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Insurance companiestest shift towards compliance and risk management

Datamonitor : 17 October, 2008  (New Product)
Report from Datamonitor indicates a shift in IT spend preference at insurance companies towards the area of risk management and compliance
The insurance industry is facing difficult times but the sector is not undergoing a systemic crisis, due to regulations and sound portfolio management by the majority of players. According to independent market analyst Datamonitor, IT budgets should be more stable than those in the banking sector, with neither robust spending or dramatic budget cuts likely to materialize, and spending priorities shifting toward Risk Management and compliance.

The financial services sector still faces uncertainties, with the ongoing crisis now spilling over into the wider economy. Commercial paper has all but frozen up, which is raising the cost of capital for every company in every sector and governments are intervening on an unprecedented scale. As these events unfold, technology vendors exposed to the insurance sector are left with uncertainties of their own regarding the state of the industry and the expected IT spend of insurers in 2009.

Datamonitor believes that although the insurance industry has been hobbled, it is not facing a systemic crisis, thanks to regulations and sound portfolio management by the majority of players. AIG, which has been the only major casualty in the insurance sector to date, was felled by a small group writing credit default swaps, not its insurance business. Therefore, its situation is exceptional, rather than a sign of things to come.

While the robust spending that was previously anticipated will not materialize, neither will dramatic budget cuts. Spending priorities will shift away from discretionary projects, as greater emphasis is placed on Risk Management and compliance.

In Datamonitor's 'Business Trends: Global Insurance Technology Trends'* survey of 200 global insurers in the first half of 2008, 61% and 47% of non-life and life insurers, respectively, said they were planning to increase investment in Risk Management and compliance systems in 2009. Moving into 2008, US insurers were displaying a proclivity to invest in the online channel for sales and service, with 60% and 50% of non-life and life insurers, respectively, stating they were looking to increase investments in this area in 2009. While improving the customer relationship is imperative, such projects may be scaled back to accommodate the increased need for risk and compliance.

Along with this shift in priorities, spending will be marginally downgraded. Datamonitor's survey found that a large proportion (50%) of US non-life insurers anticipated flat budgets, while 27% and 18% anticipated budget increases of 1-5% and over 6%, respectively. US life insurers were more tepid, with the majority noting a flat budget environment. European insurers nearly mirrored their US counterparts. Credit has become much more expensive and difficult to access since the survey was conducted, and those insurers that anticipated major spending plans will likely witness only a slight increase in their spend, while those companies with moderate planned increases will go flat.

Despite the fact that most industry players have avoided 'toxic' assets, the impact of the credit crisis on the sector should not be underestimated. The non-life market is being challenged by a soft pricing environment and poor investment income, while life insurers could be confronted by a cyclical downturn. In the US, increased competition has pushed rates down on non-life insurance in general and commercial lines in particular. According to the Insurance Information Institute, there has been an increase in the combined ratio, or the proportion of premiums spent on claims and operating expenses, for the non-life sector, excluding mortgage and financial guarantee insurers, for the first half of 2008. Lower premiums are responsible for much of this increase, however, insurers have also been adversely affected by an active catastrophe season, with roughly $22 billion of catastrophe damage already recorded in 2008. In terms of an economic slowdown or recession, the non-life market is relatively non-cyclical because many products, such as auto insurance, are compulsory, although insurers can be adversely affected because consumers often opt for base coverage in difficult times. Additionally, when businesses contract, demand for coverage wanes, particularly workers' compensation.

Life insurers are facing challenges as well, as the life insurance and retirement market is highly correlated with the economy. In good times, people buy coverage and stash money away for retirement, while coverage and retirement planning are scaled back in bad times. Life premiums grew at a rate far greater than GDP between 1997 and 2000, a period marked by high productivity and above average stock market returns. When the economy and market turned downward following the technology bubble burst and the attacks of September 11, life premiums fell from near double-digit growth rates into negative territory. It should also be noted that the premiums lagged the equity market by one year, meaning that premiums may experience the heaviest downturn later in 2009 and 2010.

In addition to lower demand, both life and non-life insurers are struggling with weak investment income. Stocks, bonds and real estate have all lost value since last year, and a number of major insurers had large positions in battered institutions, such as AIG, Washington Mutual, Lehman Brothers and Wachovia. MetLife, for example, announced that it had $800 million of investments between AIG and Lehman, the recoverability of which it is continuing to assess. The Hartford also has exposure, particularly $127 million in subordinated Lehman debt. Compounding this, insurers are large consumers of mortgage-backed securities; Allstate, for example, held $6.1 billion of mortgage-backed securities in the second quarter, nearly $200 million of which it wrote off.

In addition to the cyclicality of life premiums and poor investment opportunities, a number of insurers have engaged in higher risk strategies over the past decade. These strategies, most notably credit default swaps and securities lending, provided outsized returns during the good times, but are now responsible for billions of dollars worth of write-downs. As well as AIG, which was forced to seek aid from the US government following an increase in bond defaults, a few other insurers have been active in the credit default swaps market, including MassMutual, although not to the same extent as AIG. However, while a small proportion of insurers write credit default swaps, the vast majority are consumers of these products, which have increased dramatically in price because of the elevated risk of corporate default. The increased cost of coverage is directly affecting the industry's margins.

Despite the dour news related to a few large and key players, the industry overall is marked by highly regulated companies that possess conservative portfolios. Insurers are feeling the effects of the 'toxic' debt storm but, unlike the banking industry which is in the eye of the storm, the insurance industry has a sound business model. Insurers with aggressive and risky portfolios are rare, and are the firms most likely to suffer from the current situation. Yamato Life, for example, made up for a weak operation by allocating 30% of its portfolio to alternative investments, such as hedge funds and private equity. Conversely, Northwest Mutual has less than 1% of its portfolio exposed to sub-prime mortgages.

The US insurance industry has been controlled by a cumbersome state-based regulatory regime, hindering innovations, but it is those same regulations that have sheltered the sector from the fallout of the banking crisis. When lawmakers embark upon reforming the industry it is essential that they strive to maintain the right balance so that innovation can be achieved and exuberance tamed. In keeping with the expected regulatory changes, vendors should concentrate their efforts on Risk Management and compliance systems. Business process outsourcing may also receive a boost as a result of the market turmoil, as insurers will be seeking to mitigate costs and focus on core competencies during the lean times.

Furthermore, and perhaps more importantly, insurers will be looking to outsourcing partners with compliance expertise. As the regulatory landscape changes, players in the sector will be left with a choice: update rigid systems, implement a new system or outsource. The third option, outsourcing, is attractive, but only if vendors can deliver a smooth transition and elevated service levels.
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