As investors have come to appreciate positive business developments in the industry, the FTSE 350 life assurers have substantially outperformed over the past 12 months, delivering a total return (share price gains plus dividends) of 29 per cent - more than double the 13 per cent from the index. However, the industry faces a sea of uncertainty that could produce challenges in 2013.
UK life assurers would like a nice level playing field with plenty of earnings visibility, decent investment returns and little or no interference from the multitude of governing bodies. Instead, they are looking at the as yet unknown implications arising from the Retail Distribution Review (RDR), the debilitating effects of a low interest rate environment and the ongoing saga of Solvency II, which, if implemented without significant modification, would have a major effect on life assurers by increasing risk-related reserve requirements.
While the outlook for the coming year is full of unknowns, one certainty remains, and that is a continuation of the low interest rate environment. Rates are important because they are part of the biggest cog in the life assurer's business model. Insurers collect premiums on life policies, invest the proceeds and then pay out on maturity or death. And those premiums are invested in ultra-safe instruments such as government bonds, which is sensible enough, but returns have been slashed dramatically as a result of low, and in some cases non-existent, returns.
Insurers have tended to favour investing in short-dated gilts, but the yield on these has sunk from a little over 2 per cent at the start of 2011 to just over 0.5 per cent. Furthermore, there is little to suggest that declining rates of return have been compensated by higher product charges. This leaves life assurers with a choice; either lower the payout on policies or lean towards a higher-risk investment policy. The latter seems unlikely, so policy holders will continue to suffer and the need to retain a competitive edge will squeeze margins.
Annuitus horriblis
This all comes at a time when consumer sentiment is weak. And, faced with declining purchasing power, paying insurance premiums becomes one of the early casualties. This is storing up a time bomb, especially in regard to pensions, where the annuity market looks bloodier than the fields were at Passchendaele. There are several reasons for this. Annuity rates have fallen to record lows because these are linked to what an insurance company can make on its investments.
And there are other problems, not least an investigation into the annuity market by the Financial Services Authority (FSA), amid allegations that customers are getting a raw deal. This centres on the fact that there is wide variation between the annuity rates on offer. Insurers have been accused of not making sure that policy holders coming up to retirement are aware of the benefits of shopping around for the best deal - the so-called open-market option. Most people simply take the annuity on offer from the company they have been saving with. In addition, many customers miss out on taking up an enhanced annuity, which pays out more to those policy holders with health problems.
The investigation will hit those annuity providers offering the lowest rate - there is currently a 20 per cent difference between the best and the worst. So companies such as Legal & General (LGEN), which is the largest life business writer, could suffer as customers start to shop around, even though its annuity rates are the third best on offer, according to the Annuity Bureau. However, the Association of British Insurers is set to implement a compulsory annuity code of conduct in March, requiring insurers to be much more transparent.
To cap it all, Solvency II, which threatens to go on for a few years yet before becoming law, is attempting to introduce extremely onerous reserve requirements on annuity providers. The European Insurance and Occupational Pensions Authority has launched a long-term guarantee impact study to test the application of Solvency 11 to products with attached long-term guarantees. But the problem here is that life assurers participating in the study will have just nine weeks to complete the study in the middle of the key financial reporting season. The study covers 13 aspects, including such complexities as counter-cyclical premium and transitional measures, as well as extended matching adjustment and extrapolation of interest rates.
The bottom line
So, the scene is set for a significant squeeze on margins. The obvious answer for life assurers is to seek out new markets, notably in emerging economies where insurance product penetration is that much lower. However, writing new business involves a lot of upfront costs, which insurance companies can take years to recover from steady premium payments. These costs are met by the cash generated from established revenue streams in more mature markets, and it is this flow of cash that is coming under pressure.
Some insurers are likely to record negative earnings due to low interest rates this year, and the situation could worsen if rates remain low, a risk that some insurers are not well hedged against. Some insurers are pulling back from guaranteed return products and shifting their focus to protection and other insurance risk products, such as critical illness and health insurance policies where the operating margins are that much higher.
The other big unknown is RDR. In short, this places enhanced qualification requirements on independent financial advisers (IFAs) wishing to give advice, while banning the commission on product sales, thereby reducing the risk of mis-selling. It also means that IFAs will have to charge clients a fee just for having a chat. The good news for life assurers is that the new regime will significantly reduce churn rates, whereby some agents have advised policy holders to switch to another policy (after a typical three-year clawback arrangement, after which insurance companies cannot reclaim any commission paid out), so they can pick up a second lot of commission. And with commission payments paid upfront, many policies were simply not making life assurers any money. Some products were going to take 10 years of regular premium payments to break even. Put another way, only 45.2 per cent of regular premium pension policies sold by IFAs in 2006 were still in force in 2010, according to a survey by the FSA.
It is not quite clear yet how many customers will be happy paying a consultancy fee. Some may simply follow their own advice instead. So perhaps those policy providers best placed are those with their own internal salesforce, such as St James's Place (STJ), or Standard Life (SL.), which ceased paying commission when it came to the market in 2006. However, bespoke advisers tend to focus on people with a lot of money to invest, and it's simply not worth trying to charge a fee for someone wishing to save modest amounts.
One exception to the commission ban is life protection products; life companies will be able to continue paying commission on sales. For other products there is a potential problem, however, because customers seeking advice and taking out a policy could opt for the funds they pay in to be reduced by the life assurer and for this amount to be given to the adviser - ie, commission payments by the back door.
Overall, however, the danger remains that new business volumes will retreat at least in the short term, which means that margins could come under pressure as insurance companies play catch-up to reduce excess internal capacity to process new business.
IC VIEW:
It is too early to gauge the effects of RDR on life assurers, and there are other uncertainties too, such as the potential take-up of auto-enrolment in pensions. One thing does remain clear and it's that low interest rates look to be here for some time. Given that life assurers will not seek higher investment returns by increasing investment risk, policy returns are going to suffer and charges will have to rise, which makes a pretty unpalatable cocktail for anyone looking to invest for their retirement. The other consequence of a sustained period of low interest rates is that annuities will suffer badly, and some providers may start to reduce their operations faced also with the possibility of an increase in risk-related capital reserve requirements. Of course, the picture could change dramatically if interest rates were to rise, but that looks less than likely just yet.
