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The Future For The Life Insurance Industry Is Simple

The path to success in a competitive market full of twists and turns is to identify the simple things to do and simply, do them.

Looking back on almost 50 years in the life insurance industry, the most striking observation is how the products and process have gone from simple to complicated. Back in the day, agents bounded out of the office in search of those folks who were worried about what would happen to their family or business, “if something happened to them.” The paradigm was neat, clean and simple: Consumers were most concerned about the economic cost of dying young and there was no shortage of insurance companies ready to offer a product to meet that need.

In fact, hundreds of insurance companies vied to capitalize on this need, and the market appeared to be saturated with competition. But because banks and investment firms were prohibited by federal law (Glass-Steagall Act of 1933) from competing in the insurance industry, the truth is that Insurance_Stabilitythe industry was, in fact, competing only with itself. This meant that the insurance companies were free to offer virtually the same products. And they did. The agents selling the products may have competed fiercely against each another, but the companies were in reality competing with – not against – each other to divide up the business.

This situation created a symmetry of simplicity that functioned well for the companies, consumers and agents. Once the agent had worked with the customer to identify, quantify and accept the financial need, the solution was simple. There were only two options: Buy either whole life or term insurance. And since all companies offered basically the same products, “shopping around” for best values was as meaningful as shopping around for a best quart of milk.

The insurance landscape was so harmonious, in fact, that the environment was devoid of product confusion and consternation for both agents and consumers. There were no class-action lawsuits claiming deception, no company departments dedicated to determining suitability or the requirement for Biblically-long disclosure statements. There didn’t have to be, because the products were simple, easy to explain and understand, and targeted to meet a specific need.

Changing Times have changed the Basic Insurance Equation

Certainly the times, consumer needs and their options have changed dramatically in the past half-century, and that has forced the industry to change as well. For individuals, extended longevity has reduced the concern for the economic cost of dying too soon, but it has increased the worry about the economic cost of living too long. At the same time, the competitive ground rules for the insurance industry have changed. No longer do insurance companies have the field to themselves to simply contend with each other for the business; now they have to compete against banks and investment firms that are now free to offer products designed to meet the same consumer needs.

One upshot of this new environment is that the life insurance industry has forfeited what had been its strength and superiority in the market: the ability to offer simple solutions to complicated problems. And yet, although consumer needs may have changed over the years, they are still just as simple. But instead of fretting about what will happen when they die, the consumer is now concerned about what will happen if they live.

Unfortunately, instead of playing to its strength, the insurance industry has fallen into the trap of developing products designed to meet what the competition is doing, rather than what the consumer needs, wants and can understand. Instead of being the competition, insurance companies are following the competition by developing products that seek to mimic those offered by banks and investment firms. And even worse, insurance companies are putting themselves at the mercy of the banks and investment companies by coming to them to distribute the products. This is never a winning proposition.

Products once intended to respond to a basic need are now structured in an effort to meet every need. The byzantine products now being offered by insurance companies are akin to selling a battery-powered Swiss Army knife to someone who simply wants to butter his bread. This leads to complexity, confusion, dissatisfaction and delusion for both those selling and buying the products. One company recently introduced a new product described as, “An indexed annuity equipped with a stacking roll-up feature plus interest credits and bonuses with the goal to maximize the death benefit.” How simple is that for an agent to explain and for a consumer to understand?

The company that introduced the aforementioned product is attempting to touch all the bases by including elements of an annuity, variable annuity and life insurance all in one policy, only to end up convolution and confusion.

But they are not alone. The variations of products offered by insurance companies have now become so prolific, complex and complicated it is doubtful that even the chief marketing officer could list and explain all of them from memory. It is telling to note that in the past, agent-training focused on teaching agents how to prospect, identify the need and close the sale; today’s training tends to be nothing more than a long, PowerPoint presentation trying to explain what the product is and how it works; leaving little time to teach agents the right way to sell it.

Certainly the changed consumer needs and increased competition from banks and investment firms call for product innovation on the part of insurance companies, but real innovation makes things simpler, not more complex. All too often insurance companies seem to have confused product innovation with complexity. The truth is that products developed to meet every need end up meeting no one’s need.

Is it any wonder that the muddled approach to product development employed by insurance companies has led to confusion and frustration for both agents and consumers? Why should the industry be surprised that agents bungle the sales process and consumers are, at the very least confused, and most often dissatisfied?

Simple is as Simple does

At the risk of repetitiveness, the dominant financial concern of the consumer today is: Will I have enough income at retirement and will it last as long as I live? Just as the life insurance industry was best positioned 50 years ago to protect people in the event of death, so too, it is best positioned to protect those who live. For the industry to take advantage of this opportunity, however, it has to return to the idea doing simple things and SSI_1_business_desksimply doing them; developing simple solutions to complicated problems.

Admittedly, simplicity is the best, but hardest thing to do, and yet the effort is worth it. Remember, true innovation is not defined as inventing new things – that is creativity – but by making things simpler to do. Putting wheels on luggage was a great innovation, because it solved a need and was so simple.

The truth is that the companies and the agents are both more enamored with the complicated and confusing “bells and whistles” added to the products than is the consumer. These “special features” serve only to confound the customer who, deep down, is only anxious for their money to be safe and that they can count on the income for as long as they live. A focus on the “unique features” of the product, rather than the solution it can provide, runs the risk of the consumer feeling they have been bamboozled. And then the problems really start.

The consumer can and will adjust their standard of living to the amount of income received, but what the consumer can’t adjust to is having their income expire before they do. It is this attitude and economic fear on the part of the consumer that gives the life insurance industry an advantage; but only if the industry offers a simple solution to this complicated problem.

Looking for Real Answers

Is it still possible to develop an innovative product that is targeted to meet the income needs of the consumer and yet be simple to understand and sell? To answer that question, think about Social Security. When it comes to income needs, Social Security is probably the simplest product one could imagine: You put in money till you retire and then you receive money till you die. The product offers few options, no hedging, indexing or “stacking roll-up” features. A simple solution to a complicated problem.

Sure, people are required to “buy” Social Security, but in every survey taken, over 80 percent of the respondents say they are happy with the program. Social Security may not provide all the income people need, but you don’t see recipients rebel against Social Security although they do mutiny against any attempt to take it away. The life insurance industry could develop and market safe, simple products the consumer and agents can understand; that simply meets the needs of the consumer. That would be real innovation.

The great opportunity for the life insurance industry is the same as it was 50 years ago – to meet the long-term financial needs of the consumer. The more simplicity the industry can bring to the process, the more successful it will be.

And the Moral of the Story …

In a changing and competitive world, it is a widely held belief that complicated problems require complicated solutions, but that is not true. Success comes with simplicity. Successful people and companies attack complicated problems with simple solutions.

The appearance of complexity in a process is often the result of a simple failure to understand the real objective. The first step to making what is complicated simple is to focus on the desired result and then work back to identify the simple actions needed to accomplish the goal and simply do them.

The life insurance industry created a grand record of success by developing products that offered a simple solution to a complicated problem. The industry began to forfeit this success when it lost focus on the changed needs of the consumer and began to offer complicated solutions for a simple problem. The life insurance industry must understand that its path to a successful future is simple.


Hot Money May Cause the Life Insurance Industry to Crash and Burn

Cash is God in the life insurance business and some companies seem to be willing to sell their soul to the Devil to get it.

The appeal, power and profitability of the life and annuity insurance industry have eroded almost to the point that the industry has not only lost its prominence, but its very viability as an independent competitor in the Insurance_Stabilityfinancial services market also is being questioned. These dire circumstances are forcing insurance companies to seek capital infusions from sources they would never have previously considered and to take actions that are an anathema to traditional insurance financial management. Both actions may, in the end, threaten the very survival of the companies, but even worse is the risk that these activities may leave policyholders holding the bag and cost the taxpayers billions in bailout bucks.

There is no more cogent evidence of this state of affairs in the life insurance industry than a recent article in The Wall Street Journal which reported that the New York Department of Financial Services has issued subpoenas to a number of large private equity firms, seeking information about recent investments they have made in the life insurance industry. Regulators may be curious about this activity because the business model of private equity firms – relatively short term high returns – is so contrary to the business model of insurance companies. Just a few weeks later The New York Times reported that the New York Department of Insurance is investigating actions by insurance companies characterized as “shadow reinsurance” that are intended to artificially reduce the amount of capital and reserves needed by insurance companies.

In simple terms, here is the problem: The financial model for the life insurance industry is diametrically opposite to that of most industries. When a typical company makes and sells a product, it reports an immediate profit. When a life insurance company manufactures and sells a policy, it reports an immediate loss; a loss that may not be recovered for several years. As a result, for non-insurance companies, growth creates new capital, while a growing life insurance company consumes increasing amounts of capital. For most companies, a return on invested capital can be measured in a single fiscal year, while for a life insurance company a return on invested capital could take decades.

Capital Requirements Magnify the Issues

When it comes to managing capital needs, life insurance companies face still another financial complication. The nature of life insurance is an uncertain, long-term liability. Actuarial tables notwithstanding, the insurance company never really knows when it will have to pay or how much its future liability to the policyholder may be. With this in mind, state regulators require insurance companies to set aside and maintain a reserve of capital to meet these future liabilities. This requirement ties up capital for decades that further limits capital available for growth.

In the past, there were a number of strategies life insurance companies used to effectively deal with its capital requirements. For one thing, the insurance industry was sheltered from competition because banks and investment firms were prohibited from offering insurance products. This isolation allowed the insurance companies free rein to compete with each other to carve up the available business unfettered from free real competition from outside the industry. This meant that consumers could not comparison-shop for products based on price – as all products were priced on the same basis – and all products produced very high profit margins for the companies. This situation permitted insurance companies to use the profits emerging from existing business as “capital” to invest in new business.

Traditionally, the largest life insurance companies were not publicly traded, but were rather “mutual” companies, LifeInsurancetheoretically “owned” by the policyholders. This structure immunized the insurance company from any real pressure to show a return on invested capital, especially in the short term. In addition, the life insurance industry shared and passed around its capital among companies, in the form of reinsurance. Companies that had capital, but were not growing as quickly as others, would “loan” their capital to another company, in exchange for participating in the future profits of the business. This was facilitated because both companies were willing to accept a long term – maybe over decades – return on this capital.

There’s Trouble Ahead

But then, late in the 20th century, the life insurance industry experienced what was, in effect, a cataclysmic polar shift in its world. The life insurance industry was ravaged by a perfect storm when, in rapid succession, a maelstrom of events dramatically changed the insurance landscape.

First, there was a rush by the largest insurance companies to convert from a mutual to public structure. As a result, the short-term demands of the public market forced the management of these companies to shift, as never before, from long-term strategies to short-term, top-line sales and bottom-line results.

Then, another bomb shell: The restrictions keeping banks and investment firms out of the insurance industry were repealed and this opened the door to stiff new competition for insurance companies. The combination of increased competition and focus on short-term results caused insurance products to be marketed more as commodities – with price being the motivator – a change that significantly squeezed profit margins for insurance companies. On the heels of all this the financial crisis thundered in swamping insurance companies with hundreds of millions of dollars in investment losses at a time when interest rates for new investments dropped to virtually zero.

These were catastrophic events for an industry that always needed to wisely husband its capital and sold products that were “interest sensitive.” The fallout from this chain-reaction of events also triggered a significant reduction in the valuation of insurance companies, making it even more difficult to raise capital.

Just when things couldn’t get worse . . .

In short, just when the insurance industry needed capital the most, it ran out of capital. Companies lacked the cash required to support new business, causing them to scale back on sales. At the same time, reinsurance companies exited the market; they needed to retain all available capital to support existing liabilities.

In response to this confluence of crises, insurance companies began taking one or more of three different actions:

  • Raising capital from private equity investment firms.
  • Engaging in “financial engineering” in an effort to reduce capital requirements.
  • Moving away from the very core of insurance – the guarantee that risk of loss would be covered – by offering investment-type products that transfer the risk to the policyholder.

Any one of these actions – let alone the combination of all three – has the potential to fundamentally change the very nature of the insurance industry and threaten the future of any company that employs them. And here’s why.

It may seem like a match made in heaven: Private equity firms are flush with capital to invest and the insurance Private-Equity-Firmsindustry are desperate for fresh capital. The problem is that the business model for these two groups is not a match, let alone a heavenly one. Private equity firms seek a return on invested capital that is as much as three times higher than the normal return insurance companies can expect to achieve. Even more conflicting for the insurance industry is that private equity firms seek to be in and out of their investments within a five- to seven-year time frame, while insurance products barely break even after five years.

Another challenge for insurance companies that accept private equity capital is that these firms expect to begin receiving dividends on their investment almost immediately. The management of insurance companies that accept private equity capital will soon find they are constrained to meet the requirements of private equity and take actions that are antithetical to sound insurance management. And it could be the policyholder who ends up paying the price for this arrangement.

As mentioned above, reinsurance companies have traditionally been a reliable source of long-term capital for insurance companies, but reinsurance companies are also strapped for cash and have virtually withdrawn from the life and annuity market. In response to this, as the New York Times article pointed out, many of the largest public insurance companies have discovered a “creative” way to overcome the lack of capital available from reinsurance – they have started their own reinsurance companies.

In simple terms, these companies have set up wholly-owned reinsurance companies in states that have lower capital reserve requirements or fewer investment limitations than does the company’s state of domicile. The “parent” company then transfers large blocks of business to this “captive” company; thereby reducing the amount of reserves that have to be maintained to meet future liabilities. Voilà!, with a jurisdictional sleight-of-hand, new capital is magically created out of thin air. This may be all well and good, but should the reserves being held by the “reinsurance” company be insufficient to meet future liabilities (the reserves, after all, may amount to no more than a “conditional letter of credit” from the parent company), then once again the policyholder, or ultimately the taxpayers, could be left holding the bag.

The final action that some companies are taking is, in effect, to get out of the insurance business. Companies are developing products that are more akin to investments than insurance. This is accomplished by transferring the risk for what the future benefits may be from the insurance company to the policyholder. (For example, selling variable annuities and variable life as opposed to guaranteed life or annuities.) In other instances, companies are transferring the longevity risk – how long the benefits will be paid – from the company to the policyholder. Both of these actions have the effect of reducing the amount of capital needed to write new business and the amount of capital needed to be held in reserve. In effect, we are seeing the largest life insurance companies morph into investment companies, right before our eyes.

The Moral of the Story … 

Putting it all together, it is not implausible to foresee a scenario in which the financial services industry contracts into two players – banks and investment companies, with insurance benefits sold as an ancillary benefit on the side. This may be the most logical direction, but is does not portend good things for the life insurance industry as a viable competitor in the financial services industry.


The Potential Poison Pill of Private Equity in Insurance

Private equity investment in life and annuity insurance companies has created a shotgun marriage of the damned and the desperate.

Life insurance and annuity companies have an insatiable need for capital. Without a steady, reliable stream of new capital, it is impossible for a life and annuity insurance company to function, let alone grow. Insurance companies are dependent on a flow of new capital because, unlike other types of companies that report a profit once the product is manufactured and sold, insurance companies book an initial loss every time a new policy is sold.

Once expenses and commissions are paid and the necessary reserves are set up for future liabilities, the insurance company has paid out more than the initial premium collected for a new policy. Most life and annuity policies do not begin to generate profits for the insurance company until three to five years after it has been issued. And that creates a rather unique financial drama: The more new policies sold, the larger the losses reported and the greater the need for additional capital. And if the policyholder cancels during the first few years, the company loses most of the capital it has invested. In fact, it can take 20 years or longer for a life insurance company to make the anticipated profits on the policy. (Property and casualty insurance companies do not have the same type of capital issues, because the product cycle is much shorter – usually one year – while life insurance companies deal with product cycles that can extend over decades.)

For more than a century life insurance companies were able to access two sources of capital to meet their needs: As profits emerged from a growing block of existing policies, this “new capital” was reinvested back into the company to cover the cost of issuing new policies. The second supply of capital traditionally came from reinsurance companies. These are insurance companies with a large pool of capital, but without the wherewithal to market and issue policies directly to the consumer. As a result, in exchange for participating in the future profits of the policy, reinsurance companies offer their capital to cover the losses on new policies issued by “direct writers.”

But the world has changed. In recent years, a maelstrom of financial events – low interest rates, economic decline and stagnation, real estate depression and the toxic nature of collateralized mortgage bonds – all conspired to cause the well of capital for life and annuity companies to all but run dry. Although the cost to write a new policy remained fairly static, profits have nevertheless been squeezed. The culprits? Regulators have increased the amount required for reserves while the Fed’s low-interest-rate environment continues. The resulting reduction in anticipated profits from new policies triggered a substantial reduction in the valuation of insurance companies. That made it difficult, if not impossible, to go to the market for fresh capital. At the same time, cash infustion from reinsurance companies evaporated as they too had to shore up their own reserves and losses; reducing their appetite to invest in new life and annuity policies that may or may not produce a profit. (What capital was available from reinsurance companies shifted away from life and annuity to short-term casualty policies.)

Looking for an Answer

Starved for capital, life and annuity companies were faced with distasteful alternatives: They could either cut back on the amount of new business they were willing (able) to write, withdraw from the market altogether, put themselves up for sale (with few takers) or in a number of cases, they could turn to the only group with excess investment capital – private equity investment firms. For a variety of reasons, private equity firms never had much interest or motivation to invest in the life and annuity business; the low investment rate of return on insurance policies and the long-term emergence of profits and return of capital did not fit well with the private equity business model.

However, private equity firms also faced their own challenges. These firms had accumulated large amounts of capital from investors, but with economic and business uncertainty, they were challenged to find appropriate investments. The confluence of insurance companies need for capital and the necessity for private equity firms to invest its capital, set the stage for what seems like a shotgun marriage of the damned and the desperate.

The fundamental business models for private equity firms and life and annuity companies are so diametrically disparate that putting them together is like trying to mate a tortoise with a hare. Private equity firms attract investors based on the premise of higher (much higher) than normal market return on invested capital and a fairly short – five to seven years – return of both capital and profits. The incongruity implicit with investing private equity funds in insurance companies is the relatively low rate of return on investment (even in the best of times it may be no more than 12 percent – less than half of what equity firms seek) and the long-term emergence of profits and return of capital that is central to the life and annuity insurance business model. Despite this, private equity firms are diving head first into the shallow waters of the life insurance industry; and insurance companies, thirsty for capital, are drinking in as much as they can. This activity is the incarnation of the idea that desperate times call for desperate measures taken by desperate people.

Are Private Equity Firms the Answer?

Private equity firms have adopted two approaches when it comes to insurance investments: One strategy is to purchase an “existing block” of policies. The second, more troubling, stratagem is for private equity firms to purchase actual control of the insurance company.

Purchasing an “existing block” of insurance policies is a fairly mundane transaction. The business has an established track record of performance that can be measured; the insurance company has made the initial capital investment in the business and has absorbed the early losses. In effect, the investment firm is simply buying the discounted present value of future profits. In times of relatively low investment returns, this established and steady flow of profits can be attractive. The only investment risk for the private equity firm is that the policies will continue to perform as they have in the past. By selling the future stream of profits on its existing business, the insurance company receives a shot of needed capital to continue its operations, but at the price of reducing future profits and long-term value of the company.

The more problematic transaction – for all parties concerned – is when the private equity firm purchases control of the insurance company. Private equity firms have little, if any, expertise in the insurance industry or at running an insurance company. Those hired with experience to manage an insurance company have little, if any, experience understanding the mentality of private equity. This presents an immediate potential conflict. What private equity firms will soon learn is that purchasing an insurance company is unlike buying any other company. The investment needed to purchase the insurance company is just the down payment. For the company to grow – if that is their plan – an ever increasing stream of capital must be fed into the company. Capital that creates an immediate loss and does not return profits for decades is not something likely to please private equity investors.

For their part, insurance executives will find themselves dealing with investors who have a much higher investment risk tolerance than insurance companies can Startupssafely take; or that regulators will allow. They will be accountable to investors who view all actions from a “financial-engineering” perspective – squeeze out every penny you can as soon as you can – as opposed to long-term value-added strategies. So that they can begin to recover their investment, the private equity business model also calls for mining dividends as soon as possible from their investment in a company. Taking all this into account, insurance companies could be forced into a new paradigm of seeking short term gains and profits to facilitate the private equity dividend and “exit” strategy of five to seven years, which is their ultimate end game; as opposed to a long term, stable investment that is traditional in the insurance industry.

The inherent risk of all this for those in the insurance industry – executives, employees, agents and even policyholders – is that when private equity firms discover – if they haven’t already – the long term nature, complexities, regulatory environment and relatively low rate of investment return, they will come to view the acquisition of a life and annuity company as simply the purchase of the existing business. If this is the case, the strategy will be to allow the existing business to throw off profits in a run-off mode; cutting costs and benefits as much as possible and be unwilling to invest in the future growth and development of the company.

Private equity firms could be tempted to take advantage of a quirk in the profit flows of an insurance company. With most non-insurance companies, growth means increased profits. In the insurance industry, once a company reduces growth – writes fewer new policies – profits spike up; at least in the short term. This phenomenon fits perfectly with the mentality and time-horizon of the private equity investment model; which could motivate them to actually reduce the size of the company and stifle the growth of new business.

Certainly, at least to consummate the marriage, the private equity groups have offered encouraging if obfuscating comments as to their commitment to the long-term nature of the insurance business and their desire to build the company. That may be the case, but it is not the genetics of these companies or how they have operated in the past. It is taken as a compliment when private equity firms are accused of being more interested in profits than people – or policyholders.

If this should happen, it will lead to reduced employment opportunities, less competition within the industry, less support and fewer product options for the agent distribution system; along with less value and lower benefits for policyholders. Of course, this may not happen. After all, if you do mate a tortoise with a hare you might end up with something that is strong and fast, that can run for a long time. Then again, you might end up with a tortoise like animal that runs fast till it dies.

And the moral of the story . . .

Insurance companies need fresh capital; and they need it now. Private equity firms have excess capital they need to invest; and they need to invest it now. It may be tempting to match these two needs together, but the mating of two needs does not necessarily make for a happy solution. In fact, the business model for insurance companies and private equity firms are so diametrically at odds with each other, it is hard to imagine how such a marriage could be happy much beyond the honeymoon period. When private equity firms get beyond their short-term needs to put investment capital at work and discover the difficulty of extracting short-term gains from a low-return, long term business and insurance companies get beyond their immediate need for long term capital and discover the pressures and risks of performing in a short term environment, the only result that seems likely for both parties is short-term frustration and long term-failure.