Life After the IPO.

Adapting to the pressures of a capital-markets environment is critical for demutualized life insurers.

Going to the capital markets cap in hand is a whole new experience for recently demutualized life insurers. And the influence of the capital markets does not end after the initial public offering. Two decades ago, insurers in all lines depended less on outside sources of capital. But now that access to capital has become a principal strategic issue, focus on the capital markets is a necessity.

In today's competitive environment, recognizing the capital-market pressures resulting from the rapidly consolidating and converging global insurance market is crucial for U.S. insurers. The U.S. market, regulated by 50 state insurance departments, remains unusually fragmented, but forces beyond the scope of state regulation are driving consolidation and restructuring throughout the financial-services industry. The importance of size and scale as factors in both access to capital and cost efficiency magnifies the need for market sophistication.

For commercial and industrial companies that already compete for investor capital, increasingly stringent market requirements are old news; companies that fall by the wayside fending off tougher competition are the stuff of finance texts. But the number of insurers that are at home with the market criteria and performance standards commonly applied to all sectors is still small. Thus, while many in this industry recognize their competitive vulnerability with regard to revenues and growth potential, few realize that competition for capital is equally important.

The reorientation of company focus on market sensitivities, common standards of measurement and performance criteria has nonetheless had a dramatic impact on the industry. Major players have withdrawn from life and annuity markets. And within the past decade, traditional multilines have virtually disappeared. Meanwhile, the importance of European financial institutions as potential consolidators has risen dramatically relative to U.S. competitors, which have been held back by their fragmentation and insulation from market influence.

The long-awaited conversion of the largest life mutuals will further accelerate change, causing insurers in all industry sectors to feel the effects of greater influence from capital markets. Looking to the future, insurers will be confronted with higher performance standards, changing criteria for success and expanded competition for capital resources. And the relative lack of attention to other critical factors in the evolving landscape--changes in accounting standards and transparency, conflicts in stakeholder interests and the weakening of regulatory influence--in no way lessens their importance. Focusing on current capitalization ratios, without understanding the extent to which the market-oriented nature of capital has become a critical aspect of the competitive scene, can potentially weaken the industry as much as any other competitive disadvantage.

Insurers face an unenviable task as they try to understand industry trends and the intensity of the environment in which competition for capital takes place. Because of their lag in experience, they must focus on the threats to the core underwriting franchise simultaneously with developing a new set of criteria and performance standards for the industry. This implies acquiring sophistication as to the actual process of capital competition. They must understand that, just as operational efficiency and skillful execution are needed to sustain growth and increase profits, demands for capital efficiency (as measured by relative returns on equity) expand the scope of capital management and strategy. Both are needed to prosper.

Traditional financial strategies that favor the preservation of financial strength but ignore the associated cost can leave companies vulnerable to loss of value and momentum. For an industry whose experience in the capital markets has been limited primarily to investing premium cash flows, the challenges of adapting to this new world should not be underestimated.

It is imperative for insurers to become familiar with the standards of performance in capital markets and the different types of financial markets and their participants. They must begin to discriminate among different groups of stakeholders while working toward more transparent disclosure to facilitate better understanding of the industry in the investment community. If insurers vie for capital resources without addressing these issues, they will find it difficult to compete on a level playing field with other financial-services providers. Only when insurers begin to understand that investors are as important a customer base as policyholders and distributors, will they be ready for the 21st century.

Robert W. Stein, a Best's Review columnist, is chairman of Global Financial Services for Ernst & Young, New York.