Friday, October 8, 2010

Reshaping the insurance industry

In the aftermath of the financial crisis that started in one corner of the US mortgage market, which went on to undermine the foundation of the entire global financial system and subsequently morphed into a full-fledged global economic downturn, there has been considerable soul-searching among financial service players and regulators alike on what went wrong.

Insurance players felt that they were being unjustly penalised for the "sins" of their banking cousins. While there may be some merit to this argument, what is absolutely clear is that insurers globally today are living in a different environment, where the expectations of stakeholders have changed considerably compared with two years ago.

The Insurance Banana Skins survey of insurance practitioners worldwide, including Malaysia, that was conducted in early 2009 by CSFI (a New York-based think tank) together with PricewaterhouseCoopers illustrates this point clearly - investment performance and capital availability which were not even in the top 10 in the previous survey in 2007, were ranked as the biggest risks facing insurers compared to over-regulation and natural catastrophes before!

While insurers in our part of the world have largely escaped unscathed from the worst of the financial crisis. Malaysian insurers nevertheless faced challenging times, with the implementation of new capital requirements in 2009 in the midst of deteriorating economic growth.

Impact of the global financial crisis on insurers

Many global insurance companies have suffered losses as a result of the crisis in two significant areas. Firstly, insurers who were exposed to derivatives, such as credit default swaps linked to subprime assets, have been severely hit, while certain insurers have also been affected by the higher cost of hedging the guarantees on products such as annuities. Secondly, insurers have had to make large write downs in the value of their investments arising from mark-to-market losses in their equities and fixed income portfolio.

In this current environment, life insurance companies globally are facing major challenges in generating sufficient investment returns to meet policyholder expectations. Besides, there is a loss of faith among customers in the viability of annuity products. For non-life insurers, capacity and pricing have become major issues, along with the usual dangers posed by an economic slowdown that is a surge in claims including fraudulent ones. The credit standing of hitherto well established reinsurance players has also been subject to scrutiny.

So, has this global environment of low or negative investment returns, acute shortage of capital and loss of confidence affected Malaysian players? As in the case of the banking sector, it is fair to say that insurers here have been spared from the worst of the crisis. The exposure to the excesses of securitisation and complexity, which have plagued many global players, has not been seen in Malaysia, and the industry remains relatively sound capital-wise. While investment performance across the insurance market has understandably deteriorated over the last 18 months and the claims ratio in the non-life sector, particularly motor, has worsened, the industry as a whole still recorded profits in 2008.

Changing stakeholder expectations

The financial crisis came as a jolt to customers, investors and regulators creating scepticism and uncertainty and spurring stakeholders to take a harder line with insurers, particularly in relation to risk.

Customers, who were previously accustomed to uninterrupted returns, have become more cautious and those who are still willing to invest, favour simpler and less risky products. Reinsurers globally have also found that concerns over credit and counterparty have led to a flight to quality among insurers who cede business to them.

Regulators globally have sharpened their focus on governance and risk management. While the insurance regulatory framework in Malaysia has always placed emphasis on strong governance and effective risk management under Bank Negara Malaysia's risk-based approach to supervision, one can expect scrutiny to be intensified over time. This is especially crucial with the implementation of the risk-based capital (RBC) framework for insurers in Malaysia on Jan 1,2009. Given the quantitative assessments of risk required under the RBC framework, I would expect to see improvements in risk management practices among local insurers in their product design, underwriting, reinsurance and investment activities.

These shifts in expectations of stakeholders will inevitably have an impact on an insurer's strategy, going forward. In the following paragraphs, I will examine some key developments that are expected to have consequences for the global and Malaysian insurance market.

Organic restructuring and a reawakening of M&A

The financial crisis has seen a number of insurers withdrawing from certain geographical markets or scaling back particular lines of business. As a result, the market share and opportunities of those that remain will increase, and create fresh opportunities for organic growth and restructuring. Such an opportunity, for example, was presented during the 1990s recession in the UK when many insurers there suffered huge losses. Then came Direct Line, which started selling motor insurance at competitive rates over the phone!

In addition, many global players came under pressure from their shareholders to preserve their capital base, and therefore, do not have the appetite to make large-scale acquisitions. A number of banks and insurers are still short of capital, and are looking to divest themselves of their non-core businesses. Over time, an increase in available finance is expected to trigger d renewed wave of mergers and acquisitions (M&A) in the global insurance market.

On the domestic front, I believe there are further factors that will promote M&A activity in the insurance sector. The non-life insurance sector is currently overcrowded and fragmented, with 21 of the 31 players contributing just over 40% of the market share in terms of gross premiums. Compliance with the higher internal target ratio, and not just the minimum capital adequacy ratio under the RBC framework that Bank Negara expects insurers to adhere to, will further spur shareholders in these smaller insurers to re-examine their raison d'etre. Last but not least, Bank Negara's recent market liberalisation move to allow foreign equity limits of up to 70 % in Malaysian insurers will promote consolidation and rationalisation.

In the long term and as envisaged under the final phase of the Financial Sector Masterplan, where new licences may be issued for innovative players, I expect that opportunities will arise for niche players that are able to fill the gaps in the current market structure, for example, in developing a micro insurance model to increase the breadth and level of insurance penetration, using, for instance, the micro finance model in Bangladesh or by distributing insurance products via hitherto untapped distribution channels in Malaysia such as hypermarkets.

The end of innocence for retail investors

What customers demand from savings and investment products, and how they want to buy them, will take a new direction in many areas. Prior to the crisis, customer expectations evolved quite slowly. Retail investors who were accustomed to higher yields were largely unaware of the full extent of the risks this entailed. When business eventually picks up, the demand profile is expected to change significantly, with implications for both product design and distribution.

Where products are capital-intensive, difficult for customers to understand or inherently tricky to manage, there will be a move to a more straightforward product range. This trend is also apparent in Malaysia where there has been a discernible shift in demand, from investment-linked products to traditional protection policies such as whole life insurance.

Insurers will also face some problems as some customers in emerging markets, including Malaysia, still have an appetite for more sophisticated products but with a greater desire for investment guarantees. This will go against the grain of limiting the risks insurers in Malaysia may wish to carry to minimise capital requirements under the RBC framework for such "guaranteed" policies.

In so far as distribution channels are concerned, customers will seek more thorough and unbiased advice about products which match their risk appetite and demand profile. This will lead to a growing switch to independent advisory channels. In Malaysia, while the growth of independent financial advisors has been relatively slow, this will change as customers become more informed and sophisticated, and find that the existing agents who have limited technical knowledge struggle to meet their expectations.

Bancassurance in Malaysia has, however, become a major distribution channel over the years as insurers have sought to reduce their overdependence on agents and the associated costs, and banks have faced pressure to grow their non-interest income base. This trend is expected to continue with Bank Negara's recent relaxation of rules, which allow foreign-owned, locally incorporated insurers to enter into bancassurance arrangements without restrictions.

Challenging prospects in reinsurance

The third key development affecting the insurance market globally is the long-term prospects of the reinsurance market. Views on the future of reinsurance are mixed - some believe that demand for reinsurance will revert to pre-crisis levels and even increase, as primary insurers seek to transfer more risks; others predict that demand will fall away in many developed markets. The fact of the matter is that apart from a few segments where primary insurers have sought to spread their reinsurance buying in order to diversify their risks, it is noticeable that neither demand nor the price for reinsurance has increased globally.

In Malaysia, I expect insurers to review their existing reinsurance arrangements as the capital benefits of reinsurance under a risk-based approach will be reduced by an increased loading for credit risk, especially with more reinsurers facing rating downgrades. As insurers in Malaysia become more risk aware under the RBC framework, they will renew their focus on reinsurance arrangements and ultimately, be better able to choose what risks to retain and what to reinsure.


The shake-up of the financial services sector has undoubtedly resulted in stakeholder expectations changing quite rapidly. I expect that this change in the global environment will evolve at a rapid pace over the next two to three years, ruling out any return to the relative stability and certainty that preceded the crisis. However, in the aftermath of the financial hurricane, agile and far-sighted insurers will have a once-in-a-generation opportunity to catapult themselves to the front.
In Malaysia, boards of insurance companies will be in for some challenging times as they will have to acquire an even greater understanding of the relationship between capital and risk management under the RBC framework. Learning from the lessons of the crisis, the boards should be exploring the following key questions:
• How is the Malaysian insurance market evolving following the global crisis?
• How proactively is management running the business and investment portfolio?
• For general insurers in particular, what should the strategy be in the inevitable consolidation/rationalisation phase?
• For life insurers, how quickly can management react to shifts in customer buying behaviour, and how has management balanced profitability and risk when developing new products?
• Has management reviewed the reinsurance strategy of the insurer?

Our outlook for the insurance sector is that the new landscape that is emerging globally will present both opportunities and threats to insurers. For Malaysian insurers, the impact of key global developments and the implementation of the RBC framework are compelling reasons for them to re-examine their modus operandi. After all, why waste a good crisis?

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