As good as it gets? Hard work lies ahead if life insurers are to build on the foundation of recently improved results.

Life insurers are celebrating the best performance figures seen in more than a decade. Is this "as good as it gets" in the life industry? To see what lies in store for the industry, let's take a look at some of the key challenges it faces:

Growth and Strategic Focus: From 1998 through 2003, industry assets grew at a rate of about 6% annually, or about 3% real growth--no mean feat for a mature industry. But with two-thirds of industry assets in fixed and variable annuity products, asset growth has been driven by the annuity business, which has been growing about 1%, faster than life assets. Any premium growth also has been in the annuity area. It has been many years since the industry last saw any growth in total life premium income.

As further evidence of the dramatic shift into the asset management business, primary carriers are retaining much less risk and are earning lower mortality margins than in the past. In 2003, fully 60% of the industry's new life business was reinsured, compared with 25% only eight years ago.

The message is clear. The industry is fundamentally an asset gatherer and investment manager. Without significant change in its business model, the life industry will have trouble overcoming its characterization as a mature, low-growth business challenged to compete with the best financial institutions.

Cost Levels: General expenses as a percentage of assets under management have improved modestly in the past five years. But based on the expense levels of top-quartile performers, insurers will need to reduce cost levels by at least another 40 basis points to ensure competitive products. Clearly, much excess cost still needs to be wrung out of the system. In particular, it will be very hard for insurers to be profitable at existing acquisition expense levels.

Value Creation: After limping behind the returns on equity of other financial institutions, life industry ROEs in 2003 were the highest they have been in a decade. But insurance executives need to consider how they can maintain or improve this performance while growing their business.

In this context, what do the capital markets have to say about life company performance and value creation? In a three-year study of stock market valuations, Ernst &Young has identified the main drivers of capitalization as the vitality of the life business, the proportion of life and annuity business, cost levels and profit margins. We found that:

* The shift from life to annuity business is not creating value for the industry. Investors appear to prefer a balanced life and annuity business model, one not overwhelmed by the thin, volatile margins of the annuity business.

* The market closely watches cost levels and penalizes companies that are unable to reduce operating expenses to competitive levels.

* Profit margins, naturally, must be improved to boost shareholder value.

The industry's ability to build shareholder value in the future depends on how it addresses critical questions in two key areas:

Strategic Focus: Can the industry compete with pure asset managers over the long term, given its high-cost acquisition methods, heavy back-office costs, and more oppressive regulatory structure? Or should life insurers focus on growing the life business and other underwritten products?

Profitable Growth: How can insurers grow assets under management and at the same time widen profit margins? Growing the life insurance business is desirable, but demographics are running against the industry. Individual insurers will prosper by taking market share or by penetrating underserved markets, but for the industry as a whole, focusing on the coming need for post retirement products and services is likely to be a more compelling business strategy.

Also, while some may look to mergers and acquisitions to maintain growth, the outlook for transformational deals seems limited, since few major life companies, other than the former mutuals, remain independent. Acquisition successes are more likely in the specialized or niche product and market area, and in transactions that emphasize the acquisition of quality, low-cost distribution.

The industry should use its time in the sun to establish a solid foundation for future growth and profitability. The next few years will show whether life insurers can rise to this challenge and remain a critical part of our financial system,

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young. He can be reached at [e-mail].