SCALING ANNUTITIES.

The benefits of size in variable-annuity manufacturing begin to accrue when a company crosses the threshold of about $1 billion in sales and $5 billion in assets. So why aren't the largest players winning a bigger share of the market?

Given the slow rate of growth in most life insurance product lines, the fast-growing variable-annuity business continues to attract new entrants to the marketplace. Variable-annuity sales grew from $20 billion in 1991 to an estimated $115 billion in 1999, and based on Tillinghast-Towers Perrin's latest VALUE survey, about 80 carriers are offering several hundred variable-annuity products. Although the number of entrants is slowing, the market remains highly competitive.

In their quest for profitable growth, annuity carriers frequently want to know what level of sales and assets are needed to realize the benefits of scale. Based on two Tillinghast surveys and recent consulting experience, two types of scale emerge as contributors to competitive advantage in the marketplace. The first is distribution scale, which is the relationship between sales volume and the cost of wholesale distribution. The other is manufacturing scale, the relationship between in-force contracts (or assets under management) and the cost of product manufacturing and maintenance.

Fewer than half of the players in the variable-annuity market have the necessary manufacturing or distribution scale to produce reasonable returns in the long run.

As the market has matured, three distinct tiers of players have emerged, each with their own issues and challenges:

* Independent market leaders such as American Skandia Life Assurance, Hartford Life Inc. and Nationwide Financial Services are focused on maintaining or expanding market share in the independent distributor channel and leveraging their annuity franchise into related product lines, like mutual funds and variable life.

* Career producer companies such as American Express Financial Advisors, New York Life Insurance Co., Guardian Life Insurance Company of America and Massachusetts Mutual Life Insurance Co. are focused on protecting or expanding market share within their career producer systems in the face of increasing pressure from nonproprietary products. Many of these companies also are seeking to develop supplemental channels, following Equitable Life Assurance Society's lead.

* New and emerging players, which represent the bulk of annuity carriers in today's market, are looking to increase their sales rapidly to achieve scale and, ultimately, top-tier status.

Although many issues are similar for players in the career and independent distributor channels, the focus of this discussion is on independent manufacturers.

Distribution Scale

An annuity carrier's wholesale distribution function includes both its field wholesalers and related sales/marketing functions, such as internal wholesalers, sales management, administrative support, marketing and sales promotion and the sales-support desk. While annuity companies sometimes outsource their wholesale distribution function, increasingly the trend has been to perform the function internally to increase control and accountability and, hopefully, reap the benefits of increased sales volume. In pricing variable-annuity products, the allowance for these distribution costs typically falls in the range of 100 to 140 basis points of premium.

While some expense components of the wholesaling function are mostly variable in nature, such as wholesaler overrides, other elements of the expense structure are fixed or semi-variable. For example, technology infrastructure, sales-support desk staffing, national and key accounts function, and sales management all should be scale-sensitive by virtue of their expense behavior.

In Tillinghast's 1998 Wholesaling Effectiveness Survey, participants provided a wide range of wholesaling costs, from a low of 50 basis points to a high of 185 basis points; the average was 115 basis points. The unit cost of wholesaling declined with sales volume, exhibiting a very distinct scale effect. For companies in the survey with less than $1 billion in sales, the average cost of wholesaling was 140 basis points, compared with 85 basis points for those companies with greater than $1 billion in sales. Although the sample size of companies is not large enough to further refine the size segmentation, differences in the cost of wholesaling increase even more when the smallest companies are compared with the largest companies.

Achieving scale in distribution provides companies with many financial and strategic advantages in the marketplace. From a purely financial perspective, a distribution cost advantage of 50 basis points translates directly into an increase in return on equity of nearly 1.5%. The strategic advantages of distribution scale also are compelling and ultimately should translate into enhanced future profitability. From a strategic perspective, all or a portion of the "scale dividend" is reinvested in the business rather than taken as additional profit. This investment may take a number of forms:

* increased product competitiveness by lowering charges or adding features;

* increased technology investment in the wholesaling operation to improve service levels and cost efficiencies;

* increased size of the wholesaling force, both to deepen relationships with existing sales representatives and to develop relationships with new representatives; and

* increased investment in targeted distributors through seminars, attendance at conferences and dedicated key-account representatives to improve product visibility and shelf-space positioning.

Annuity companies are using both the profit-taking and reinvestment approaches to varying degrees. Companies appear to be pursuing two primary strategies. The first is to leverage distribution scale to manage overall wholesaler compensation. As wholesaler sales volumes increase, the compensation-override formula is reduced, thus decreasing unit wholesaling costs and increasing distribution profits.

The other strategy, by contrast, seeks to maintain wholesaler formula overrides, with less emphasis on significantly reducing the cost of the wholesale distribution function. Any additional "profit," therefore, would be earmarked for reinvestment. This approach results in higher levels of wholesaler compensation, with a favorable impact on wholesaler retention. The important advantage that distribution scale provides is the flexibility to make choices about how to realize value from distribution scale.

Manufacturing Scale

An annuity company's manufacturing functions include product development, issue, customer service, policy administration and related maintenance functions. For purposes of this discussion, it also includes overhead functions, although arguably overhead supports both the distribution and manufacturing function and should be allocated accordingly. While companies have the ability to outsource manufacturing functions and make their costs more variable, most perform these functions internally. Typical pricing allowances for these functions, including overhead, are $70 per policy in force, plus $150 per policy issued.

Even more than the wholesale-distribution function, annuity-manufacturing operations should produce scale benefits. Very few of the manufacturing costs are purely variable in nature, with the higher cost functions such as the people and technology-intensive customer-service and policy-administration areas being largely fixed or semi-variable.

Tillinghast's 1999 Annuity Expense Survey examined the impact of scale on unit-manufacturing costs. The survey group was divided into two categories--those with greater than $6 billion in variable-annuity assets and those with less than that amount. The impact of scale can be observed for manufacturing costs associated with both issuing policies and maintenance/overhead. The survey found that:

* Issue costs are about $130 per policy issued for the large companies, compared with $163 per policy for the smaller companies, a 20% cost advantage for the larger companies. Interestingly, when the group of smaller companies is further divided between those with greater than $2 billion in assets and less than $2 billion in assets, no meaningful cost differences emerge. This suggests that there may be a scale threshold for issue costs.

* Maintenance and overhead costs are about 26 basis points of account value for large companies, compared with 37 basis points for smaller companies, a 30% cost advantage for the larger companies. Examined from the perspective of contracts in force, a similar cost advantage emerges for the larger companies. Much of this cost advantage accrues from lower overhead expenses rather than lower maintenance expenses. Again, there is no scale advantage observed between companies with more than $2 billion or less than $2 billion in variable-annuity assets, suggesting that there is also a scale threshold for maintenance and overhead expense.

As with scale in the wholesaling function, the actual competitive advantage associated with manufacturing scale is probably understated. Those companies with large bases of variable-annuity assets and contracts in force are making the same choices about profit taking vs. reinvestment on the manufacturing side. For instance, it appears that large companies are reinvesting their maintenance scale dividend in technology to build future competitive advantage. Again, scale allows them this strategic and financial flexibility.

What's Wrong With the Picture?

If scale provides significant competitive advantage in the marketplace, larger players should have a growing concentration of market share. But the market share of the top-10 annuity sellers reached its peak in 1993 and has been falling since then. Although the roster of top-1 players has changed during this time period, the 52% market share of the top-10 writers is the same today as it was in 1991. While the market share of the top 20 has increased from 65% in 1991 to 77% as of June 30, 1999, it has remained essentially flat since 1993.

So what is going on here? A number of dynamics seem to be affecting the market. Most players today appear to be focused on sales and revenue growth rather than profits. This is particularly true for new and emerging players. Given the observed scale requirements of the variable-annuity business, a significant number of smaller annuity carriers probably are not achieving their profit targets. Additionally, in recent years, companies have benefited from the extremely favorable capital-market performance, which has produced better-than-expected revenue gains and potentially masked expense overruns.

To get the attention of distributors, many smaller companies are forced to price their products at market rates and design products with state-of-the art features. As a consequence, many of them are unprofitable and will find it extremely difficult to achieve their profit targets, although most are generally optimistic about doing so. The attractive growth rates in the variable market coupled with the strong demand in the field for variable products have left many companies feeling they have little choice but to enter the market.

Shakeout Coming

The benefits of scale begin to accrue when a company reaches the thresholds of about $1 billion in sales and $5 billion in assets, although the bar appears to keep getting higher. The largest players are likely to have even greater scale advantages.

In 1998, only 40% of companies achieved $1 billion in variable-annuity sales, with 29 companies producing fewer than $500 million in sales. On the manufacturing side, less than 50% of the companies had at least $5 billion in assets, and at least 24 companies had less than $2 billion in assets.

While some of these companies ultimatcly may grow and achieve scale, many will not. These companies simply will be unable to produce reasonable returns for their shareholders and policyholders.

Meanwhile, the market is becoming more demanding. Distributors continue to exercise their power, demanding more investment in technology, sales support and revenue sharing from annuity manufacturers. At the same time, manufacturers who do not offer significant sales and asset volume are faced with a greater challenge in negotiating fee-sharing arrangements with their investment advisers. In short, the current situation seems untenable in the long run for many subscale competitors.

A shakeout in the variable-annuity market has been predicted for several years, but it has not yet occurred. What is likely to cause such an event? A change in the economic environment is likely to have the greatest impact on the variable-annuity market. A sustained rise in interest rates and/or an equity-market correction would depress not only sales but profits, as fees linked to account values fall faster than expenses. Another possible scenario would be a change in the tax or regulatory environment. In such an event, many of the marginal variable-annuity players are likely to conclude that remaining in the market is not worth the investment. This would create further consolidation through acquisitions or simple competitor attrition. Such an event also may cause companies--particularly smaller companies with a career agency force--to examine alternative business models, such as strategic partnerships to private label annuity products. Or it could lead to the creation of more "virtual" annuity companies, w here most manufacturing and distribution functions are outsourced.

Difficult Choices

Companies in the variable-annuity market face difficult challenges and choices despite an ideal environment for variable-annuity sales. With the majority of companies below minimum-scale threshold for the variable-annuity business, prospects for the future are uncertain.

Companies must scrutinize their variable-annuity business and determine whether they are likely to achieve necessary scale and profitability in a market where scale is increasingly demanded. Meanwhile, companies that have achieved scale must determine how they can use that scale to further improve their positions.

The time for this critical re-examination is now. By waiting for a shock to the system to force strategic choice, annuity companies may lose the flexibility to shape their futures.

John Fenton and Eric Speer are principals with Tillinghast-Towers Perrin.