In this episode of the McKinsey on Insurance podcast, partner Henri de Combles de Nayves sits down with senior partners Ramnath Balasubramanian, Pierre-Ignace Bernard, and Bernhard Kotanko to discuss the main themes within the first chapter of McKinsey’s Global Insurance Report 2023.1 They dive deep into the issues and opportunities that life and retirement insurers face today and explain how these companies can accelerate growth and exceed their performance targets, including updating the life insurance model. An edited transcript of their conversation follows.
Henri de Combles de Nayves: We’ve seen that the life and retirement industry has experienced increasing instability. What are the forces at play that will shape the industry going forward?
Ramnath Balasubramanian: There are several forces that we believe will shape the industry going forward. First, there is an increasing awareness of personal risk and security. As we come out of the pandemic, there has been a heightened awareness and concern about personal health as well as personal savings and financial security. The number of people over the age of 65 is expected to double over the next 30 years, growing from around 0.8 billion to 1.7 billion. A large part of that growth is going to come from developing economies like India and China, but developed economies will also continue to make up a significant part of that population, too.
Many citizens are realizing that they will be personally responsible for their healthcare and retirement savings because several government-provided social-security programs are dealing with high levels of indebtedness. For example, for some social-security programs in the most advanced economies in the world, we estimate that there is close to a $41 trillion pension funding gap. That gap represents an opportunity for the life and retirement industry to meet the needs of citizens globally.
Another force that will shape the industry over the next few years is the macroeconomic environment, particularly interest rates. The industry has seen a decade-long era of ultralow interest rates, and that’s put a lot of pressure on life insurance balance sheets. In the past six months, we’ve seen the opposite phenomenon: interest rates have risen by more than 300 basis points across several markets and countries. While the increase in nominal interest rates does provide a tailwind in the near term for life insurers, insofar as they’re able to rebalance the asset side of the portfolio quicker than they had been able to on the liability side, there are a few important considerations they also need to keep in mind. One is that they’re dealing with an extremely volatile economic environment in terms of equity market and credit market volatility, which increases return expectations from investors as cost of capital goes up, as well as financial costs such as hedging.
The second is the difficult economic environment, which will likely cause credit deterioration and ratings migration. As a result, life insurers will need to actively manage risk and rebalance the investment side of their portfolio. The third consideration is that real interest rates have stayed low despite nominal interest rates increasing because inflation has outpaced the growth of nominal interest rates. We expect this trend to continue over the next several years as the working-age population declines.
Henri de Combles de Nayves: Bernhard, based on your perspective in Asia, are there any other forces that you perceive to be relevant?
Bernhard Kotanko: Two aspects: one is focused on the global level, and one is more specific to the role of Asia on the global insurance stage. The first is technology. Insurance and life insurance are information businesses. Over the years, there has been a lot of investment in technology. We have seen IT spend grow from 2 percent of gross premium to 3 percent. We are on the cusp of a new era for life insurance to harness the power of data, analytics, and digital customer engagement. So this will enable insurers to find different ways to address the gap that Ramnath alluded to and find more efficient ways to engage and operate.
Over the years, there has been a lot of investment in technology. We have seen IT spend grow from 2 percent of gross premium to 3 percent.
In Asia specifically, there has been a macroeconomic shift, and despite any geopolitical context, Asian economies and societies will continue to grow. The role of the middle class will also grow, which is central for life insurers because people’s savings ratios are enough that they can invest in life insurance and are concerned about protecting their families. In Asia, the number of middle-class people will grow to about 1.2 billion by 2030, so it will be the largest force on the consumer side for life insurance.
Henri de Combles de Nayves: Pierre, how has the industry performed in the tumultuous environment it has experienced over the years?
Pierre-Ignace Bernard: The performance of the industry over the last couple of decades has been lackluster. We have seen significantly lower nominal growth of industry activity versus the GDP. In the US and Europe, for example, between premium growth and GDP growth, we have an average gap of two percentage points over the past couple of decades. Across Asia and in Japan, there’s an astonishing 7 percent gap.
We’ve also seen weak productivity development over the past couple of decades compared with what we’ve witnessed in other service industries. The life insurance industry has not been able to deliver productivity gains, and that shows in the development of their cost base. The outcome of that is that the industry has struggled to generate returns in excess to the cost of capital.
Last, market caps over the long term have been depressed. The cumulative market cap of the top 20 life insurers in the US 40 years ago was quite close to the cumulative market cap of the top 20 banks in the US. Today, it’s only one-sixth. Obviously, these are averages, and there have been certain markets doing better than others and certain players that are more successful than others.
Henri de Combles de Nayves: How are sources of value creation shifting over time?
Bernhard Kotanko: It’s critical to look at individual value pools across and within geographies. In the US, the products that provide principal protection with some upside based on market performance have done well. Over the same period, more market-oriented annuity products have struggled. In France, equity markets have grown substantially, whereas general accounts suffered. In the coming years, we will see if the trend changes. But it shows that it’s important to look product by product in each market.
In Asia, the picture is on the product side, particularly for health-related products. China and India are the big growth hotspots and have ample value creation opportunities driven by the underlying macroeconomics, but we also see that some Southeast Asian markets have high demand. Beyond the product and market mix, it’s important that we see a shift in value creation to investment alpha. Despite nominal tailwinds, we expect low-for-long real rates. In that environment, it is critical that insurers shift to generate investment alpha.
Last, there has been portfolio restructuring. Many insurers aspire to be the global insurer, and in Asia, many insurers have quite mixed portfolios and are struggling with how to trim those portfolios for value creation. We expect the pressure will increase to demonstrate how a portfolio creates value and is a source of growth.
Henri de Combles de Nayves: What do you see as the biggest structural changes happening to the industry?
Ramnath Balasubramanian: One of the big trends we have been seeing from the last decade is the emergence of private capital—particularly platforms that have been known by some private-asset and alternative-asset managers. There are several reasons why private capital finds the life insurance industry attractive: the industry’s performance has been disappointing, the returns have been below cost of capital, and productivity improvements have not taken shape. This provides an opportunity for someone else to come in and drive the performance improvement and drive up the return trajectory of some individual companies.
In addition, a lot of the alternative-asset managers and private capitals see life insurance as a source of permanent capital, a stable pool of long-date liabilities that can be deployed into many different asset strategies—everything from traditional fixed income to more-structured products and alternatives. For these alternative-asset managers, that reduces the fundraising burden that they typically go through and creates more predictable sources of income. As a result, you’re seeing a phenomenon today where, in the US, for example, platforms owned by private capital make up nearly 9 percent of all the assets in the industry, and that number was less than 1 percent a decade ago. Not only are they playing an important role in terms of some of these legacy liabilities that they’re acquiring from traditional insurers through M&A, but they’re also starting to play an important role in terms of new business. For fixed-index annuities, for example, which have been growing significantly in North America, private capital–owned insurers account for close to 40 percent of all the market share, and they’re growing faster than the market. These insurers also provide investment management solutions to the industry. So in many ways, this category of insurers is not playing a very significant role in terms of industry structure.
The second big structural shift is how distribution is evolving. If you look at the market cap of pure-play distribution companies relative to life insurers, the total shareholder returns of these distribution companies have been close to two and a half times that of traditional life insurers. To Bernhard’s point, we’re seeing a consistent shift in value toward distribution. We’re also seeing a phenomenon where value and premiums are shifting from a traditional captive-carrier tied distribution to more of an independent distribution. In the US, for example, independent distribution now accounts for close to 55 percent of all premiums across life insurers as well as annuities. And there are similar trends in Europe and Asia.
Henri de Combles de Nayves: The industry is facing a real inflection point. Considering these new trends, how can the carriers reimagine their operating model to survive in this environment?
Ramnath Balasubramanian: In the context in which the insurance industry finds itself today, evolution will not be enough. It’ll require a fundamental rethink and reimagination of the business model. If you look at the traditional model today, most life insurers do all activities across the business system and the value chain. And we’re average at best across most, if not all, of the activities in the value chain. We’re also seeing the phenomenon where customer needs are converging across health, wealth, retirement, and investment management. As a result, future life insurers will need to create a business model that is simpler, narrower, and more focused and unbundle the value chain.
We see four different types of business models that could emerge and could be the basis of value creation in the future. One business model is “distribution specialists.” These models primarily use a client-centric approach and have a range of different insurance, wealth and investment management, and health products available through an open architecture approach. These business models will typically invest a lot in client-facing technology. By design, they’re extremely capital light because they don’t take on any of the balance sheet risk and are typically valued on metrics like inorganic growth as well as operating margins.
A second business model is “product origination specialists.” These are business models where the insurer has strong capabilities in product design, risk assessment, and underwriting and will have privileged access to distribution. It could be their own distribution, or it could be third-party distribution, but it will typically have constraints in terms of balance sheet and capital or investment management capabilities. In this case, they will largely rely on originating the product using the distribution and product development capabilities but will use someone else’s capabilities on the balance sheet side and the investment management side. So they’re transforming a more traditional, capital-intensive model into a relatively capital-light model because they’re combining balance sheet and fee-based earning streams. We think many publicly traded insurers may gravitate toward this model, given investor demands and expectations in terms of how business models are evolving.
The third model is “balance sheet specialist.” This is the complement of the product origination model. These business models will typically not have the capabilities and access of individual distribution but will have a strong, weighted balance sheet; strong investment management capabilities; and robust risk management capabilities. So they can provide solutions to the other insurance companies through legacy book transfer of M&A, through flow reinsurance, or through other solutions. We’ve seen privately owned insurance companies gravitating toward this model.
Last, there will be a handful of “truly integrated insurers”—and it is a handful because the bar for distinctiveness will be high in terms of distribution capabilities, product development, risk management, capital position investment management, and their operations and technology. We think that there will be few insurers that meet that bar to become fully integrated insurers in the future.
Henri de Combles de Nayves: The industry is quite heterogeneous, so different players will probably face different challenges and adopt distinctive strategic postures. How do you see this unfolding for some of the players?
Pierre-Ignace Bernard: Insurers will come with their own sets of challenges and opportunities. Top-traded insurers, for example, will have to be extremely clear on what their unique competitive advantage is and make sure that they protect and strengthen it. It could be that they are dominant in certain geographies, or great in certain lines of business, or have better positioning in the value chain. Second, they will have to selectively find potential to create more value. For example, they could form a partnership with others to build state-of-the-art investment management capabilities in private assets, or they could convey to the market the value of their portfolio of gross opportunities.
Stock-traded insurers are usually expected to deliver regular results, and their growth potential is not always properly valued. So there is probably opportunity to improve that within their business. Shifting to private-equity owners and operators, they would have to develop new gross vectors above and beyond the legacy M&A levers that they’ve been using. They could do that through geographic expansion, by using stronger organic gross capabilities, or by thinking about different levers to create value beyond the investment alpha that has been core to their proposition over the last decade. They could, for example, reinvest technology and operations in areas where they could make a difference.
Bernhard Kotanko: In our report, we also looked specifically at mutuals and state-owned insurers because they are a core pillar of the life insurance industry in many geographies. Mutuals’ strength is in their reputation, their customer loyalty, and the strong captive distribution. They typically have lower cost of capital, and in some markets, they have the potential for operational efficiency at scale. They take a holistic approach to customer needs and to their role in society. All of this speaks to the core principle of what insurance is about. As they look toward the future, there are many strengths mutuals can build upon. We see specific opportunities in how to further innovate product offerings and how to specialize in areas to find distinctive competitive advantages. Some mutuals are challenged with operational efficiency and need to bring down costs to ensure competitiveness and customer service. It’s also critical for mutuals to think about their distribution models. As mentioned, many are strong in traditional captive-adviser networks but need to develop partnerships on the digital side in affinity networks and foster new ways to connect with peers.
For state-owned insurers, in many countries, these insurers play a critical role bridging public social services and the private life insurance sector. They also typically have strong distribution capabilities, benefit from a lower cost of capital, and can make long-term investments in their role in society. Where they struggle is innovation. They need to get on the cutting edge of digital innovation so they can keep up with the pace of the private sector. State-owned insurers also are disadvantaged in the talent market. They need to strengthen their positioning to attract the talent for the future. Both mutuals and state-owned insurers are important business models, but an exciting element of the life insurance industry is that you have different models competing in the sector for the benefit of customers, hopefully to create a more resilient society.