Healthy shrinkage: the number of U.S. life insurance companies has fallen over the past decade by nearly half, a change that is probably for the better.

The United States was once home to 2,343 life insurance companies. That peak occurred in 1988, according to the American Council of Life Insurers. Since then, a major trend of life companies has been to consolidate. By 2004, the number had fallen by 50% to 1,179.

It is a trend that is widely known, but it doesn't mean that the industry is crashing. True, the number of new policies issued also has declined each year, but annual premium continues to grow. Mostly, the declining number of insurers reflects a different kind of entrepreneurial spirit--the ability of insurance executives to recognize merger and acquisition opportunities in their markets, to cultivate deals and to integrate the acquired businesses or companies. Successful mergers or acquisitions lower costs, improve competitiveness and expand distribution.

The consolidation process has been slow, according to Michael Ryan, insurance sector leader for transaction services at KPMG LLP and author of a recent report on mergers and acquisitions in the global insurance industry. "Experts have been predicting consolidation for the last decade, and it's happened to some degree, but it's been a lot slower than anybody's predicted."

What drives consolidation in the United States? The main factor is that there is less opportunity for pure organic growth because the life market is mature, said Ryan.

"There is much more parity and less differentiation between products, and the products available are from a broader range of companies," he said. "Because of that, the mergers and acquisitions will continue. They're really going to have to because a small to medium-size life company that doesn't have a market differentiator will need the size and scale to compete."

It is also a healthy trend, said Ryan. "The trend is clearly one of reduction of costs and the ability to distribute products in different ways," he said. "It's a much more competitive market, which is good for the consumer and good for the industry. "The trend has pushed insurers to offer better and more varied products, to tailor them to consumers, and to find new ways to meet consumer needs, he said. And lower insurer costs have driven down product prices, he added.

But Ryan also said that some insurers will continue to find and exploit opportunities in niche markets, probably more through advantages in distribution and service than through product differentiation. Larger companies have greater flexibility to experiment with alternative distribution sources, while smaller companies typically have unique distribution with less room to experiment, he said.

Effective Consolidators

Effective buyers of businesses or companies don't rely on chance, circumstance or opportunism. Instead, successful companies assign key staff members to work at M&A as part of their everyday duties. The Lincoln National group of companies, for example, maintains a staff of five people headed by Barbara S. Kowalczyk who monitor publicly traded companies or blocks of businesses Lincoln might want to acquire. Using publicly available financial information, they monitor the direction of strategies and stay in touch with people in the industry, said Kowalczyk, senior vice president and director of corporate development.

"I find that patience in the M&A market is always a good thing," Kowalczyk said. "Finding the right partners, the right blocks of business, and being able to execute that transaction is a difficult process. There are lots of insurance companies out there, lots of asset managers, but finding the right field that aligns with your strategy, a partner that wants to do a transaction, and then actually executing that and integrating that transaction, is a complex process."

Indeed, Lincoln's purchase in April of the Jefferson-Pilot group of companies followed several years of discussion between the two companies, Kowalczyk said. The transaction was valued at about $7.3 billion. And Kowalczyk recalled visiting a chief financial officer several times over a three-year period in the late 1990s about a transaction. "Finally that seller got to a point at which it was ready to sell, and we were ready to buy, and the stars matched up, and we were able to do a transaction," she said. "So when I said M&A people need to be patient, sometimes what you'd like to accomplish takes some time."

Kowalczyk said the Jefferson-Pilot acquisition was so large that her group is in the process of developing a new M&A strategy. "We had spent the last 10 years focusing our company on the businesses we wanted to be in, so we had divested businesses and we had bought businesses," she said. "Now that we have merged Jefferson-Pilot into the family, we are in different businesses, and we have different business leaders.... So we're taking a hard look at our enterprise strategy, at how we make sure that Lincoln Financial Group has the products, distribution, brand and service that will make us a real competitor in the baby boomer market."

The acquisition/merger is likely to have a lasting significance in several ways. One is that it makes Lincoln larger and should provide a foundation for future growth, Kowalczyk said. Another is that it brought to Lincoln a large portfolio of fixed products that will balance Lincoln's portfolio of variable products and provide a buffer against interest-rate and stock-market volatility. And the integration of the companies has brought more talent to the organization, she said.

Integration also brings big challenges to any merger. Kowalczyk said integration planning was in progress even as the companies announced their intentions to merge in October 2005. At that time, Lincoln announced where senior-level executives would be deployed. "Since closing in April, the senior leadership team has met about every week on integration and has accomplished a great deal," she added. "But I will always tell you that getting onto the same ledger system and reducing the number of administrative platforms to whatever number of single digits you would like to have at some point takes several years.... It also helps that both Lincoln and Jefferson-Pilot have done a number of transactions, and we have people in both of our organizations who are skilled at integration and executing on those plans."

Having a team attuned to the industry and in touch with the leadership of other companies can translate into being ready when an opportunity arises. Social issues are always important, and timing is important in transactions, said Kowalczyk. "You might be at a point where someone is looking for some talent in a particular area, or at times it happens because a CEO is ready to retire or take on a different role," she said. "Especially in large transactions, when many times it's CEO to CEO negotiating the major parts of a transaction, they have to be on the same page on what roles they're going to play in the new organization. You can't have two CEOs. So those are things that have to be worked out early on, at least among a few people, so that you can start having that conversation about how you bring the businesses together."

Of course, once Kowalczyk's team is in deal mode, she brings in corporate and human-resource officers and reaches out to leaders of the different business lines to be part of the team. Also, depending on the size of the deal, she uses outside vendors such as investment bankers, actuarial consultants and law firms to help make the deal happen.

Growth and Contraction 

The urge to merge--and the development of the necessary skill sets--was not very strong in 1987, when Robert D. Shapiro formed The Shapiro Network after more than 21 years in insurance-industry consulting and investment banking. The network brings together resources from various companies and professions to help insurers with strategic planning, mergers and acquisitions.

"What I could see then was a lot of denial in companies," he said in reference to a broader context than just mergers and acquisitions. "Strategies were developed because the boss wanted to see strategies, but often strategies weren't followed, and they rarely drove the activities of the company." That proved frustrating to Shapiro "because I never saw enough of it come to fruition in a way that I felt I actually made a significant contribution."

That has turned around in recent years. "Where I have had more fun ... is where companies hit a wall, and there's a mandate to turn around," he said. "So that sense of urgency creates a will to actually do the tough things and change what the company is doing."

In that context, the shrinking life industry is a healthy development. "It makes companies more competitive and creates some scale," he said. "Many smaller companies can't compete. If they keep traveling the path they're on, they're often going to wind up as a desperate seller or worse. At some point, a company can't expect to sell business at the pricing of other companies that are hundreds of times larger." Small companies are also more prone to mistakes, he said. "You don't have as many people and as many resources to look at pricing, mortality and persistency. It's too easy to bet the company in trying to grow, but not even realize you're betting the company." When Conseco and General American collapsed, for example, no one was paying enough attention to this risk, he noted.

Despite the shrinkage since 1988, the U.S. life industry is still considered by most to be highly fragmented. That condition stems from the middle decades of the 20th century, when many insurers were forming, Shapiro said. At that time, capital requirements were much less than today, risk-based capital had not been formalized, and companies were easier to start. In havens such as Arizona and other states, companies could be started for $30,000 or $40,000, he said. Many newly formed insurers were regionals.

In the early 1960s, entrepreneurs, often sales people, started up companies. Existing companies formed subsidiaries to handle separate business lines, and companies in other businesses formed life insurers, Shapiro said. According to ACLI data, the number of life insurers tripled between 1950 and 1980. During that period, many companies had their own "captive field force," Shapiro said. The game started to change in the 1970s, when brokers began to sell life insurance and cull producers out of career-agency companies.

So competition--from brokers and other companies more focused--now makes it tougher to start and run companies, Shapiro said. And the mutual companies that didn't have much pressure on them 50 or 60 years ago have found themselves competing with companies using newer kinds of distribution, companies with expenses of half or a third of what high-cost companies had to bear, he said.

Current healthy life companies include those with scale, Shapiro said. Among them are companies such as MetLife Inc., Prudential Financial, and now even Lincoln with the Jefferson-Pilot acquisition. Then there are companies that fall into the category of "efficient, specialized, low-cost machines." Shapiro includes Northwestern Mutual Life in that category. "It's focused on individual life insurance," he said. "It doesn't sell group insurance or health insurance. It has incredible scale and focus. It's a simplified business, it's basically one business, and it has career agents. It's an unusual situation because its business model is tough for anyone else to replicate."

Niche companies are exemplified by Aflac (American Family Life Assurance Company of Columbus) and Thrivent Financial, Shapiro said. He predicted that 10 years from now, life insurers able to sell to middle-income Americans will often come from companies outside the life business, such as mutual fund and health-care organizations, that will broaden their platform for their controlled customers from another related financial-services business. "In a sense, they'll be able to start without all of the legacy bureaucracy a lot of the life companies have, and then build the right kinds of things to serve their customer base," he said. "It ties into my theory that there's a lot more distribution being built outside of what we usually count."

Strategy and Execution

Ryan of KPMG said the companies in the best shape can be either small or large, provided they understand what they do well and what their market is. The larger companies have a greater ability to spread their profits and operations over a larger base and therefore are better prepared to weather any economic storms, but they also have a tendency to move more slowly. A smaller company that stays true to its market can do very well. "It's the ones trying to be all things to all people that struggle the greatest," he said.

Thirty-year industry veteran Jay Novik, however, is skeptical about the value of mergers and acquisitions. "We have looked at a few deals, but found them to be overpriced," said Novik, a partner in Black Diamond Capital Partners, an actuary and an active investor in insurance ventures. "M&A per se has been neither positive nor negative to the U.S. business. There have been some acquirers that have been less than careful in their operational controls. The highly competitive environment in the U.S. life business overshadows the impact of M&A."

Consolidation has had and will have a major impact on the life reinsurance business, but not on life insurance, he said. "There have been waves of consolidation in the past followed by breakups and sales. I do not see a fundamental change in the competitive environment in the near future."

Key Points

* The 18-year trend toward mergers and acquisitions is generally considered positive for the life industry, although transactions must be evaluated on a case-by-case basis.

* The quality and vision of management plays a big role in successful M&A activity.

* Identifying, executing and integrating acquisitions is a skill set that insurers can develop.

* The pressures of a mature life market in the United States drive companies toward consolidation.

The Urge to Merge (or Buy)

While the number of mergers and acquisitions has fallen short of some expectations, some recent transactions have been large.

MetLife Inc.

What: Bought Travelers Insurance Co., Travelers Life and Annuity, and Citi Insurance International from Citigroup

When: July 1, 2005

Price: $11.8 billion

Brief: MetLife gained scale and distribution; Citigroup continues divestiture of insurance-related businesses

Lincoln National Corp.

What: Merged with Jefferson-Pilot Corp.

When: April 2006

Price: $7.3 billion

Brief:. Both businesses gained scale, distribution and diversification of product lines

Manulife Financial Corp.

What: Merged with John Hancock Financial Services Inc.

When: April 2004

Price: 100% share exchange worth about $11 billion

Brief: Both businesses gained diversification of product lines and distribution; Hancock lends potent brand name

Prudential Financial

What: Bought American Skandia variable annuity business

When: May 2003

Price: $1.3 billion

Brief: Instantly provided product and third-party distribution

What: Bought Cigna retirement business

When: April 2004

Price: $2.1 billion

Brief: Prudential expanded core retirement-savings business; Cigna focused more on its health-insurance business

What: Bought Allstate Financial's variable annuity business

When: June 2006

Price: $591 million "initial investment"

Brief: Boosted Prudential to third-largest provider of adviser-sold variable-annuity products; provided access to Allstate's proprietary and nonproprietary distribution

Protective Life Corp.

What: Year 2006 acquisitions include Western General's vehicle extended-service contract business (terms undisclosed) and J.P. Morgan Chase & Co.'s life insurance and related noninsurance businesses ($1.2 billion in cash). Sixteen previous acquisitions since 1990 totaled $723 million in capital.

Brief: Protective's Acquisition Division is one of five. It has demonstrated success in deploying excess capital for acquisition and effective integration of whole companies or blocks of business.

Learn More

Lincoln National Life Insurance Co.

A.M. Best Company # 06664

Distribution: Independent agents, brokers, banks and wirehouses

Jefferson-Pilot Life Insurance Co.

A.M. Best Company # 06928

Distribution: Independent general agents, national account marketing firms, career general agents, home service, broker/dealers, financial institutions

For ratings and other financial strength information about these companies, visit www.ambest.com.

[GRAPHIC OMITTED]

Insurers' Taste for Acquisition

Domestic and Cross-Border
Deals Globally

Domestic deals accounted for
about 75% of all deals over the
past four years.

                 Cross-border    Domestic

2000    765           33%           67%
2001    714           35%           65%
2002    574           24%           76%
2003    598           18%           82%
2004    618           23%           77%
2005    574           27%           73%

Impact of Acquisitions
On Shareholder Value
In the Past Three Years

Was the acquisition process worth
the effort? Respondents to the
KPMG survey mostly said no, at
least during the first three years.

Increased substantially    12%
Increased slightly         17%
No changed                 24%
Decreased slightly          5%
Decreased substantially     1%

Acquisition Plans Over the
Next Three Years

A higher proportion of European
insurers versus North American
insurers have been acquisitive
over the past three years, and
they intend to be over the next
three years. Asian companies
responding to the survey
expressed more interest in
organic growth.

                                 North
                                America    Europe    Asia-Pacific

M&A not part of the strategy      26%        26%          48%

No current plans but would
consider acquiring
if an opportunity arose           58%        44%          29%

Actively seeking companies to
acquire                            9%         25%         14%

Source: KPMG May 2006 study,
Run for Cover? Study includes all
kinds of insurance companies, not
just life insurers.

Note: Table made from bar graph.

GETTING TOGETHER: Michael Ryan, insurance sector leader for transaction services at KPMG LLP and author of a recent report on mergers and acquisitions in the global insurance industry, says consolidation has been slower than predicted.