Drawing Lessons from the Past to Chart a Course for Insurers

Drawing Lessons from the Past to Chart a Course for Insurers

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Drawing Lessons from the Past to Chart a Course for Insurers

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  • Developing Strategies for the Postcrisis World

    When it comes to understanding the implications of the current crisis, many companies—not to mention economists and policymakers—still have more questions than answers. The uncertainty that hangs over most markets can make it difficult for insurers to commit to strategies that could pull them out of the crisis.

    The past provides a useful perspective, although it is often used in a somewhat biased and narrow way. Most companies’ view of the crisis is shaped by a combination of their own unique experiences and the economic history of their home markets. A search through the headlines of major business publications in Germany, Japan, and the United States over a recent three-month period shows how different issues rise to the surface in different markets. References to “depression” were most common in the United States, references to “deflation” were most common in Japan, and references to “inflation” were most common in Germany. Government responses, such as fiscal and monetary policies, can also be captive to this historical prism.


    Although their particular field of vision is certainly relevant, insurers can also draw important lessons from further afield. There is no shortage of parallels to be found in the past financial and economic crises of other countries. These events provide cues for insurers that are looking for ways to limit their exposure to future shocks while taking advantage of the turmoil.

    Refocusing the Business on Managing Risks

    One of the most consistent lessons from past crises is also perhaps the most obvious: insurers that pursued growth at the expense of managing risk were far more likely to succumb to the turmoil. There are many examples. In Germany in the 1920s, insurers sold policies without hedging the currency risk. During the Great Depression, insurers ventured into risky banking businesses. In Japan’s lost decade, insurers sold guarantees at or even above high target rates, while foreign entrants moved aggressively into variable annuities and were dangerously exposed to the current crisis.

    A familiar pattern emerged in the early stages of this crisis, when it became clear that some insurers had prioritized growth while disregarding, misjudging, or downplaying risk. This tendency was driven by a mix of optimism and competitiveness, but even more by the role of risk management within the organization. At some companies, risk management was confined to a group of specialists who were effectively seques-tered from the business. These specialists were focused on measuring risk but not necessarily on managing it. Business leaders disengaged from this critical activity, and quantitative models were allowed to supplant qualitative judgment.

    Insurers must refocus on their core objective: managing risk. They have to understand the risk implications of their business decisions, particularly those that concern underwriting and asset management. To make risk an integral part of business strategy, insurers will need to institutionalize linkages among the underwriting, asset-management, and risk-controlling functions. This can help ensure that key business decisions are made only after stress tests and war games have been used to run extreme scenarios. It should also prompt insurers to rethink seemingly attractive growth decisions—like venturing into high-risk investment-banking activities or selling products that are predicated on the sustained growth of capital markets.

    Risks, in general, should be managed over both the long and the short term. Over the long term, insurers should focus on potential economic crises and gravitate toward a mix of businesses and products that are capable of withstanding them. For example, they should limit the proportion of highly procyclical products—such as variable annuities—in the portfolio. Over the short term, insurers should focus on developing hedging strategies to counteract financial shocks.

    Insurers should also adjust their risk processes and responsibilities. Every member of the executive board needs to understand the inner workings of the models used to assess risk. For their part, risk controllers and actuaries need to demystify their processes. Throughout the company, more attention should be devoted to systemic risks that are not accounted for by risk models. In addition, risk controllers should be expected to detect, not just measure, risk. They will need to convert weak signals into strong indicators, keeping in mind that the warning signs may not always be negative—so special attention should be paid to products or businesses that seem unusually profitable. The board should guide the business away from products and investments whose risks cannot be sufficiently assessed and monitored.

    Proactively Managing the In-Force Book

    For most life insurers, the in-force book of business will, to a large degree, determine how they fare for at least the next ten years. It can offer a stable source of profits, but it can also lead to seemingly intractable problems in certain situations.

    A sustained economic downturn would lead to a significant decline in assets, but most life insurers would be able to weather such a storm. If, however, a downturn led to a long period of low interest rates and asset returns—as it did during Japan’s lost decade—many life insurers would be in jeopardy.

    Insurers therefore need to understand the consequences of different macroeconomic scenarios—and not just the ones that they expect to see. Special attention should be paid to those scenarios that would have the most severe impact on the business. Most important, insurers must take steps to protect their in-force book as soon as they see signs that such a scenario might be unfolding.

    Hedging strategies, such as buying long-term interest swaps, can be used to counteract potentially adverse macroeconomic changes. Several life insurers recently bought longer-duration swaps to protect themselves from a “Japan-like scenario.” They do not necessarily expect this scenario to materialize, but if it does, they realize that its consequences would be drastic enough to warrant a hedge (even one as expensive as a long-duration swap). Furthermore, in the event of such a scenario, hedging the risk through interest rate swaps would no longer be affordable.

    Issues with the in-force book can be partially dealt with by migrating clients from one type of product to another or by reducing their rights. These measures are far from easy—they could entail waiving penalties on lapsed policies or paying down policies—but they are viable. Several players in the United States and Taiwan have started programs to migrate clients away from products that have high guarantees. (Echoing the experiences of companies during Japan’s lost decade, insurers in the United States and Taiwan have been jolted by a shift to a low-interest-rate environment.)

    Insurers might also want to enlist the help of regulators to resolve negative spreads in in-force books, perhaps by making the case that the alternative would be total insolvency. But regulators are understandably reluctant to take measures that might conflict with the interest of the consumer. In past crises, they lowered guarantees or payouts only after significant numbers of insurers had failed. In certain markets, the insurance sector as a whole may want to seek regulatory intervention, but this will raise sensitive issues. Although guarantees must be honored to the greatest extent possible, doing so may lead to a difficult situation in a deflationary, low-asset-return environment. New customers cannot be expected to
    finance higher guarantees for in-force customers. That would be unethical and would undermine the entire industry’s credibility. It would also lead to even more insolvencies.

    Working together, the industry and regulators might decide to split the in-force business and new business into separate books. Insurers could then limit guarantees for the in-force business when necessary, while migrating customers from problematic in-force products to more sustainable options. New clients would be insulated from legacy issues. However, this approach is likely to trigger more oversight and new rules, including maximum guarantees for specified periods, more investment restrictions, greater cost transparency, and firmer guidelines about the quality of advice.

    Pursuing Growth Opportunities

    Every crisis presents new business opportunities. During each of the three crises described in this paper, successful insurers consistently found attractive options for M&A deals or organic growth.

    Successful acquisitions tend to happen in the later stages of a crisis, when balance-sheet weaknesses become obvious. Such information should allow acquirers to confirm that legacy book issues have been resolved before proceeding with an M&A deal. It should also make it easier to zero in on the viable parts of the target—those that do not require constant cross-subsidization. Companies interested in M&A may want to wait until the target’s in-force book has been restructured, possibly by regulators. That is what some competitors did during Japan’s lost decade.

    A crisis also provides opportunities for companies to grow organically by taking advantage of weakened or distracted competitors and changing demand. Financial and economic crises alter the priorities of consumers, who tend to become more concerned about the core promise of insurance: security. In fact, sales of insurance products increased during the Great Depression and in the early stages of Germany’s hyperinflation crisis because they were seen as safe havens. During the current crisis, demand for traditional life offerings may prove to be resilient for the same reason, particularly in markets where banks have been hardest hit and where strict regulations have forced life products to remain somewhat conservative.

    Insurers could also grow by aligning their offerings with crisis-related demand—for example, by selling products that protect against inflation. An ongoing exploration of shifts in consumer behavior will help insurers identify such opportunities.

    But the Japanese example shows that insurers have to balance the needs of consumers (and their own growth opportunities) with the long-term risk implications for the business. During the lost decade, Japanese consumers were searching for safe investments, but at the same time low interest rates motivated them to look for more attractive returns. Consequently, several new entrants were able to launch variable annuities that appealed to many consumers. As we now know, the decision to focus on variable annuities created its own risks. Insurers used short-term instruments to hedge very high long-term guarantees, making them extremely vulnerable to the volatility created by the current crisis.

    A crisis may also lead to new opportunities in distribution. In South Korea, for instance, the Asian crisis of the late 1990s ushered in two changes that eventually redefined distribution. First, insurance products became more sophisticated. As a result, existing channels, which relied heavily on unqualified agents, became increasingly outdated. Second, massive restructuring in the financial services sector led to a flood of highly qualified individuals searching for jobs. Together, these factors allowed international competitors such as ING and Prudential to set up qualified-agent networks to sell advanced products.