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Introduction to the Insurance Industry

Insurance and risk management make up an immense global industry. According to a

survey conducted by a leading global insurance firm, Swiss Re, worldwide insurance
premiums totaled $4.270 trillion in 2008 (the latest data available), up about 6.3% from
$4.061 trillion in 2007. This was equal to about 6.18% of global GDP. Global life
insurance premiums were $2.79 trillion during 2007, while all other types of insurance
totaled $1.78 trillion.

In America alone, the insurance business employed about 2.31 million people in 2008,
and insurance gross premiums totaled $1.13 trillion, making the U.S. the world’s largest
insurance market. For 2009, life, accident (including supplemental health) and annuity
premiums in the United States will total an estimated $679 billion. Property and casualty
premiums will total about $450 billion for 2009. U.S. life insurance firms held about
$4.51 trillion in assets in 2008, according to the Federal Reserve Bank. Approximately
4,500 companies underwrite insurance in America, but the industry is dominated by a
handful of major players.

According to Swiss Re, total insurance premium volume for 2008 was $1.75 trillion in
Europe; $933.3 billion in Asia; $104.9 billion in Latin America and the Caribbean; $29.2
billion in the Middle East and Central Asia; and $54.7 billion in Africa. Again, these
figures are from Swiss Re (www.swissre.com).

Premiums on a per capita basis remain very low in much of the world, pointing to
excellent long-term opportunity for expansion of sales of insurance products of all types,
including annuities. While it will take many years for underdeveloped nations to begin
spending significant amounts on insurance products, much of the world is still clearly a
fertile field for expansion of companies that are willing and able to invest time and
money in emerging markets.

Per capita premiums worldwide were $646 in 2008, compared to $2,990 in North
America. More than 87% of that year’s premiums were earned in industrialized nations,
leaving a bit more than 12% earned in emerging markets.

Massive sources of insurance company earnings come from the sale of annuities and
other retirement and investment products, along with profits (or losses) that insurance
underwriters earn on their own assets and reserves. 2008’s stock market meltdown had a
significant effect on profits and assets at life insurance companies in particular, and
property & casualty companies to a lesser degree. Insurance companies also hold
immense investments in real estate, hedge funds, private equity, venture capital funds and
other types of investments. The global financial meltdown hurt all of these asset classes
and thus hit the capital base of the insurance industry in a hard way. At the same time,
business bankruptcies, unemployment and cost-cutting by both businesses and consumers
hurt insurance sales in developed countries. The best growth was in emerging markets,
including a 16.3% premiums increase in 2008 in South and East Asia. Europe showed a
6.2% decline while North America showed a 3.1% decline.

In America, insurance is unique in the financial services field because, unlike banking
and investments, which are regulated largely (although not entirely) by federal agencies
such as the Securities and Exchange Commission, insurance is regulated primarily at the
state level. This means that insurance firms must deal with up to 50 different sets of state
regulations and 50 different state regulatory agencies. At the same time, they must
develop dozens of different premium rate structures that appropriately reflect the costs of
meeting local risks and fulfilling state requirements. As a result, few insurance
underwriters offer all of their insurance products in all 50 states; many do business only
in a limited number of states. It is a regulatory and administrative nightmare that limits
consumer choices and drives up overall insurance costs.

underwriting does not earn consistent levels of profits. Property and casualty insurance
companies sometimes face a year of losses, rather than profits, due to natural disasters
such as hurricanes, floods or an overly active fire season. Occasionally, insurance
underwriters go broke, and firms that rate the financial stability of insurance underwriters
always list more than a few that are not financially sound. For example, Yamato Life
Insurance Company, a leading Japanese firm that had been in business for nearly 100
years, took bankruptcy in October 2008.

American insurance underwriters found their stocks falling sharply in 2008 when
investors realized that many of these companies needed to raise new levels of capital due
to losses in the firms’ reserves and investment assets. At the same time, markets were
reacting to the fact that net profits can fall sharply during tough economic times. Hartford
Financial raised $2.5 billion in new capital in October 2008 by selling shares to Allianz, a
major German insurance firm. MetLife raised $2 billion in new capital during the same
month.
course, the biggest news was the U.S. government’s need to bail out global insurance
giant American International Group (AIG) in the fall of 2008. AIG was considered by
most analysts to be a reasonably well-managed insurance company with good long-term
potential in the global market. Unfortunately, a relatively small division at AIG had taken
immense risks by writing credit default swaps (CDS) totaling hundreds of billions of
dollars. This is what broke the company’s back. CDS are essentially an unregulated form
of insurance, used by investors and financial firms of all types to hedge against potential
losses in the value of bonds and debt instruments of all types—such as collateralized debt
obligations consisting of pools of mortgages. The American government promised AIG
up to $85 billion in loans in exchange for effective control of the firm and a change of top
management. That need quickly grew to about $150 billion when AIG found it difficult
to find buyers for assets and operating companies that it intends to sell. Over the mid-
term, AIG is refocusing, primarily as a U.S. property and casualty company. It will retain
some strategic investments in foreign general insurance and life insurance operations, but
many of its overseas operations have been sold. The company lost nearly $100 billion in
2008.

2005, Hurricanes Katrina and Rita in the U.S. cost insurance underwriters vast amounts
(damages, both insured and non-insured totaled about $58 billion) and created significant
controversy over flood insurance in general. Many changes resulted, and insurance
underwriters felt compelled to boost rates for many types of insurance, especially in Gulf
Coast markets. Despite predictions of damaging hurricane seasons for 2006 and 2007,
large losses did not occur, and underwriters earned fat profits. During 2008, hurricanes
caused significant and costly damage in Louisiana and Texas. Recently, much of each
hurricane season’s risk was sold by primary underwriters to hedge funds and reinsurers
who buy portions of large, high-risk insurance policies. This enables property & casualty
underwriters to continue to earn reasonable profits while laying-off a significant part of
potential losses if there is a devastating hurricane.

The insurance industry includes a wide variety of sectors and services. The most obvious
are insurance underwriters that cover the risks and issue the policies, along with the
agencies that sell insurance. However, there are also large numbers of consulting firms,
claims processing firms, data collection firms and myriad other specialized fields serving
the industry.

In addition, there are insurance brokers, which have traditionally posted enviable profits.
Normally, insurance brokers—companies that are supposed to represent the interests of
major corporate clients while finding these customers the best coverage at the best rates
—would be little known to the general public. However, scandal rocked the brokerage
sector during 2004, and regulators’ efforts to control this sector created significant
changes. Meanwhile, some members of the brokerage industry promoted the idea of
important changes from within, including the abolition of “incentive payments” from
underwriters to brokers, and a focus on acting as advocates for clients.

Recent regulatory changes have heightened competition within the insurance industry—
an area in which competition has always been fierce. Massive mergers and acquisitions
have resulted, creating financial services mega-firms, many of which offer a complete
range of financial services and products to their customers, from checking accounts to
investment products to life insurance. For example, banks are slowly gaining market
share in the sale of insurance products, particularly annuities and life insurance.
Investment companies like Merrill Lynch (now part of Bank of America) have been eager
to sell insurance to their customers as well. At one time, bank holding companies were
aggressively acquiring insurance agencies. Competition will only become more intense.
While there are tens of thousands of small insurance firms worldwide, the industry tends
to be concentrated in a few hundred major companies, many of which enjoy brands that
are household names. A handful of these leading firms operate on a truly global scale.

the U.S. and Europe, regulators are considering sweeping changes in the regulation and
oversight of financial services firms of all types. The focus will be on making risks held
by such firms more transparent and maintaining sufficient levels of capital to cover
potential losses. The insurance industry will undergo additional scrutiny and oversight as
a result.

Meanwhile, the U.S. health insurance industry may be in for massive changes. America is
unique among the world’s most highly-developed economies in that the government does
not offer or oversee a universal health coverage system. As a result, health coverage in
the United States is provided by a wide variety of providers ranging from firms that
operate hospital systems and sell policies that provide care within those hospitals, to
companies that only underwrite health insurance. Generally speaking, this is a highly-
profitable business that has shown stellar growth over the past few decades. At the same
time, the federal government pays for about 35% of all U.S. health costs via Medicare
and other systems, while the states pay for 12.6% largely via Medicaid.
As of late October 2009, Congress was battling fiercely over proposed reforms of
America’s health system, which may include the extension of coverage to about 25
million currently-uninsured people.

Initially, health care reform may provide positive growth to the earnings of health
insurance providers. If Congress enacts a plan that relies primarily on the private sector to
cover Americans who are currently uninsured, then insurance industry revenues may rise
as a result of increased volume. The problem for the industry is that Congress will
undoubtedly attempt to reduce costs and profits throughout the health industry. Insurance
providers may eventually suffer, or be forced into consolidation in order to streamline
operations and deal with lower profit margins. On the other hand, insurance providers
may find that they have to innovate and evolve by offering supplemental policies—that
is, policies that provide enhanced coverage above and beyond basic coverage mandated
by universal care. Supplemental insurance is typically a much higher profit margin
business. A major question is whether the government will create a “public option”
insurance provider that will compete with private insurance firms.

universal coverage is highly subsidized by the federal government, then health care
reform could result in one of three possible outcomes depending on the so-called public
option.

1) If there is a public option, then private insurance companies will eventually suffer as
current private sector clientele migrate to the public option for lower premiums.

2) If there are stringent limits on care provided by a public option, then private companies
will evolve into something like today’s supplemental companies, providing special
coverage somewhat similar to the way that Aflac does today. This supplemental coverage
might include special, non-covered, treatments for cancer, like Proton Beam Radiation
(PBRT), or might cover expenses of private rooms, certain specialists, or non-covered
very expensive pharmaceuticals.

3) If there is no public option but the government sets up a procedure whereby virtually
everyone will have insurance, subsidized when necessary, then today’s private insurers
might grow substantially in terms of number of people covered. However, in this case,
insurers over the long term could eventually face Medicare-like, government-imposed
restrictions on what can be covered, how much can be charged, etc. The result could
easily turn into a profit squeeze for both insurers and providers. Costs for the government
could rise so quickly and so high that it could even impose profit limits. For example,
both Massachusetts and Tennessee have been forced to backtrack substantially on their
relatively new statewide universal plans because costs ramped up much higher and much
faster than they ever thought possible. It is reasonable to assume that pain from a scenario
like this would be passed along to insurers.

Global Insurance Industry Trends: What are the Implications?

Understanding global insurance industry trends and what they mean for U.S. insurers is
important. But the real winners are likely to be those who can successfully implement
change.

Over the past few years it has be come apparent that the global insurance industry is
being shaped by a small number of well-defined external drivers of change. These are
commonly identified as:

* Increasing consolidation, convergence and globalization;

* An evolving socioeconomic and political context;

* Changing consumer concerns and buying behavior;

* Rapidly developing technology;

* Broadening distribution patterns; and

* Shifting regulations.

While each of these drivers of change is still relevant, viewing the industry against this
backdrop can now provide only a superficial view. The world is moving on. In this
article, we have attempted to identify 10 of the most important current issues facing the
industry globally and venture an opinion in relation to their implications.

For some time, size seems to have been viewed by many insurers as an objective in itself,
bringing with it market power and reduced costs. It is true that the cost of new technology
and the desire for economies of scale continue to drive consolidation. In our judgment,
however, the reality is that as markets increasingly deregulate, few groups will have the
required capital to achieve global dominance, and still fewer will be able to successfully
obtain the management skills to be winners in all lines of business in a more open
competitive environment.

U.S. and European insurers moving into Asia, Latin America, and other developing
markets face challenges in managing cross-cultural issues. This was nicely put by Thou
Yan Li, commissioner of China's Insurance Regulatory Commission in Shanghai at the
China Rendezvous conference earlier this year when he said, "Although foreign
companies have certain advantages in some aspects, our domestic companies are in the
same market with the same language, culture, and legislation. It is easier for domestic
companies to contact each other. In these aspects, the foreign companies are no match."

Add to this that the cost of acquisitions is becoming increasingly prohibitive as suitable
targets become fewer. So, if the old thinking was get bigger to get more cost-effective,
the new thinking must be get more specialized. Multiline global insurers present
management challenges of significant scale. Successful companies will become more
focused, with some getting out of any activity where they are not best in class. We can
expect to see more outsourcing of noncore activities and more strategic alliances with
both financial services and nonfinancial services companies as insurance groups move to
operate in a flexible alliance model.

The Internet

It has been said that the Internet will do for services what the production line has done for
goods. What does this mean for insurance? Some commentators have proclaimed the
Internet as the final solution to the insurance distribution problem. Such a simplistic
answer could hardly be further from the truth as it only addresses a small part of the
question. Yes, the Internet will become a strong distribution channel for simpler products
but no one should underestimate the power of the agent or adviser. The bottom line is that
customers will always self-select distribution.

In an Internet world no one can own the customer; the customer is empowered by
knowledge. As far as distribution through the Internet is concerned, there remain many
unanswered questions. How to deal with channel conflict? How to prevent margins from
being eroded? And most fundamentally, if you build a Web site, will customers find it
and buy from it?

The good news about the Internet is that its real power is as a driver for complex business
models that integrate all methods of distribution, as a facilitator of straight-through
processing in policy administration and claims management, and as a reducer of
procurement costs. Business costs will fall dramatically; for example, financial services
group AXA has estimated that policy management costs will drop by 98 percent

All the major global insurance companies are spending billions of dollars on their e-
business strategies. The winners will be those that target their spending most effectively.
As Bill Gates put it in his book, Business @ the Speed of Thought, "we always
overestimate the change that will occur in the next two years and underestimate the
change that will occur in the next ten."

For most insurers, the priority should be to use the Internet first to re-engineer business
processes, and second to enhance existing distribution channels. Only after that should it
be used to create new distribution models. Traditional insurers with large, often part-time,
agency forces face particular challenges in channel enhancement but also have much to
gain. A more professional and productive agency force will be a logical outcome of
insurers adopting modern Internet-driven business models.

Regulation is Shifting

Deregulation worldwide is encouraging the emergence of universal financial services

organizations, like Zurich Financial Services, to replace stand-alone banks, insurers, and
brokerage firms. It is also enabling new and nontraditional players, such as Virgin of the
UK, to enter the market. Overall, this promises to be a new test for bancassurance
models. This trend is already affecting Asia where the Malaysian and Singapore
industries are classic examples of the deregulatory forces at work. Big Bang in Japan is
another. The conference for Emerging Insurance Markets in Kuala Lumpur, Malaysia,
earlier this year confirmed this trend will continue.

At the same time, this deregulation is being countered by increasing controls over the
way products are delivered and sold to consumers. Market conduct is an emerging issue
in many countries well beyond just the United Kingdom and United States. There is a
shift from regulation of what is sold by a particular institution to regulation of how it is
sold. To meet this new situation, new regulators are emerging--such as the Financial
Services Authority in the United Kingdom and the Australia Prudential Regulation
Authority--supported by new consumer protection legislation that typically sets out how
an insurer can deal with its agents and its customers. This legislation covers matters like
agent authorization and training as well as the way in which advice can be given to
consumers.

In the United States, in order to enforce the Gramm-Leach-Bliley Act mandates on

privacy, state legislatures and regulators are promulgating laws and/or regulations to
implement all or part of the new model privacy regulation adopted by the National
Association of Insurance Commissioners In Kansas City, Mo. In some state legislatures,
the insurance industry is vigorously opposing proposed legislation to the extent that it
varies from the national uniform standards or would restrict the sharing of information
for business purposes.

An implication for insurers is that their customers will become more demanding as they
become better educated and have access to better remedies. Successful insurers will
increasingly need to pay close attention to corporate governance issues including privacy
and market conduct.

Breaking the Value Chain

The traditional view of an insurance business as a provider of fully integrated service

delivery is obsolete. Distribution, underwriting (manufacture), administration, and funds
management are becoming increasingly disaggregated. As companies seek to meet
customer needs, they will need to place emphasis on multiple channels and multiple
relationships rather than providing all the products and services themselves.
Distributors will seek to provide customer convenience and greater value by bringing
together a range of products, theirs and other peoples, in one offering designed to deliver
wealth creation. In this context, savings products, life risk and property risk are all points
on the same continuum. Customer convenience is the key. The battle will be for the
opportunity to serve customers in tomorrow's market

On the surface, global companies have advantages in building brand awareness. For this
reason, global groups like Allianz, AXA, and ING are changing the names of their
operations around the world to their own. There are obviously many insurers with strong
domestic brands--Sun Life in Canada, Northwestern Mutual in the United States, HSBC
in Hong Kong, Cathay Life in Taiwan, Samsung Life in Korea and Tokio Marine & Fire
in Japan, to name just a few-but the challenge remains for an insurer to build a global or
at least pan-North America/pan-Asia brand before existing global brands take over.

A conclusion to be drawn from this is that we should not expect to see start-ups rising to
prominence in insurance in the same way as we have seen in the technology sector unless
they are backed by strong brands and extensive capital.

It used to be true for insurers that too much capital was barely enough. This was because
the whole emphasis of insurers was on maintaining statutory solvency rather than
profitability.

Insurance companies, particularly in the U.S. and Europe, are now recognizing that they
compete for capital with other types of companies. Active capital management is needed
to maximize shareholder returns.

Swiss Re is a good example of a company that has sharply increased its shareholder value
by actively managing its capital. Storebrand and Chubb are others. Many insurers still
have a lot of work to do in this area. Successful capital management requires a
combination of actuarial and financial skills.

As global brands become increasingly important, as global companies learn to leverage

their skills worldwide, as they centralize their back-offices in low-cost jurisdictions, as
funds are increasingly managed globally, it will follow that larger players with strong
brands and quality management will have a clear advantage.

Asian and developing insurance markets presently are widely seen as opportunities for
the existing global players. But it is a realistic expectation that strong Asian-based global
insurers will also emerge.

Choosing a strategy, however, is only a part of the battle. "What to do?" is no longer the
question. The real question is "how to make it happen?" Implementation linked to
constant innovation will be the true key to success. This means having not just a good
leader to set the strategy, but a cohesive team with strong project management skills to
implement it. Or as Bob Mendelsohn, CEO of Royal & SunAlliance put it, "Companies
that are successful will be those that learn fast, fail fast and recover fast."