle market demand for life insurance continue to be present. However, due to a general shift away from active marketing of life insurance to this segment, the broader market can now be regarded as "under-served." It is likely that there is an unmet demand and potential for much greater penetration, but the current distribution mechanisms appear unsuitable for accessing this market in an economically feasible manner.
Some newer distribution channels show promise. However, we are probably years away from a consistent business model for moving simple security-oriented products efficiently through alternative channels with a "pull" marketing strategy and a streamlined risk selection process that would be suitable for a mass market. Some companies are currently tinkering with various experimental approaches. When the solution is found, it will be a break- through for the industry.
Demand for estate-planning-oriented products will remain uncertain until the long-term status of the estate tax is resolved. However, there appear to be other stimulants to demand in the older age population for life insurance products–currently, there is ongoing research on underwriting tools and risk classification paradigms for this demographic. The sustainability of this demand remains in question until the forces causing it are fully understood. Demand for life insurance driven by tax-advantaged investment returns may be affected by tax law changes, which are still evolving.
Demand for annuity products may also be affected by tax laws, as previously explained. The full impact of tax laws already enacted is not yet clear. Further changes to the law are possible, with negative consequences. On the positive side, there appears to be increasing demand for the guarantee features in annuities, particularly as the population ages and larger numbers of retirees look for safe places to invest their nest egg. Income annuities are likely to be a growth area, though this market may be slow to develop and may never become as prominent as some people anticipate. Overall, except for the tax-law factor, the future looks strong for annuity products.
Supply: So far, there has been no clear parallel in the insurance industry to the trend of mega-mergers sweeping the banking industry. The economics of retail banking point to scale economies and the network externality effect of a dominant presence in a geographic market–a comprehensive coverage of branches and ATMs feeds on itself. Customers like to have accounts in a bank that has a large number of branches and ATMs in their geographic area. While scale benefits undoubtedly exist in the insurance industry, the value of mega-scale is not clear, especially due to the somewhat doubtful value of brand development.
Gradual consolidation is expected, driven as much by the preferences of the distribution system as by the wishes of the industry itself. While this might not result in mega-companies, overall the trend will be toward companies being larger and as a result there will be fewer companies. A somewhat large company could be necessary to achieve critical mass for co-marketing annuities with name-brand fund managers. There is also likely to be some momentum toward offering a seamless marketplace for savings (and security) products through a comprehensive distribution system associated with a broadly diversified holding company of financial services organizations, including commercial banking, insurance, investment banking and brokerage.
Substantial changes in the overall structure of competition in the insurance industry, including the scope of operations and the size and number of companies will depend to a large extent on changes in how the industry's products are distributed. If the traditional agency system declines considerably, the structure of competition in the life industry will probably undergo a transformation.
Distribution: New channels will grow in market share, especially in annuity sales. In the short term, due to the decline in the number of traditional agents, life insurance distribution costs will probably increase and prices may gradually go up. As field compensation improves, the industry may be able to recruit more agents, leading to higher sales growth. Over the long term, it is possible that the industry will find a way to mass market its products through less expensive direct channels. If that happens, it is likely that a few companies will come to dominate the industry.
Internationalization: A potential bright spot for the U.S. life insurance industry is the growth in prosperity occurring in developing economies such as China. These economies are currently undergoing the transformation that occurred about a hundred years ago in the United States, which fueled demand for life insurance and led to the growth of life companies in this country. Many domestic life insurers are expanding into these countries, with subsidiaries or joint ventures with local companies. Many of these operations are profitable. There is demand for savings as well as insurance products.
There is considerable potential for the U.S. life insurance industry in the coming decades as a result of the globalization of the economy and rapid economic development in some countries abroad. With patience and investment in the right countries, some companies are likely to reap a big reward.
Societal Trend Toward Personal Responsibility: Long-term prospects for the life insurance industry are strong, due to the trend toward personal responsibility for financial security. Governments are already over-extended and will be challenged to meet their social insurance and welfare obligations toward an aging population. Private sector solutions such as insurance and annuities will play a prominent role in filling the gap left by reduced government commitments. There is also a trend toward a lower level of employer responsibility for the security of the workforce. As a result, growth in voluntary employee benefit programs will occur.
In the near term, it is not clear that major changes in social insurance programs will occur, but in the longer term, these changes are all but certain. Many younger people already expect changes in social security to occur before they retire, and their expectation is that benefits will be less generous. As this notion takes hold broadly, demand for insurance and savings products will strengthen.
Regulation and Taxation: These are external factors that insurance companies do not control. The optional federal charter might be to the long-term benefit of the industry. While short-term competitive damage is feared by insurance companies operating under state charter, state regulators have a high incentive to take action that will diminish or eliminate the competitive disadvantage. Already, discussions such as the interstate compact are taking state regulation in that direction.
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 current products more competitive compared to alternatives. In addition, the design of future products can change substantially. 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. This trend favors large insurance companies that have the resources to maintain the infrastructure for these complex analytical processes.
This completes our analysis of the life insurance industry. We have examined the industry from the point of view of all the major stakeholders, tracing its history from its early years to the present, and highlighted several factors that may impact the industry in the future. We have provided a roadmap of the current landscape and current trends. Each topic we have touched upon merits a detailed article, but this overview can only provide a high-level summary.
Our description of the overall economics of the industry (business model), its generic operating strategy and the techniques that insurance companies can successfully apply to achieve sustainable competitive advantage provides appropriate background to evaluate the future prospects of life companies that readers may wish to analyze, when combined with specific financial and strategic information pertaining to a company and applied with financial and business insight. In fact, this industry analysis was originally written to accompany a detailed strategic case study prepared by the SOA for use in a continuing education seminar. The industry analysis was intended to facilitate the evaluation of the strategic alternatives facing the hypothetical insurance company described in the case study.
Narayan Shankar is currently a senior actuary at Allstate Financial.
The author is grateful to the SOA for providing the opportunity to write this analysis during his employment with the Society, however the opinions expressed here are his own and do not reflect any official position of or endorsement by the Society. He also appreciates the many friendships and close professional relationships he developed with actuaries throughout the United States and Canada during his tenure as life practice staff fellow at the Society.