The traditional value proposition of life insurance in Europe has been called into question. Breakout moves have not reached industry scale. And as the need for old-age provisioning continues to grow, the challenges continue to increase.
These challenges include an ultralow interest-rate environment, which has prevailed for more than a decade; industry-wide structural costs that have not been sufficiently addressed, especially administration and acquisition costs; and a new capital regime (Solvency II) that not only demands higher capital charges for high-guarantee books but also leads to higher volatility in risk capital charges over time (Exhibit 1).
Further complicating matters, the COVID-19 crisis has accelerated these challenges. Capital-market turmoil and a further reduction of interest rates have put pressure on the solvency and profits of life insurers, with effects ranging from decreasing premiums paid because of lockdowns and increasing economic uncertainty and mortality.
In this article, we explore how insurers can create value from their closed books—policies that continue to generate revenue but no longer receive new business—as well as which partnerships and circumstances show the most potential.
Life insurer performance in Europe and the United States is polarized by company—and many insurers are struggling
In principle, there are two sources of value creation for life insurers looking to address the current market challenges: new business and the optimization of in-force books, both open and closed. Closed books typically pose the primary profitability challenge for the following reasons:
- they account for approximately one-third of all premiums paid
- they often include a high share of high-guarantee policies
- fixed costs per policy increase over time as the book decreases in premiums and number of policies (the so-called runoff)
- many are still managed on inefficient legacy systems, as high investment returns on the capital market offset high costs from inefficient IT
- policy migrations tend to be complex, sometimes taking years and requiring huge costs to complete
Our simulation shows that an additional decrease in solvency of up to 50 to 80 percentage points is likely under a muted recovery scenario, which assumes GDP doesn’t recover to pre-crisis levels until 2024. This impact is mainly driven by two sources: deteriorating financial markets (a 25 to 40 percentage point reduction in solvency) and declining top line (an additional 10 percent decrease in top line would result in a 30 to 40 percentage point reduction in solvency). The negative solvency effect will be particularly severe for life insurers with already-low solvency ratios or with comparably less-sophisticated capital and investment management. These insurers in particular need to think about strategic options for how to run their books efficiently as well as how to safeguard the gurantees in their books in the long run, including closed-book consolidation.
Life insurers can reap much more value from their closed books by applying five levers
The potential efficiency gains from more-effective closed-book management are substantial: the return on equity (ROE) of an average closed-book portfolio in the European market can be improved by up to three to five percentage points. The following five levers can help: operations and IT, investments, capital, technical excellence, and commercial uplift (Exhibit 2). Traditionally, incumbents have focused on operational and commercial levers, often not succeeding in extracting the full potential of other levers, as modernizing digital technology alone can reduce costs in operations or IT and operations by 40 to 50 percent, respectively.
Players should reflect on whether they are best positioned to pull these levers themselves or whether partnerships could prove beneficial. Depending on the specific situation of a carrier, insurers could leverage external partnerships in several ways. Some players might consider outsourcing parts of their business, establishing partnerships to reduce balance-sheet exposure by engaging in reinsurance or swaps, or selling a closed book.
Closed-book consolidators have taken root across geographies—and may be good partnership options for some life insurers
When insurers face strategic choices regarding closed books, they should consider the performance of specialized closed-book consolidators. Such entities are either owned by private-equity (PE) companies or independent insurance companies or are part of larger financial holdings.
The profitability picture shifts by line and geography. In Continental Europe, nonlife insurers have outperformed life insurers over the past decade. In the United Kingdom, life insurers’ total returns to shareholders (TRS) have been higher than that of nonlife insurers during the same period. And in the United States, the performance of life insurers has been comparable to nonlife insurers (Exhibit 3).
Mature markets: United Kingdom and United States
The United Kingdom stands out with several favorable structural differences affecting life insurer performance. For instance, the UK life insurance market’s product offering more closely resembles an asset management market than a traditional life insurance market, and players in both the United Kingdom and the United States typically have a much lower share of high-guarantee savings products in their portfolios compared with Continental Europe.
In the United States, mature closed-book market consolidators have achieved significant scale, reducing in-force policy operations costs by 22 percent and technology costs by 41 percent. This trajectory of total cost reduction is visible across many players after the deal has transpired, though such deals have not consistently translated into higher investment margins.
Developing markets: Continental Europe
In Europe, the operating model of consolidators is often fully focused on the management of closed books. In the less mature German market, consolidators have managed to reduce costs after the acquisition of closed books, though so far the effects have been less visible than in more mature markets.
Based on their operating models, closed-book consolidators seem positioned not only to pull a broad range of performance improvement levers but also to translate the effects into stronger overall performance—beyond even the individual improvement of isolated levers. Moreover, they can profit from a management team fully dedicated to improving closed-book performance, which is rarely the case at traditional life players with broader strategic agendas.
There is some early evidence that closed-book consolidators can indeed outperform traditional life players and achieve a broader and more sustainable performance improvement. In our experience, insurers can increase the value of a closed-book portfolio, gaining three to five percentage points on ROE, and adopt a tailored retention scheme for the closed-book management team.
Download Running up on runoff: Strategic options for life closed books, the full report on which this article is based (PDF–1.1 MB).