Lecture for Nottingham University Business School

1
Lecture for Nottingham University Business School

• Current trends and challenges in the global
  insurance industry
• Kurt Karl
• Swiss ReEconomic Research ConsultingNew York,
  February 11, 2002

2
Agenda

• Long-term trends
• Profitability and the cycle
• Liberalization / Consolidation / Convergence
• Reinsurance markets

?
3
Global premium volume growth is accelerating,
after years of slow growth
Source sigma No. 6/2001
4
The average premium growth in emerging markets is
nearly twice as high as in the industrialised
countries
Real growth rates in
Average 8.6
Average 4.7
Source sigma No. 6/2001
5
Global premium income 2000 the industrialised
countries dominate
Source sigma No. 6/2001
6
Motor has the highest share in the European
Non-Life market
Western Europe2000
7
Non-life insurance Premium growth is recovering
from the soft market
Real growth rate in
Source sigma No. 6/2001
8
Life premium growth another boom year
Real growth rate in
Source sigma No. 6/2001
Richard MacMinn Is much of this growth due to
demographic changes? Will changes in state
provision or support of pensions alter this
pattern?
9
The twelve most important countries of the global
market by business share 2000
Source sigma No. 6/2001
10
Non-life insurance penetration higher income
levels boost insurance demand
Premiums in of GDP
GDP per capita in USD
Source sigma No. 6/2001
Richard MacMinn How well positioned is the
industry to manage the growth in coverage that
must be expected in the emerging markets?
11
Life insurance penetration income, taxes and
social security systems make the difference
Premiums in of GDP
GDP per capita in USD
Source sigma No. 6/2001
12
Conclusions

• Growth in insurance premiums has begun to
  accelerate after a long soft market.
• Life premiums are increasing more rapidly than
  non-life premiums.
• Premiums in emerging markets generally rising
  more rapidly than in industrialized countries.
• Insurance premiums rise more rapidly than income.
  Hence, premiums as of GDP rises as per capita
  income grows.
• Life is more income elastic than non-life
  insurance, particularly above USD 10,000 per
  capita.

Richard MacMinn How price elastic is the demand
in some of the emerging markets?
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Agenda

• Long-term trends
• Profitability and the cycle
• Liberalization / Consolidation / Convergence
• Reinsurance markets

?
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The main questions

• What are the main drivers of profitability in
  non-life insurance?
• How important is investment activity as a driver
  of profit, capital funds (leverage), and
  volatility?
• What patterns are there to the insurance cycle,
  in length and between countries?
• What underwriting result is necessary to achieve
  an average economy-wide ROE?

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Profitability

• Insurance companies generally lose money on
  underwriting
• Combined ratio 100 x (losses expenses)/ net
  premiums, 100 x (UWL UWE)/NP
• Combined ratio is typically gt 100
• Negative underwriting results ( NPE - UWE - UWL)
• Particularly true for long-tailed lines (e.g.
  liability)
• Insurance companies make virtually all profits
  from investing premiums before making actual loss
  payments

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Profitability

• Insurance pricing cycle is determined by flow of
  capital into and out of the industry
• Surplus (assets less accounting liabilities for
  unearned premiums and unpaid claims) rises and
  falls for variety of reasons
• Large losses ? Capital flows out
• Prices rise in the insurance industry ? Capital
  flows in
• Bull stock market, asset values rise, surplus
  rises

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Investment results have grown increasingly
important for profitability.
Net investment result in of net premiums
Source Economic Research Consulting
18
Rising reserve ratios...
in of net premiums
Source Economic Research Consulting
19
... have increased asset leverage.
in of net premiums
Source Economic Research Consulting
20
Stable inflation outlook after a decade of
decline...
Consumer price inflation,
forecasts
Source DRI-WEFA
21
... drives down long-term interest rates.
Long-term interest rates,
forecasts
Source DRI-WEFA
22
No general trend towards lower expense ratios
Expenses in of net premiums
Source Swiss Re Economic Research Consulting
23
US Underwriting results show a strong cyclical
pattern.
Underwriting result in of net premiums
Source A.M.Best
24
Capital Constraints Cycle in the U.S.
Asset-induced changes in surplus US 1968-2000
in
Sources A.M.Best, Swiss Re Economic Research
Consulting
25
9/11 losses compared to global cat losses
?
in USD billion, at 2000 prices
Source Swiss Re Economic Research Consulting
26
Fresh paid-in capital comes into the market after
major catastrophes
Figure 2
hard market
hard market reinsurance
Fresh capital in of surplus
Sources A.M.Best, Swiss Re Economic Research
Consulting
27
Underwriting cycles correlated across major
markets.
Operating result in of net premiums
Source Swiss Re Economic Research Consulting
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Conclusions

• High investment returns of the 90s lead to a
  soft market and more asset leverage. The future
  investment outlook is uncertain.
• Underwriting results follow a cyclical pattern
  with an average length of about six years. These
  cycles are increasingly synchronized across
  countries and to some extent across lines of
  business.
• Insurance prices are improving, but more needs to
  be done. Combined ratios need to improve by at
  least 7-14 to return to average profitability.

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Agenda

• Long-term trends
• Profitability and the cycle
• Liberalization / Consolidation / Convergence
• Reinsurance markets

?
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Liberalization is a worldwide trend recent major
changes that affect insurance markets
Deregulation Convergence Capital market and
opening up environment of borders US Abolition
of the Glass Steagall Act Europe Third
Directive Introduction of 1994 the Euro
1999 Japan Big bang Big bang Big
bang 1996-2001 1996-2001 1996-2001 Asia WTO
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Deregulation and liberalization A competitive
mapping of the global insurance markets
Market access (de facto)
European Union
easy
Hong Kong
Taiwan
Singapore
Poland
USA
Argentina
Czech Rep.
Japan
Philippines
Mexico
Malaysia
Insurance regulation (de facto)
Thailand
Russia
India
China
difficult
price form
solvency
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Types of mergers and acquisitions
Between insurers Across Sectors

• CNA - Continental (95)
• Travelers - Aetna (96)
• Axa-UAP (96)
• Commercial Union -
• General Accident (98)
• CGU - Norwich Union (00)

• Credit Suisse - Winterthur (97)
• Travelers - Citicorp (98)
• Lloyds TSB - Scottish Widows (99)
• Allianz - Dresdner (01)
• Munich Re-HypoVereinsbank (01)

Within one country

• Allianz - AGF (98)
• Zurich - BAT (98)
• Aegon - Transamerica (99)
• ING - Aetna (00)
• Swiss Re - Lincoln Re (01)

• ING - Barings (95)
• Zurich - Scudder (97)
• AXA - Sanford Bernstein (00)
• Allianz - Pimco (00)

Across Countries
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Value proposition and potential rationalizations
for the four types of MAs Within one country
Between insurers
Across sectors
Domestic insurance MAs
Domestic conglomeration

• Economies of scope through
• cross-selling are key motives.
• Risk and revenue diversification.
• Optimum use of complementary
• distribution networks.
• Rationalizations with
• administrative functions may
• offer economies of scale.

• Economies of scale linked to
• costs are the main motive.
• Cutting distribution networks
• and administrative functions
• (rationalization), including
• information technology and
• risk management areas.

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Value proposition and potential rationalizations
for the four types of MAs Across countries
Between insurers
Across sectors
International insurance MAs
International conglomeration

• Size is the main motive.
• Diversification
• Matching the size of clients
• and following clients.
• Possible rationalization within administrative
  functions.
• Higher growth potential in
• foreign markets.
• Saturation of brand name in
• home market.

• Economies of scope through
• cross-selling together with size are
• the two main motives.
• Risk and revenue diversification.
• MA offers few rationalizations
• because institutions are in different
• countries and subject to different
• regulations and practices.

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Risks associated with the four types MAs Within
one country
Between insurers
Across sectors
Domestic insurance MAs
Domestic conglomeration

• Managers may be unable to focus on or understand
  integration issues
• Possible personnel friction due to
• differing staff rules and pay scales.
• Problems with integrating fiscal and accounting
  systems due to differing reporting requirements.
• Reputation risks for separate core target
  markets, in the medium
• and long term.

• Integrating technology may prove to be more
  expensive than expected
• Managers may become overly focused on internal
  issues and lose market share

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Risks associated with the four types MAs Across
countries
Between insurers
Across sectors
International insurance MAs
International conglomeration

• Integrating technology may prove to be more
  expensive than expected
• Managers may become overly focused on internal
  issues and lose market share
• Foreign exchange risks.

• Maximum risk. All risks
• relating to domestic conglomeration
• and international insurance MAs.
• Reputation risks in the medium
• and long term.

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Differences and similarities of financial
intermediaries

• Value propositions / comparative advantages

• Risk management and underwriting
• Structured finance (offers insurance
• as capital supplement to equity and debt)
• Capital and asset management

Insurers

• Liquidity
• Credit monitoring
• Payment services
• Distribution
• Strong capital base
• Retail network

Commercial/ retail banks

• Wholesale business
• Financial innovation
• Strong distribution
• Research and analysis

Investment banks/ securities firms
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Differences and similarities of financial
intermediaries

• Risk appetite

• Risk retention capacity (event risks and
• natural catastrophe)
• Comparative advantage in risk diversification
• Increasing appetite for capital market risks
• (financial, credit, etc)
• Risk financing on the rise
• Address previously uninsurable risks

Insurers
Commercial/ retail banks

• Takes on credit, market and interest rate risks
• Risk transformation e.g. securitization

Investment banks/ securities firms

• Accustomed to financial market risks
• Risk transformation e.g. securitization

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Comparison of banks and insurers
Banks Insurers

• Protect against
• hazard risk
• Catastrophic loss
• occurrence
• Equity risk
• Credit risk via
• bond portfolio and ART
• Solvency

• Provide liquidity
• Liquidity shortage
• bank runs
• Credit risk
• Liquidity

Main value for clients
Liability risks
Asset risks
Main concern
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Asset shares, US
The share of US financial intermediary assets
held by depository institutions has slid
dramatically over the past two decades.
Mutual
Funds
Mutual
4
Pension
Funds
Funds
Depository
23
18
institutions
32
Securities
1
Depository
institutions
Insurers
60
17
Pension
Funds
Insurers
25
15
Securities
5
1980 total assets USD 8.3 trillion
2001/Q1 total assets USD 26.9 trillion
Note 1980 asset total is adjusted for
inflation. Source US Federal Reserve Flow of
Funds Accounts
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Asset shares, UK and Japan
Relative shares of financial intermediary assets
in UK and Japan, 1989-2000, in percent
UK Japan
1989 2000
1989 2000
Depository institutions Insurance and pension
funds Other institutions
64.7 55.0 25.3 27.1 10.0 17.9
55.2 47.9 16.4 20.6 28.5 31.5
Source Bank of Japan Flows of Funds Account, UK
National Statistics.
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Protect margins by extending insurability
margins
Liquid markets for traditional insurance risks
and financial risks
Currently not or inadequately covered insurance
and financial risks (illiquid markets)
Currently not covered other risks
Business risks
Negative publicity Warranties etc.
Political and regulatory risks
Credit risks, various commodity price risks
Terrorism Product recall Loss of data Prototype
failures
Interest rate, exchange rate risks
Auto insurance Fire insurance Transport
insurance Product liability
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ART gallery
Alternative risk transfer
ART
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Is the traditional insurance company an
endangered species?
Conclusion
Traditional players face unprecedented
challenges. But they will stay afloat if they

• leverage technology to improve customer service,
  increase business process efficiency and utilize
  on-line sales channels,
• remain open-minded about new product innovations,
• consider outsourcing strategy for non-core
  activities, and
• maintain and further strengthen their brand
  recognition.

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Agenda

• Long-term trends
• Profitability and the cycle
• Liberalization / Consolidation / Convergence
• Reinsurance markets

?
46
Global reinsurance business An industry
fact-sheet

• Reinsurance clients not only comprise non-life
  and life insurers but also large corporations,
  major pension funds and capital markets.
  Reinsurance is a wholesale business.
• The leading global reinsurers provide their
  clients with (1) risk underwriting capacity and
  pricing/reinsurance structuring expertise, (2)
  protection against large complex risks and
  natural catastrophe volatility and loss and (3)
  risk management/risk mitigation services, as well
  as financial and asset management (e.g. through
  integrated solutions and products tailored to
  captives).

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Global reinsurance business An industry
fact-sheet

• Reinsurance is a global business because it
  relies on global risk diversification.
• Global reinsurance premiums amount to 127
  billion (98 billion in non-life, 29 billion in
  life) with North America and Western Europe
  accounting for the lions share (80). Total
  insurance industry was 2.4 trillion in 2000,
  (0.9 trillion non-life, 1.5 trillion life)
• In 2000, for every 100 in premium income, the
  top 10 global reinsurers incurred losses and
  expenses of more than 110.

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Global reinsurers value proposition
before R/I
after R/I
Risk capital before R/I
Risk capital after R/I
Direct insurer
Reinsurer
An insurer buying reinsurance can release a
certain amount of risk capital which is larger
than the additional capital the reinsurer needs
in order to absorb the buyers risks. This
overall improvement in capital productivity is
the economic value added of reinsurance. It is
based on global reinsurers superior geographical
and lines-of-business diversification.
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Reinsurance in the 21st century Managing
clients capital and risk
Underwriting services
Risk transfer
Risk financing
Risk transfer via redistribution (to capital
market investors)
Finance advisory/ equity investments
Asset management

• IPOs
• Capital raising
• MA
• Merchant banking
• Run-off management

• Combining reinsurance with asset-liability
  expertise and worldwide asset management
  capabilities

• Based on global risk expertise

• Derivatives
• Securitization of insurance risks (e.g.
  earthquake)

• Based on geographically product-wise balanced
  risk portfolio

• Finite reinsurance
• Multi-year solutions
• Diversification over time

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Reinsurance value for the customer A wide
spectrum of services
Risk assessment and risk management
Risk transfer, absorption or financing
Claims containment/ claims management

• Risk awareness enhancement
• Risk portfolio analysis
• Risk dialogue (e.g. on insurability)
• Policy design and wording
• Risk management
• Loss prevention
• Advice on pricing

• Containing claims cost
• Contractual/legal aspects
• Claims adjustment support
• Feedback to underwriting

• Optimizing risk carrying economics
• Reducing results volatility
  (diversification)
• Minimize cost of risk-adjusted capital
• Supporting business and financial strategy
• Risk underwriting capacity
• Balance-sheet management
• Bottom-line optimization
• Regulatory, accounting, tax
• Structuring reinsurance programs

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Value proposition of reinsurance

• Global diversification ? reduces cost of capital
  of primary insurers
• Insurers of last resort ? provide liquidity to
  insurance industry
• Provide services, including underwriting support
• Globally regulated by rating agencies ?
  maintaining a AAA rating is essential for a
  global reinsurer

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Development trends in risk transfer finance
globally diversifiable risks
globally reinsurable risks
locally insurable risks
individually diversifiable risks
1950
1995
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The future of reinsurance
Complex risk analysis
Rapid change of risk and financial markets
Advisory services
Value added achieved through technology and
knowledge management
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Traditional reinsurance is efficientand here to
stay
Cat bond deal 2000 pages
Traditional reinsurance contract 30 pages
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Conclusion

• The global reinsurance companies can provide risk
  transfer and risk financing in a win-win
  transaction
• Global re-insurers will play a pioneering role in
  extending the boundaries of (re-)insurance
• Reinsurance companies are providing increasingly
  sophisticated solutions with financial features
• Global re-insurers will continue to demonstrate
  the value of their risk management skills
• Traditional reinsurance is not expected to
  disappear