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The Industry Needs an Intervention

Leaders in the insurance industry, like many other industry executives, are seeking routes to profitable growth amid unprecedented economic, financial and regulatory change. No longer can companies pursue top-line growth for its own sake without adverse consequences or rely on cost cuts alone to boost margins. Today, companies must strike a strategic balance that will sustain profit growth and shareholder returns over the long term.

This is no easy trick, as tectonic forces unsettle the insurance industry — which is accustomed to measuring the pace of change in decades, not years or quarters. A business-as-usual approach falters in the face of quickly shifting customer needs, rising capital requirements, new regulatory burdens, low interest rates, disruptive technology, and new competitors.

Many companies aren’t getting the results they need from textbook moves such as fine-tuning marketing programs, updating products, enhancing customer-service systems or beefing up information technology. That’s because traditional operating levers for executing strategy simply weren’t designed for the challenges confronting insurers today. Strategic success now requires something more: a structural response. A company can’t adapt to 21st-century conditions without modernizing its 20th-century structures.

The key is for companies to realize that strategy equals structure. Strategy — the big and important ways that a company chooses to compete — must naturally and intrinsically weave in key operating model dimensions, including legal entity, tax positioning, capital deployment, organization and governance.

Finally, once strategy and structure are wed, companies must recognize the role of culture in making new structures work, and use their cultural strengths to promote the changes and ensure that they have staying power. Here’s how:

Responding to the Pressures

Rapid evolutionary change has rendered time-honored organizational structures ineffectual or obsolete in many cases. Before attempting to execute new strategies, insurance companies need to reevaluate every dimension of their operating model.

Structural inadequacies take many forms. Some companies lack the scale needed to generate profitable growth under new capital requirements. Others with siloed, hierarchical organizations lack the flexibility to respond quickly to market shifts. Poor technological capabilities often hamstring old-line insurers facing new digitally oriented rivals. And tax reform and regulation looms as a potential threat to profitability in certain business lines.

See also: Why Is Insurance Industry So Small?

In our work with insurers, we at Strategy&, PwC’s strategy consulting business, have seen certain common responses to these pressures. Their responses divide these companies into three groups:

  • The first group of companies have anticipated the effects of marketplace trends and made appropriate structural adjustments, clearing the way to profitable growth. For example, life insurer MetLife avoided costly regulatory mandates by selling registered broker distribution to MassMutual and spinning off its Brighthouse retail operations. Others, including Manulife and Sun Life, have made substantial acquisitions to consolidate scale positions.
  • The second group of companies have recognized the need for structural change, but have yet to carry it out. With plans made, or under discussion, these companies are waiting opportunistically for the right deal to come along.
  • A third group of companies, however, have hunkered down behind existing structures, making only minor tweaks and hoping to emerge from the storm without too much damage. For some, this is a rational choice because of constraints that leave them with little or no maneuvering room. In other cases, action is impeded by a company culture that reflexively rejects certain options.

Companies in the first two groups are giving themselves a chance to win. But the response of companies in the third group smacks of self-delusion in an age when strategy equals structure.

Time for Real Change

Without a doubt, many insurers work diligently and continually to improve their businesses across dimensions. They gather insights into consumer needs and behaviors, nurture unique capabilities to differentiate themselves from competitors, modernize products, update distribution strategies and embrace digitization in all its forms. These are all sound approaches, but they’re inadequate in addressing the unknown facing insurers today. Their belief that they will persist assumes a certain stability in underlying economic and market conditions that hasn’t been seen since the financial collapse nearly a decade ago.

Forces unleashed by that crash and its aftermath undermined the pillars of many insurance business models. We’ve seen years of only modest growth, with property/casualty insurers expanding at a 3% pace, and life insurers barely exceeding 1%.

The long stretch of sluggish global growth has put pressure on revenues and forced insurers to compete harder on price. Near-0% interest rates that have prevailed since the Great Recession are squeezing profit margins, especially in life insurance. On the regulatory front, tougher accounting rules are driving up costs while heavier capital requirements weigh down balance sheets and dilute returns.

Compounding these challenges are the potentially destabilizing effects of tax reform on earnings and growth. Taxes may actually rise for some insurers, an outcome that could force them to raise prices or find other ways to protect shareholder returns. In many cases, the benefits of falling tax rates may be diminished by the loss of deductions for affiliate premiums, limits on deductibility of life reserves, accelerated earnings recognition and a slowdown of deferred acquisition cost deductions.

Competitive dynamics are shifting, too, as expanding “pure play” asset managers such as Vanguard and Fidelity block growth avenues for insurers. Established companies and some new entrants are innovating and experimenting with disruptive distribution models. Others, including private equity firms, are looking to bend the cost curve through aggressive acquisition and sourcing strategies.

To be sure, some long-term trends could benefit certain insurers, or at least improve their risk profile. Longer life spans and the shift of responsibility for retirement funding to individuals may drive demand for annuities and other retirement products.

However, many companies are as unprepared to capitalize on these opportunities as they are to meet long-term challenges. Often the problem comes down to scale. Some insurers lack the resources to build new distribution platforms and customer service capabilities in growing markets such as asset management, group insurance, ancillary benefits and retirement plans. Although offering an individual product may be relatively easy for new market entrants, the difficulty and cost of establishing such platforms creates a desire for scale and increases pressure on smaller competitors.

Sometimes, the issue isn’t scale but a failure to respond quickly enough as conditions change. Buying habits are changing as consumers — particularly the younger cohorts — make more purchases online. Yet our research indicates that people still want some personal assistance with larger and more-complex transactions.

It takes investment and experimentation to find and refine the right business model for new marketplace realities. But some companies haven’t built the necessary assets and capabilities or adjusted to evolving distribution patterns and consumer behaviors.

The proper response to each challenge and opportunity will be different for every company, depending on its unique characteristics and circumstances. In virtually every case, the right solution will involve structural change.

Joining Strategy and Structure

As companies recognize that traditional approaches to annual planning, project funding and technology architecture may be hindering innovation and real-time responses to changing market conditions, many are rethinking and redesigning their core processes to facilitate change. Recent transactions in the sector show the range of structural options for companies that want to advance strategic goals in a changing marketplace. Below are some examples.

Exiting businesses. Sometimes, the best choice is to move out of harm’s way; companies can preserve margins by exiting businesses targeted for higher capital requirements or costly new accounting standards. MetLife’s Brighthouse spin-off bolstered its case for relief from designation as a “systemically important financial institution,” and the associated capital requirements. Exiting U.S. retail life insurance markets also enabled MetLife to focus on faster-growing businesses that are less vulnerable to rock-bottom interest rates. The Hartford recently announced the sale of Talcott Resolution to a group of investors, completing its exit from the life and annuity business.

Partnerships and acquisitions. When scale is an issue, the solution may lie outside the company or in new structural approaches. Some insurers form partnerships to expand distribution, diversify product portfolios or bolster capabilities. Companies also adjust their scale and capital structures through mergers, acquisitions and divestitures. Sun Life paid $975 million in 2016 for Assurant’s employee benefits business, filling gaps in its product portfolio and gaining scale to compete with larger rivals. MassMutual’s purchase of MetLife’s broker-dealer network in 2016 enlarged the MassMutual brokerage force by 70% and freed MetLife to pursue new distribution channels.

Expanding into new lines and geographies. New product lines offer another path to faster growth or fatter profit margins. Several insurers have moved into expanding markets with lower capital requirements, such as asset management. Voya, Sun Life and MassMutual have acquired or established third-party asset management units to capitalize on investment expertise they developed managing internal portfolios. The Hartford recently agreed to acquire Aetna’s U.S. group life and disability business, deepening and enhancing its group benefits distribution capabilities and accelerating digital technology plans. We also see companies establishing technology-focused subsidiaries such as Reinsurance Group of America’s (RGA’s) RGAx and AIG’s Blackboard.

Cutting costs. Some companies have moved aggressively to improve their cost structure. Insurers seeking greater financial flexibility have divested assets that require significant capital reserves. Aegon unleashed $700 million in capital by selling blocks of run-off annuity business to Wilton Re in 2017. An insurer that offloads its defined-benefit plan to another via pension-risk transfer frees up capital and eliminates continuing pension funding requirements. Other cost-saving moves focus on workforce expenses. In addition to rightsizing staff, such measures include relocating workers to low-cost areas or jurisdictions offering significant tax incentives. Prudential and Manulife slashed expenses by establishing overseas operating centers that take advantage of labor cost arbitrage, create global economies of scale and reduce taxes.

See also: Key Findings on the Insurance Industry

Transformation and Culture

Once companies have launched ambitious structural initiatives, they don’t always recognize the role of culture in making the new structures work. But this is a mistake.

Culture is a pattern of behaviors, norms and mind-sets that have grown up around existing organizational structures; the two (culture and structure) are tightly linked, and you can’t change one without affecting the other. No culture is all good or all bad. But certain cultural traits are more relevant to structural change than others.

Cultural attributes affect a company’s ability to make necessary changes. A company that is consensus-driven and focused on preventing problems before they arise may be indecisive and slow to act. These traits may cause it to wait too long and miss the optimal moment for a structural transformation. Other companies, by contrast, have a tradition of quickly seizing opportunities. When this trait is supported by other important characteristics — more single points of accountability, strong leadership and an aligned senior management team — it can foster the rapid decision making essential to structural change.

Culture also comes into play after executives decide to initiate structural change. Most employees have strong emotional connections to the culture — this source of pride, along with a clear and inspiring vision of the future, can motivate them to line up behind the change and can inspire collaboration across organizational boundaries to drive the transformation. Leaders at all levels can generate momentum by signaling the desired cultural shifts and embodying the new behaviors needed to execute structural change.

A new structure without a corresponding evolution of culture amounts to little more than a redesigned organization chart. Culture makes or breaks the new structure, influencing factors as diverse as resource allocation, governance and the ability to follow through on a vow to “change how work gets done.” It’s not uncommon for a company to expend tremendous effort and resources on a complete structural overhaul, only to see incompatible cultural norms thwart its strategic execution. For example, a new, streamlined operating model intended to accelerate decision making and foster cross-functional collaboration won’t take root in a culture that exalts hierarchy and encourages employees to focus on narrow functional priorities.

Culture also influences a company’s willingness to make the deep structural changes in time to avert a crisis. Those who wait until market conditions have undermined their operating model put themselves at a disadvantage. Nevertheless, few companies attempt structural change in “peacetime.”

Absent a crisis, cultural expectations often limit directors to a narrow role monitoring indicators such as growth and profitability, while management concentrates on achieving specific strategic objectives. Under this traditional allocation of responsibilities, emerging structural issues may not get enough attention. Successful companies, by contrast, continually reassess their structure in light of evolving market conditions. They understand that organizational structures aren’t permanent fixtures, but strategic choices to be reconsidered as circumstances and objectives change.

Capitalizing on Changes

Amid the confusion of today’s insurance industry, one thing is clear: Business as usual won’t deliver sustained, profitable growth. As powerful forces reshape markets, conventional tools for executing strategy are losing their effectiveness. Today’s challenges are not operational, but structural. Many insurers lack the scale, capabilities or efficiency to compete effectively as competition intensifies, regulatory burdens increase and financial pressures rise.

Winning companies are meeting structural challenges with structural solutions. Approaches vary from company to company. Some add scale or enhance capabilities, whereas others streamline cost structures or exit lagging business lines. With the right cultural support, these structural responses position a company to capitalize on industry changes that are confounding competitors.

You can find the article originally published on Strategy & Business.

This article was written by Bruce Brodie, Rutger von Post and Michael Mariani.

Possibilities for Non-Traditional M&A

2015 was a record year for announced insurance deals, as long-anticipated industry consolidation finally started to occur. Several factors have driven consolidation, notably slow economic growth and persistently low interest rates, both of which have limited opportunities for organic growth and forced insurers to reconsider their long-term competitive strategies. Combined with record levels of corporate capital and private equity funding, these pressures have created the perfect opportunity for both buyers and sellers.

Historically, regulatory or financial pressures have driven insurance carve-outs. [An insurance carve-out is a transaction in which a seller divests part of its business (e.g., a particular customer group, product line or geographic area) rather than an acquirer buying the entire enterprise. The seller typically benefits from exiting sub-scale or unprofitable lines, while the acquirer is able to increase scale or geographic reach.] These pressures typically have included repayment of emergency funding received during the financial crisis, fulfillment of regulatory conditions for receiving state aid, divestment to free up capital and improve solvency ratios in preparation for Solvency II, or the shoring up of capital via asset sales following losses.

In recent years, we have seen the industry move away from complex multi-line business models. Insurers are exiting sub-scale business lines to improve returns and compete in an environment in which technology is disrupting tradition business drivers. There are many insurers considering carve-out transactions or IPOs as sellers, and there are even more looking to build market share by acquiring and consolidating businesses with their existing operations.

See also: Insurance M&A Stays Active in 2016  

However, insurance carve-outs tend to be more complex in both transaction structure and post-merger integration than an acquisition of an entire insurance enterprise, and require careful planning and execution to successfully separate the acquired business (“SpinCo”) from its former parent (“RemainCo”).

What should executives be aware of when they consider these types of transactions?

  • Planning and Organization
    • Confidentiality, maintaining optionality and speed of execution are critical to maximizing deal value.
    • The flexibility to execute deals via alternative structures (described below) helps maintain optionality. In addition, a thorough understanding of the M&A landscape is necessary for sellers to run a competitive sales process and for buyers to understand how to properly position themselves for success.
    • To facilitate speed of execution, executives need to simultaneously focus on multiple priorities, including deal execution, separation planning and negotiation of transitional service agreements (TSAs). Leading practices include having a transaction committee that can rapidly make decisions and a project office that guides the planning effort.
  • Transaction Structures
    • Acquisitions of an entire insurance enterprise typically involve the purchase of all of a holding company’s issued stock. The holding company, its subsidiary legal entities, assets and liabilities, products and licenses, people, technology and infrastructure transfer to the control of the acquirer at close. A carve-out requires a different approach. It is rare that the business being sold is fully contained within a single subsidiary legal entity. More frequently, the business being disposed of is written across numerous legal entities and is mingled with business that is core to, and remains with, the vendor. Therefore, carve-outs typically use a mix of strategies to separate the insurance business of SpinCo from RemainCo:
    • Renewal rights – The acquirer receives an option or obligation to renew the acquired business in its own legal entities.
    • Reinsurance – Renewal rights may be accompanied by reinsurance transferring the economics of the historical book either to the acquirer, to other entities owned by the vendor or to a third party.
    • Fronting – Certain domiciles, such as Japan and the U.S., require regulatory authorization of products or rates prior to their availability to policyholders, and such product approval frequently takes longer than regulatory approval for a change of control. When an acquirer doesn’t have regulatory approval to immediately write the business in its own legal entities, the transaction structure typically allows an acquirer to:
      • Continue to issue and renew policies using the vendor’s legal entities for a defined period of time, and
      • Assume the economics of the business via reinsurance. The acquirer frequently is responsible for administering the business (which is still the legal and regulatory responsibility of the vendor’s legal entities) via a servicing agreement.
    • Stock transactions – These are used when assets and liabilities can be segregated into legal entities (e.g. using the European Economic Area’s (EEA) insurance business transfer mechanisms), or when a legal entity, such as a specialist underwriting agency, specifically supports the business being sold.
      • Transfer of assets and contracts/TSAs – Just as the insurance business being sold may be diffused across the vendor’s legal entities, the same may also apply to the people, facilities, technology and contracts with sellers that support the business. While a certain portion of these will clearly align either to SpinCo (and will transfer at close) or RemainCo, there will be a significant subset (particularly in IT and corporate services) that support both and are not easily divisible. For such functions where SpinCo is heavily reliant on the resources of its former parent and it is not possible for the acquirer to fully replace such services prior to the transaction closing, a TSA provides the acquirer and SpinCo with continuing access to and support from RemainCo’s resources after close.

Negotiating the TSA

TSAs provide access to the resources and infrastructure of the former parent for a defined period. While in certain simpler transactions, TSAs can be for as little as three months and require only that the support provided previously be maintained at the same service levels and at the same cost basis, it is more common that acquirer and vendor during the months prior to close:

  • Understand and define the reliance of the business being sold on its parent (and vice versa);
  • Set the duration post-close for each service required under the TSA;
  • Agree on the charging basis e.g. fixed monthly fee, usage, hourly rates (for tax efficiency, each service is usually priced individually);
  • Establish service levels and post-close governance processes.

The acquirer should set realistic timeframes for exiting from individual services. The complexity of insurance policy administration systems, the frequent integration of certain capabilities (such as billing, commissions, and contact centers) across products and the need to separate networks, migrate data centers and implement replacement mainframes frequently require TSAs of 24 to 36 months.

TSAs also may cover centrally provided non-IT services, including HR/payroll/benefits administration, facilities management, procurement, compliance or financial and management and regulatory reporting. However, the duration of these TSAs tend to be shorter – usually a few months, or sufficient to support regulatory and financial reporting for the period following close.

Ideally, the acquirer should seek as much flexibility as possible with the duration of the TSA. It should have the right to terminate the TSA early, the option to extend it at pre-agreed rates and the inclusion of force majeure clauses (a natural catastrophe can significantly affect exiting from a TSA).

Contract assignment and access to shared reinsurance

An area of often-underestimated complexity in carve-outs is the need to ensure that the separated business can continue to receive the benefit of third-party contracts with suppliers, distributors and reinsurers. In most jurisdictions, contracts cannot simply be novated (the insurance business transfer mechanisms of the EEA provide certain exceptions), but instead each contract must be evaluated to determine if assignment simply requires notification to the counterparty or its express consent.

The challenges that arise in contract transfer are both:

  • Logistical – 85% of counterparties contacted typically respond at first instance. However, a recent carve-out had more than 50,000 contracts that needed to be assessed, prioritized and migrated. In this instance, chasing down the remaining 15% was a real challenge.
  • Commercial – Certain experienced counterparties, knowing the tight timeframe for most transactions, may try to renegotiate better terms either prior to the contract being assigned to the acquirer, or prior to permitting the vendor to use the contract to provide services under the TSA.

Also important in a carve-out is a clear apportionment of access to historic reinsurance programs shared between the vendor’s continuing business and the business being sold, as well as definition of the resolution process for any post-close disputes.

Executing close

Transaction close for virtually all insurance carve-outs is triggered by the receipt of one or more regulatory consents enabling the execution of fronting, reinsurance and stock transfer agreements.

When migrating staff and assets supporting SpinCo to the acquirer, supporting staff and assets are moved into a legal entity, the ownership of which transfers at close in certain cases. However, when the relevant staff are not employed or supporting assets are not owned by legal entities transferring to the acquirer at close, there will need to be arrangements for the valuation and transfer of both tangible and intangible assets (e.g. trademarks) and the offering of employment and enrollment in benefits to selected staff by the acquirer. This is a significant logistical exercise for an HR function.

See also: Group Insurance: On the Path to Maturity  

Insurance carve-outs are also particularly challenging for finance functions:

  • The combination of renewal, reinsurance and legal entity acquisition in the transaction structure complicates accounting immediately post-close.
  • Cross-border acquisitions can include acquirers and sellers with different accounting standards (e.g. IFRS, U.S. GAAP, statutory and JGAAP) that often have very different rules on the treatment of assets and liabilities.
  • The practice of closing at a month or quarter end – which in some ways can simplify the transition – may also introduce a tight and immovable timeframe for external financial and regulatory reporting.

Lastly, although there typically will be several months between the deal being agreed upon and the close, this may not be sufficient time – particularly in larger acquisitions across multiple locations – to roll out the acquirer’s networks and desktop technology prior to close. Therefore, full access to the acquirer’s IT capabilities may need to wait until later in the integration.

Post carve-out integration

While an acquisition of an entire enterprise provides a pre-existing governance structure, an insurance carve-out typically includes fewer members of senior management and requires rapid integration of functional management within the acquirer’s existing structure, the expansion of governance and compliance structures to include the acquired operations and the establishment and communication of delegations of authority and decision-making rights.

Due diligence should have provided the acquirer with initial hypotheses as to the organizational capabilities required by the combined organization, interim and end-state operating models, and opportunities for synergies.

As with any insurance acquisition, synergies in carve outs are typically realized through:

  • Functional consolidation.
  • Platform consolidation and process standardization, which enhances productivity and enables staffing efficiencies.
  • Facilities and infrastructure reduction, and
  • Reduced costs through more efficient third-party vendor selection.

PwC’s research indicates that the most successful acquisitions are those that develop momentum by demonstrating tangible integration benefits in the first 100 days. Accordingly, the acquirer should act fast but should also be prepared to revisit pre-deal assumptions and revise its integration roadmap as the two organizations integrate and new information becomes available.

Conclusion

Based on what we see in the market, notably a recent succession of P&C and reinsurance megadeals, we predict that insurance industry consolidation will continue apace. Multi-line insurers have divested themselves of numerous franchises and this trend seems likely to continue. Because these types of transactions are complex and depend on many internal and external factors, companies that are considering such moves will need to be aware of and address the many challenges and issues we describe above.

This article was written by John Marra, Mark Shepherd, Michael Mariani, and Tucker Matheson.