Paul Waterhouse explains why policyholders, advisers, analysts and insurers should be interested in S&P’s life ratings
The landscape of the European life markets is changing rapidly. Markets have been deregulated. Life insurers that - in the past - have flourished in overly regulated environments are facing intense competition for the first time. Innovative products have appeared. State provision of protection and retirement benefits are being curtailed and increasingly transferred to the private sector. Barriers between banking and insurance are being dismantled. New distribution media - bancassurance, telesales and direct marketing - are displacing agents and brokers in many segments of the market. Indeed bancassurance distribution has become the dominant method for simple tax-advantaged savings products in many countries.
Greater competition and deregulation has driven life insurers to consolidate and improve efficiency. The more open operating environment for life insurers, together with intense competition, has led to product innovation and improved policyholder benefits. However, it has also led to an increased risk of life insurer failure. In recent years a handful of life insurers have run into financial problems in France, Finland, Germany and the Netherlands. Moreover, a number of smaller life operations, failing to achieve the critical size needed for success, close their doors to new business on a regular basis. In such cases, portfolios are usually transferred to larger market participants without significant detriment to policy holders. As deregulation continues and competition intensifies, the risk of failure will continue to increase.
In order to achieve greater capital efficiency and increased shareholder and policyholder value, life insurers are turning to the capital markets to finance acquisitions and expansion. This trend is likely to continue in the Euro-zone countries as monetary unity leads to a larger, more liquid capital market. Investment bankers are obliged more and more to examine the earnings potential and financial security of life insurers.
The increasing risk of insurer failure means that financial intermediaries, policy holders and consumer groups are turning to tools that facilitate the assessment of financial strength as part of their analysis for selecting or recommending life products. The increased used of the capital markets by life insurers also means that investment bankers are being obliged to analyse the financial security and earnings potential of life insurers on a more frequent basis. Investment bankers are demanding reliable, unbiased opinions about the financial strength of life companies. In the light of increased competition, life insurers are also becoming more and more interested in how their own financial strength compares with that of peers.
The marketplace is demanding insurer financial strength ratings on Europe’s leading life insurance companies. Standard & Poor’s ‘EuroLife’ initiative is a first step in addressing the demand for independent, expert, unbiased opinions about the financial strength of Europe’s leading life insurers. The initiative involves complementing our existing (and growing) interactive coverage with ‘PI’ ratings. ‘PI’ ratings are financial strength ratings of insurers that have been analysed solely on the basis of information available in the public domain. As one would expect, ‘PI’ ratings tend to be more conservative, less qualitative and less prospective than ratings assigned using our fully interactive and comprehensive analytical process. The ‘PI’ analyst does not have access to confidential information regarding an insurers financial health. In particular, a ‘PI’ analyst is not privy to insurers strategic plans for the future and rarely has the opportunity to assess the quality and capabilities of management at first hand. However, in using only financial and qualitative information available in the public domain, the ‘PI’ analyst is in the ‘same boat’ as the policyholder in judging financial strength.
An S&P’s insurer financial strength rating is an opinion of an operating insurer’ financial capacity to meet the obligations of its policies. However, a rating is not just about an insurer’ capability to remain solvent. The guarantees attaching to savings orientated life policies are rarely onerous in Europe. Indeed, in some markets guarantees have been eliminated from many products. Most life insurers, provided they do not pursue overly imprudent business practices, should have little problem in fulfiling ‘contractual minimum’ guarantees for their policies. However, policy holders expect to receive substantially more than contractual minimum benefits. An insurer financial strength rating therefore also indicates an insurer’ capacity to achieve a consistent, competitive long-term performance.
Ratings are opinions of financial strength. They are not financial advice or investment advice or product recommendations. Nevertheless, financial advisers, intermediaries and investment analysts are increasing using ratings as an important tool to assist them in formulating their recommendations to clients. Our coverage of European life insurers currently extends to 175 companies who between them represent over 70% of premium volumes in western Europe. All parties can take comfort from the fact that most of the life insurers analysed have been assigned secure ratings (‘BBB’ and above). Only a small number of life companies are rated at ‘BB’ or below.
Whilst the financial security characteristics of life insurers vary from company to company and from country to country, European life companies are - in the main - well capitalised (on a realistic basic that takes into account hidden asset values and any technical reserve redundancies. Life companies are also generating reasonable earnings.
However, there are challenges ahead that will put pressure on ratings in the future. Competition is increasing in every market. Investment yields have fallen, particularly for fixed interest investments and this will place pressure on earnings. Moreover, most markets have already implemented measures to improve efficiency gains. The easy improvements in efficiency have already been achieved. Life insurers will therefore find it more difficult to maintain earnings by cutting costs in the future.
The transfer of state benefits to the private sector will be both an opportunity and a challenge for life companies. The opportunity is greater growth. However, retirement products require different skills from traditional life products and savings policies. Improving longevity also poses challenges for pricing and reserving. We expect a greater diversity of financial strength ratings to emerge in the future as insurers face the challenges ahead.
Deregulation and increased competition have led to product innovation and improved policyholder benefits. This has been good news for policy holders. Moreover, in the face of increasing competition, this positive trend will continue. However, the risk of insurance failure is also increasing.
In selecting a financial product a wealth of elements must be taken into consideration. It is likely that the final choice of policy and provider will be decided upon price (or historical performance) or perhaps product flexibility. However, more fundamental questions need to be addressed before arriving at this ‘final’ decision stage.
Firstly, will the insurer selected still be in business when the policy matures? Secondly, will the chosen insurer be capable of maintaining its performance over the lifetime of the policy? Good historical performance is all very well; but a potential policyholder is concerned with future performance. The past is not always a good indication of what will happen in the future. No one can address these questions with certainty. However, an insurer financial strength rating can provide a useful indication. The high proportion of secure ratings assigned to the life insurers in this study indicates that the majority of major European life insurance providers have robust financial strength and should be capable of sustaining their perform.
Insurers should also take comfort from the high percentage of secure range ratings. The life industries of Europe remain in good health despite the intense competition of the 1990s. For those life insurers intending to approach the capital markets or entering into financial transactions with third parties, the presence of a ‘good’ rating may prove advantageous in their negotiations. The ratings will also bolster public confidence in the life industry and their own company, particularly during periods when other market players encounter problems. Ratings may also prove to be a useful marketing tool. Finally, ratings may provide life insurers with a useful benchmark for judging their own financial strength against peers.
At first glance it may appear that there is a fundamental conflict between financial strength from a policyholder’ perspective and from an investor’ perspective. The more surplus that is allocated to policy holders, the less will be available for shareholders and vice-versa. In fact, the two are not totally in conflict and insurers must establish a fine balance between the demands of both stakeholders.
A life insurer that allocates too much to policy holders, at the expense of investors will find it difficult to attract additional capital to finance new business expansion or acquisition. Such insurers, lacking the financial flexibility of their peers, may find themselves disadvantaged in an environment where insurers are consolidating and investing for future efficiency gains. By contrast, those insurers who favour investors at the expense of their policy holders will become uncompetitive, lose market share and see their business position deteriorate.
Paul Waterhouse is director, insurance
ratings , at Standard & Poor’s in London