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The insurance industry: navigating the sea of change.

U.S. FINANCIAL institutions of all kinds have been buffeted by profound economic and regulatory shocks during the past two decades, and the insurance industry has been no exception. As this process has unfolded, the distinctions among financial institutions have become blurred, and the financial sophistication of individuals and corporations has increased. Intensified competition has also led to additional risk-taking by many financial institutions with varying adverse effects among the major segments. Finally, preserving and accumulating capital has become a more acute issue for all U.S. financial institutions, including insurers, as its renascent role as the first line of defense against failure has become more sharply defined.

This report highlights the evolution of the products and services offered by the insurance industry, and the economic forces that are driving this evolution. It also looks ahead to probable future changes in the products and services of insurance companies, as they navigate the sea of change. Particular emphasis will be placed on changes in the industry's product mix, and the pricing and the distribution system for those products from the perspective of the buyers of insurance services. These buyers include both individual and corporate purchasers of life, health and property and casualty insurance products.


This heterogenous industry offers a wide range of products and lacks any significant concentration |Greenless and Duggan~. A general breakdown of its products include: (1) premium-based products, such as life insurance, annuities, and health insurance; and (2) fee-based income sources. The latter includes, for example, third-party management of pension funds.

Significant changes were observed in the life-health industry's product mix during the 1970s, the 1980s and the early 1990s. Frank Schott provides a detailed review of the evolution of this sector of the industry in the next article. In this article, we highlight the industry's product evolution to date, which can best be seen in the changes in its revenue sources over the past thirty years. Among the premium-based revenue sources, income from life policies eroded in relative importance as interest rates rose during the 1960s and 1970s. This reflected a move away from "whole life" polices and toward "term" policies during the 1960s and 1970s. That substitution was motivated, mainly, by consumer disaffection with the returns offered on whole life policies compared with alternative investments |Greenless and Duggan~.

Table 2

Life Insurance Purchases in the U.S.
(Hundreds of Thousands)

 Ordinary Group Industrial Total

1960 8.734 3.734 12.287 24.755
1970 10.968 5.219 7.582 23.769
1980 14.750 11.379 2.878 29.007
1988 15.579 15.793 0.217 31.589
1989 14.694 15.110 0.156 29.960
1990 14.066 14.592 0.133 28.791
1991 13.471 16.230 0.112 29.813

 Variable Universal Universal
 Life Life Life

1983 0.178 1.185 -
1984 0.223 2.551 -
1985 0.186 3.545 0.101
1986 0.200 3.949 0.259
1987 0.205 3.726 0.410
1988 0.124 3.508 0.343
1989 0.074 3.437 0.320
1990 0.058 3.058 0.345
1991 0.105 2.659 0.329

Source: American Council of Life Insurance, 1992 Life Insurance
Fact Book

In short, the buyers of life insurance products "unbundled" the traditional life insurance package. The pure insurance portion was redirected toward low-cost term insurance products. What was previously the investment portion of whole-life policy premiums exited the insurance industry for higher yielding alternatives such as Treasury securities, the so-called money market certificates offered by Banks, and the emerging money market mutual funds (MMMFs).

Then, in the early 1980s, the industry responded with the introduction of new products that combined insurance products with redesigned investment products. Thus, the investment portion of the newly combined products offered performance-based yields. The popularity of these hybrid products, particularly the universal life policy, was significant, and it helped to stem the erosion of premium income. Nonetheless, the relative importance of whole life premium income continued to slip for the remainder of the 1980s.

However, the new performance-based yield products did slow the growing importance of simple term policies, and the market share of term policies peaked at 60 percent of the face value of all new life policies in 1982, compared with about 40 percent in the 1960s. The dollar market share of new term policies then declined, dropping back to 45 percent in the mid-1980s |ACLI~. Since 1988, however, the popularity of term insurance has again increased, reaching 50 percent in 1991. This renewed interest in term insurance probably again reflects unbundling by the users of insurance products as interest rates fell in recent years. Better yields can now be achieved through more direct investment vehicles, such as mutual funds investing in equities, while term insurance still provides the cheapest form of pure insurance.

As whole life insurance premiums have declined in relative importance, annuity premiums have gained. Annuity premiums represented nearly one-third of all revenues in 1990, including both individual and group annuities. (Note: the

sharp drop in 1991 probably reflects, mainly, the effects of the failure of Executive Life.) Individual annuities are designed to supplement retirement income |Greenless and Duggan, and Schultz~, while group annuities are typically purchased by pension funds.

For many, individual annuity accounts are becoming an increasingly significant source of potential retirement income. All holders of annuities benefit from the tax-deferral feature applied to the investment income from annuities. Some (e.g., those employed by nonprofit firms and institutions) also achieve a further tax benefit through 403|b~ plans because the initial investment also reduces taxable income in the year that the annuity is purchased |Lavine, Schultz~, up to a statutory limit of just under $10,000.

Here too, however, evolutionary change is well underway. First, insurer risk has emerged as a major factor. The year 1991 saw a sharp drop in annuity premium income, mostly attributable to the failure of Executive Life. Second, competition may intensify; for example, banks are becoming important providers of annuities, just as they have expanded into the mutual fund business.

Health insurance premiums, the third source of premium income, has also trended downward during the past decade, as a share of total income. Because health care evolution has been covered in the April 1993 issue of this journal, we will not devote much attention to that product here. However, the outcome of health care reform will surely have a major bearing on the insurance industry as a whole.

Finally, the industry has experienced a slight increase in the relative importance of "other income". This largely reflects the rising role of insurance companies in the third-party management of pensions. However, this involves fee income only, as no premium income is normally generated in these activities.


This industry also has two key segments: personal and commercial.

Two well-known features have made the commercial segment a particularly risky business: the underwriting cycle and the ease of entry and exit |McGee, Huffman and Bernstein, USDC~. In a companion article in this issue, Hollman, Hayes and Burton review the industry's underwriting cycle. They also explain how the interaction of the underwriting cycle and the investment income cycle contributed to the deterioration of the financial health of the P & C industry during the 1980s. The ease with which capital can enter the industry also exacerbates its cyclical characteristics. When premiums are at the high point of the underwriting cycle, capital rushes in, setting the stage for excess capacity and a predictable plunge in prices and premiums collected |McGee~.

The personal segment, in contrast, has traditionally been viewed as being subject to less intensive competitive pressure. However, even here the industry has recently experienced problems stemming from increasingly costly claims and litigation trends, particularly in automobile insurance. In response, a number of states have passed ill-conceived legislation limiting premiums.

More recently, a succession of spectacular natural disasters has also pummeled the industry. Where these have occurred, the failure rate has been high, to say the least.

Looking ahead, buyers of property and casualty insurance products will likely see several developments unfold. P & C insurance will almost certainly cost more in the future |DeMott~, and deductibles will likely be higher.

So far, premium rates have failed to surge, though they are moving up. These rather mild increases are surprising in light of the staggering underwriting losses now hitting the industry. Some observers believe such small rate increases are still reflecting excess capacity, while others see it as the product of one-time gains flowing from the sharp decline in bond rates over the past year or two |DeMott, Schroeder~.

Possibly the most important issue is the P & C insurers' survivability, i.e., will the insurance company be around when the time comes for their claims to be paid |Harrell and DeMott~?

While all issues are important, the latter ought to be the most important consideration to business buyers of property-casualty insurance. Aggressively priced premiums are a common phenomenon in this industry |McGee~. Such premiums may be cost effective in the short run, from the buyers perspective, but this must be balanced against the carrier's survivability.

Capital and reserve levels are important ingredients in assessing survivability. Also important is the length of the pipeline for claims. Here, special care must be exercised. For example, young companies will have a short pipeline, but, over time, their pipelines will fill, and many more claims will have to be paid. Thus, the survivability of aggressive young companies may be even more questionable than the survivability of troubled but well-established firms.


Taxes and the Insurance Industry

The life industry benefits from a number of tax advantages |Greenless and Duggan, Demott, Schultz~, undoubtedly an important feature driving the growth of individual annuities and life products. Unfortunately, those tax advantages may fall prey to a tax-hungry Administration. In particular, eliminating the preferential treatment of the investment portion of life insurance products and annuities will be a tempting target for this Administration, should additional tax revenue be needed.

Thus, buyers of such products must be aware that the rules can be changed at any time, as the 1986 Tax Reform Act demonstrated so vividly. Over and over, the Clinton Administration has stated its willingness to tax wealth rather than encourage its accumulation. Thus, buyers of annuities ought to be forewarned.

Demographic Changes

Demographic changes also will have a heavy bearing on life-health products in the future. Experience shows that most insurance products are purchased by individuals in the 25-44 year age cohort |ACLI~. Moreover, their market share of purchases has been quite stable in recent years. In 1981, that age group accounted for 48 percent of number of new policies and 67 percent of the dollar amount of new policies. A decade later the 25-44 age group bought 50 percent of new policies and 66 percent of the dollar amount of new policies, suggesting a very stable pattern of insurance purchasing by this age group.

Unfortunately, that cohort has begun to shrink in absolute size. The 25-29 age group peaked at 22.132 million persons in 1989 and fell to 21.524 million in 1990. The 30-34 age cohort peaked in 1991, and the 35-39 cohort will peak in 1996. In sum, there will be far fewer potential buyers of traditional insurance products by the late 1900s than at the present. Their relative importance will have shrunk even more as the so-called baby boomers begin to gray. Because of that trend, life insurance companies may be driven away from their traditional insurance products and toward more services geared to the needs of the aged.

Annuities are the "first-generation" product designed to tap this growing market. In years to come, products offered to older buyers are likely to expand beyond annuities, because annuities are viewed by many as a bet between the insurance company and the individual as to how long the individual will live. Products with less of an implicit actuarial "bet" will likely become more important to the aging baby-boom generation now that more of them have come to realize that they, too, will not live forever. More straightforward investment products may be expected to emerge as insurance companies evolve to meet the growing needs of many "boomers" who want to accumulate more wealth and manage their assets more directly. The newer investment instruments will likely have fewer insurance characteristics and more investment characteristics.

The Blurring of Financial Institutions

The demographic changes underway will also foster a further blurring of distinctions among financial institutions. As part of its diversification away from insurance-type products, the insurance industry's interest in banking will likely rise. At the same time, the banking industry's quest for fee-based insurance products will continue to grow, in spite of intense opposition from insurers. Most recently, the banks won an important court battle allowing them to sell insurance, nationwide, through banks located in "small" towns.

To an insurance company, banks have an intriguing distribution system, providing ready access to a vast consumer (depositor) market. More insurance companies may soon see that distribution system as an efficient alternative to their costly agent system. Others may see it as an efficient means to broaden their market base for wealth accumulation and asset management products, as well. If so, interest by insurance companies in acquiring banks may grow, matching or exceeding the interest that banks have in the insurance industry. When that happens, the legal-regulatory barriers to such mergers may fall, just as the barriers to mergers between banks and thrifts have melted away in recent years.

The investment banking industry will also be appealing to insurance companies. Some may choose the route followed by Prudential Insurance Company. That firm's acquisition of Bache Securities provided it with immediate diversification into the securities market, but not without significant growing pains. Presumably, others can learn from Prudential's difficulties.

Other insurance companies may choose the mutual fund route into which the banks have run pellmell. However, the mounting regulatory concern over bank-related proprietary funds may also temper the speed with which insurance companies will be allowed to move beyond annuities.

Unbundling of Products and Customer Retention Efforts

Experience gained over the past twenty years has indicated that the buyers of insurance services can now more effectively evaluate the products offered to them. Where value is not perceived, they go elsewhere. The decline in importance of whole life and the rise in importance of term life, at least through 1983, demonstrate this clearly.

Asset management and wealth accumulation products will also become more diverse. As diversity increases, products will be increasingly unbundled. In such an environment, fees will become an even more important source of revenue. At the same time, providers of such diversified investment products will try to develop more complex client relationships designed to make it more difficult, or at least financially expensive, for clients to switch suppliers or unbundle products.

The investment companies have already made switching to competing mutual funds expensive through such tactics as deferred sales fees. Such tactics will likely intensify as competing insurance firms also strive to lock in long-term relationships. Individuals acquiring such fee-based products ought to read the fine print regarding hidden and deferred exit fees.

Insurance companies have already discovered ways to keep their clients from switching annuities between providers; mostly via back-end surrender fees |Lavine~. In short, business retention schemes are sure to become more complicated and interwoven as products become more complex and diverse.

Guarantee Funds and Moral Hazard

In the area of property and casualty products, the regulatory focus is being directed sharply toward assuring survivability to deliver on claims. However, the regulators' options are limited and run the risk of increasing moral hazard. Thus, any effort to broaden the present state-level loss-sharing guarantee funds, beyond single state programs, clearly heightens the danger of encouraging additional risk taking.

Demanding more capital is at least a partial alternative to broader-based guarantee funds. However, more capital can also foster added risk-taking as firms attempt to maintain ROE targets in the face of lower leverage.

The life-health industry is not immune. Dramatic failures such as Executive Life and Mutual Benefit show that even life companies can fail. The latter is instructive because it shows that this industry is now vulnerable to bank-like runs. Thus, policy runs by customers fearful of a firm's deteriorating health can push it over the brink by simply reversing cash flow, as customers stop paying their premiums and even draw down their cash value whole life accounts.

State guarantee funds do offer some protection for the products of the life-health companies. However, they are often inadequate. A recent failure in Georgia, for example, quickly swamped the state's guarantee fund |Jereski, 1993a~. Interestingly, that firm's problem was not poor credit standards, but overly aggressive investments in CMOs. It appears that, in the quest for yields, some insurers have taken aggressive positions in these hybrid securities. However, these are difficult securities to value, and some CMOs' value can change dramatically as interest rates fluctuate. |Jereski, 1993b~ Thus, the survivability of the life companies has become an important consideration for those buying their products to meet personal wealth accumulation goals.

More capital, and the adoption of risk-based capital requirements, may be the industry's best solution to moral hazard problems |Keran~. The demands of capital adequacy under a risk-based capital regime, however, will be a shock to many insurance companies |Hardman~. It may well force mergers on some and demutualization on others. Still others may choose to sell selected business lines, although that approach risks selling the better segments of their business and increasing the risk of failure for the remaining segments.

The bottom line of all this is fairly obvious. Any investor buying wealth accumulation and asset management products offered by insurance companies, which claim to generate returns in excess of competitive rates, ought to consider the higher return inherently more risky. Only if the level of risk implied by the return is consistent with the buyers appetite for risk should the purchase be made.

Moreover, even conventional insurance products are a risky buy when sold by life companies that also offer aggressive returns on their investment products. The survivability of the entire insurance company can be at risk when a firm trades more risk for a higher return on selected product lines. An insurance firm's entire business must be reviewed when evaluating the survivability of an insurer, even when only conventional insurance products are purchased. The recent burgeoning of insurance company rating services provides ample evidence that buyers are willing to pay for this kind of information.


Changes in the product mix of insurance companies will probably accelerate in the years ahead. The astute buyer ought to separate insurance products from wealth accumulation and asset management products, at least for purposes of analysis. Insurance products ought to be purchased with the objective of minimizing the cost of the desired coverage, balanced against risks regarding the survivability of the provider. Investment products offered by insurance companies ought to be viewed as any other investment vehicle. Here, too, the quest for yield must be balanced against the investors appetite for risk. Insurance companies will be competing intensely with all other financial service firms for this business segment.

Finally, the tax situation of annuities must be kept in mind. Should the Administration's quest for tax revenue need to be broadened, taxing annuities represents a lucrative expansion of the tax base. This approach is all the more likely from an Administration that has demonstrated a distaste for the private accumulation of wealth.


American Council of Life Insurance (ACLI), 1992 Life Insurance Fact Book, Washington, D.C., 1992.

DeMott, John S., "Business Insurance Will Cost You More," Nation's Business, June 1993, pp. 44-8.

Greenless, Johns S., and Duggan, James E., "Life-Health Insurance Markets," Research Paper 9202, The Office of the Assistant Secretary for Policy, U.S. Treasury, July 1992.

Hardman, Adrienne, "Navigating the Storm," Financial World, March 2, 1993, pp. 26-8.

Harlan, Christi and Vogel, Thomas T., "SEC Studies Risks of Exotic 'Derivatives'" Wall Street Journal, April 29, 1993.

Harrell, William D., and DeMott, John S., "Business Lessons From a Disaster, "Nation's Business, May 1993, pp. 38-9.

Huffman, Lucy, and Bernstin, David, "Property-Casualty Insurance Markets," Research Paper 9203, The Office of the Assistant Secretary for Policy, U.S. Treasury, August 1992.

Jereski, Laura, "Seized Insurer's Woes Reflect Perils of CMOs," Wall Street Journal, May 12, 1993a, pp. c1 and c18.

Jereski, Laura, "Extend-o-Matics Keep Wall Street Ahead of Regulators," Wall Street Journal, July 12, 1993b, pp. c1 and c16.

Keran, Michael W., "Insurance Industry Capital Regulation," The Prudential Insurance Company of America, Economic Review, October 1992, p. 4.

Lavine, Alan, "Dodge this Dodge," Financial World, July 6, 1993, pp. 62-3.

McGee, Robert T., "The Cycle in Property/Casualty Insurance," Federal Reserve Bank of New York, Quarterly Review, Autumn 1986, pp. 22-30.

Schroeder, Michael, "Why Insurance Rates Have Lost Their Old Bounce," Financial World, May 10, 1993.

Schultz, Ellen E., Variable Annuity Buyers Warned to Check to Underlying Funds," Wall Street Journal, July 13, 1993, pp. c1 and c17.

U.S. Bureau of the Census, Current Population Reports, #P25-1095, U.S. Population Estimates, by Age, Sex, Race, and Hispanic Origin 1980-1991, U.S. Government Printing Office, Washington, D.C., 1992.

U.S. Department of Commerce (USDC), "Insurance," U.S. Industrial Outlook 1993, U.S. Government Printing Office, 1993, pp. 52.1-52.10.

Albert E. DePrince, Jr., is Professor of Economics and Finance and William F. Ford is the holder of the Weatherford Chair of Finance at Middle Tennessee State University, Murfreesboro, TN.
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Title Annotation:The Insurance Industry, Retrospect and Prospect
Author:DePrince, Albert E.; Ford, William F.
Publication:Business Economics
Article Type:Industry Overview
Date:Oct 1, 1993
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