Turn headwinds to tailwinds adjust strategies to benefit from the continued growth of the Chinese insurance industry

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1 Turn headwinds to tailwinds adjust strategies to benefit from the continued growth of the Chinese insurance industry Grow larger, grow bigger has been the mantra of growth in the past decade for the Chinese life insurance industry. years ago, there were only a handful of life insurance companies while there are now more than 60 life insurance entities (including pension and health companies), with more waiting for approval to commence operations. Premium income has increased more than -fold from RMB85 billion in 2000 to RMB1,4 billion in 2011, an annualised growth rate of 26%. The main factors contributing to this growth include the general growth of the Chinese economy over the past decade, rising per capita income, low insurance penetration and density, urbanisation, and an increase in the awareness of the needs and benefits of insurance. In 2011, a series of challenges became more prominent for the industry as a whole, causing companies to reassess their business models in the evolving environment. In his first policy speech as the new chairman of the China Insurance Regulatory Commission (CIRC) in January 2012, Xiang Junbo said that despite the good growth of the insurance industry in recent years, there are still significant inadequacies in the insurance industry relative to the expectation of society; deep-rooted issues cannot be overlooked and need to be resolved quickly. In this article, we will examine in more detail some of these challenges, including sales setbacks for both agency and bancassurance channels, unfavourable capital markets, capital adequacy and lack of suitable human resources, and their implications. We will highlight some developing trends in areas such as risk management, product and service innovation and in transaction activities. Distribution Challenges Agency Channel Since AIA China introduced the individual agency distribution model in China in 1992, this channel has become a key distribution mechanism for life insurance products. The total number of agents increased from around one million in 2001 to around three million by the end of 20, reaching such a scale that an inevitable slow down has started, with annual growth rates of 28%, 27%, 14% and 12% in 2007, 2008, 2009 and 20 respectively. Previously, most companies simply relied on an increasing number of agents to generate new business, and at the time, even if agents were able to sell just a few policies each, this would contribute to companies top line (which was and still is the focus for many companies). The quality of agents tended to be of secondary importance. In 2011, some of the largest companies as well as smaller companies saw their number of agents decline for the first time. Furthermore, the agency turnover rate has remained high over the last decade. It is not surprising to observe an agency retention rate of 30% (or lower) to 40% in the first year for typical life insurance companies, with very few agents able to stay on for more than three years. Poor retention is a result of the previous approach to simply recruit to increase the size of the agency force (without necessarily focusing on the quality of the agents recruited), the poor reputation of life insurance agents, increasingly onerous qualification requirements (which is ultimately good for the industry), lack of career path and the availability of relatively more attractive career options. Moving forward, a more professional agency force is starting to emerge that should better ensure business quality, focus on sales, increase in productivity and, critically, service policyholders more effectively. 4 towerswatson.com

2 Figure 1. Number of agents in the past six years Thousands 3, % 27.43% 30% 3,000 2,500 2,000 1, % % 25% 20% 15% % 1, % 5% 500 0% Source: China Insurance Yearbook No. of agents Growth rate Bancassurance Channel The bancassurance channel was fi rst introduced in China in the late 1990s and its importance as a life insurance distribution channel has risen rapidly. Today, this channel is still characterised by the many-to-many model whereby banks sell products from multiple life insurance companies, and life insurance companies sell their products through multiple banks. From 2005 to 20, life insurance premium income sold through banks rose from RMB90 billion to RMB440 billion, with bancassurance s share of the total life insurance market rising from 25% to around 45%. This increasing trend was disrupted in 2011 when the China Banking Regulatory Commission (CBRC) issued a regulation requiring commercial banks to prohibit insurance companies sales people selling insurance products within bank outlets, in order to protect bank customers interests. At the same time, CBRC placed a restriction that each bank outlet can sell life insurance products from no more than three life insurance companies. In early 2011, CIRC and CBRC issued a joint regulation to further regulate bancassurance sales. Bancassurance Sales Regulations Number of Products Sales People Information Disclosure Misleading Behaviour Each commercial bank outlet can sell insurance products from no more than three life insurance companies. Sales people from insurance companies are not allowed to sell insurance products in bank outlets. Only bank staff with appropriate qualifications as insurance agents can sell insurance products at banks outlets. Sales people should fully inform customers of the characteristics, attributes and risks regarding the insurance products they are promoting. Sales people should not misleadingly sell products by means of prize giving, lucky draws, rebates, or giveaways of material objects or insurance policies. Sales people should not mix insurance products with saving products, mutual fund products or other wealth management products. Sales people should not simply compare the investment returns on insurance products to the above-mentioned products. Sales people should not overstate the returns on insurance products. Source: CIRC towerswatson.com 5

3 These regulations have had a signifi cant impact on bancassurance sales in 2011, with total new business premium dropping around 15% in 2011 compared to 20. Moving forward, companies will need to focus on developing deeper relationships with banking partners, including training and developing bank staff for bancassurance purposes, designing tailored products and assisting banks to extend their relationships with customers. Exclusive relationships are likely to start to emerge, particularly given some banks now directly own major stakes in life insurance companies. Incentives must therefore be created for banks and insurance companies alike to work together to create win-win situations. Capital Adequacy Challenges 2011 was also a tough year for life insurance companies capital adequacy. The unfavourable capital markets caused investment yield deterioration and signifi cant unrealised (and realised) capital losses. Coupled with the capital consumption from rapid business expansion and increased competition for policyholders and distributors, many companies, including the largest ones, needed to raise capital through various means, including capital injection from shareholders, reinsurance, funding from markets and through issuing of subordinated debt. Taking subordinated debt issuance as an example, a range of companies issued subordinated debt that in aggregate exceeded RMB50 billion in 2011 alone, amid new regulations issued by CIRC to tighten the eligibility criteria for issuing such debt. This amount is signifi cantly larger than in 2009 and 20, where the total subordinated debt issuance in the industry was around RMB5 billion and RMB billion respectively. With companies continuing to issue subordinated debt, life insurance companies may face signifi cant repayment pressures when these instruments mature. Capital calls on existing domestic shareholders have also become more challenging given that shareholder return expectations have often not been met, leading to their reluctance to commit further capital, and that the current economic environment might mean shareholders themselves need to conserve capital for their other businesses. Issue Date Company Term (Year) Nov 2011 China Life Dec 2011 China Pacific Life Sep 2011 New China Life Sep 2011 Ping An Life May 2011 Taikang Life Aug 2011 Sino Life Sep 2011 Happy Life Feb 2011 AEON Life Dec 2011 Guo Hua Life May 2011 Sinatay Life May 2011 Hua Xia Life Amount (RMB million) 30,000 8,000 5,000 4,000 2,000 1, Source: CIRC Rising interest rates and equity markets In the last two years, the People s Bank of China (PBOC) (China s central bank) raised interest rates fi ve times (e.g. fi ve-year bank deposit rate was raised from 3.6%, the rate at December 2008, to 5.5% in July 2011). While this has benefi ted insurers investment performance somewhat, it has also made life insurance products relatively less attractive to bank deposits and other wealth management products, given the maximum guaranteed rate on life insurance products of 2.5%. This in turn has resulted in some companies experiencing higher than expected discontinuances as policyholders take advantage of the returns offered from alternative products. Equity market performance in 2011 was poor with the Shanghai Composite Stock Index declining by 21.7% during the year, which further exacerbated companies capital adequacy position. 6 towerswatson.com

4 Shortage of Skills Another key challenge faced by insurers is the availability (or lack thereof ) of suitably qualifi ed personnel to manage insurance companies, whether these are people in the management, fi nancial, actuarial, distribution or operational areas. As alluded to at the start of this article, the life insurance industry is still relatively young. With a plethora of new companies in the past decade or so, each of these new companies requires personnel to run and manage the operations. Virtually by defi nition, most personnel would only have years or less in actual industry experience. Short of recruiting from more developed markets (where experience may not necessarily be relevant to the Chinese market), personnel skills will take time and experience to develop, and the critical shortage is a signifi cant challenge to all companies alike and likely to remain so for sometime yet. Consequentially, this poses not insignifi cant operational risks for companies. The life insurance industry certainly faced significant headwinds in However, it is important to put these challenges into perspective. With the challenges faced by the industry in 2011, many companies are continually considering adjustments to their overall business strategies. Up to now, many companies have adopted very similar business models and strategies, with little differentiation. Successful companies in the future will need to distinguish themselves through different means among these could be focus on profi tability (rather than market share), fi nding appropriate customer/ distribution segments and partnerships, specialisation in certain products with greater attention to customer-focused services, specialisation in specifi c distribution approach, geographies or demographics, expense controls, appropriate capital management and risk management or by obtaining, training and retaining quality human resources. In the rest of the article, we highlight some of the emerging trends that could help the industry to further develop on a more robust basis. Emphasis on risk management One key objective of CIRC is for the industry to manage risk scientifi cally. In late 20, CIRC issued comprehensive risk management guidelines to ensure all life insurance companies adopt a best practice approach to managing all its risks, including investment, insurance, operational and reputational risks. Implementation of the risk management measures could potentially have implications on how companies are fundamentally managed, including in areas such as capital management, investment strategies, product pricing, sales management, etc. Successful companies in the future will need to distinguish themselves through different means. Key requirements of the comprehensive risk management guidelines Appoint a chief risk officer or risk management manager, who should not be responsible for sales or investments. Set up a risk management department, independent of finance, investment and actuarial departments. Set up a risk management committee, establish a comprehensive risk management framework and a risk management information system. Establish an asset liability management system and specify the responsibilities and roles of relevant departments. Establish a process to determine economic capital to measure overall risk position and exposure, by year end Submit annual comprehensive risk management reports. Source: CIRC towerswatson.com 7

5 Product, Distribution and Service Innovation Currently, life insurance products offered by companies are largely similar, with most products sold being savings oriented products with guaranteed returns and relatively low protection coverage. Product innovations to meet customer needs - in 2011, CIRC released interim rules for variable annuity (VA) products for qualified companies to sell these products to meet the needs of customers who are looking for some levels of guarantees together with some upside potential. Up to now, two relatively small companies, namely AXA-Minmetals and Sino-United Metlife have launched VA products while most are adopting a wait-and-see approach. In this interim form, these new rules are not likely to create a significant VA market, but are nevertheless seen as an important step towards allowing newer products in the future. The pure risk market to date has been under-penetrated. In line with CIRC s overall vision to promote protection business rather than products that are mostly savings oriented, this is one area with significant growth opportunities. Looking further ahead, given the change in China s demographics, and with rapid ageing in particular, there are also significant needs for retirement and health products, both of which are currently underdeveloped. Emerging distribution channels - in terms of distribution, companies are looking to explore alternative distribution channels such as independent insurance brokers (several large groups of insurance brokers have formed over the last few years), direct/tele-marketing, alliances (e.g. alliances between unrelated life insurance companies with property & casualty insurance companies or other non-insurance companies), group sales or internet sales (noting that some smaller life insurance companies are already generating significant proportion of their business from these emerging channels). In addition, joint ventures are also trying to better utilise their domestic partners networks. A key challenge remains as to how best to manage these emerging channels together with the traditional channels. Customer service - often overlooked in the market is how policyholders are serviced, both pre-sale and post-sale. This is one area that, with the right customer focus and proposition, companies can distinguish from their competitors and generate greater customer affinity. Servicing has become more important given the high turnover of the agency force, the prohibition of insurance sales people to sell in bank outlets, and increasingly sophisticated and knowledgeable customers. It is also becoming a focus of the regulator. These factors are all forcing companies to be more attentive to customer needs. New Players and Market Integrations With the challenges faced by distribution as well as the relatively less competitive products against other financial companies, competition further intensified in 2011 in terms of competition for distributors and policyholders alike. Other emerging competitive drivers include: Banks entering insurance sector - in recent years, large domestic banks have been keen on entering the life insurance market, and three out of the Big Four commercial banks in China have bought controlling stakes in life insurance companies. It is expected that these insurance companies will start to further utilise their parent banks extensive distribution network in their sales strategy. Newly setup regional companies - in 20, CIRC gave the green light for the establishment of provincial/regional based life insurance companies. These are companies that are headquartered in provincial capitals and are allowed to run their businesses within that province for the first two years before they are potentially permitted to expand nationally. The companies are typically sponsored by leading provincial entities, and are likely to have some local advantages compared to national companies. Transaction activities - transaction activities among domestic shareholders of life insurance companies are becoming more prevalent. A number of drivers contribute to this trend: Dissatisfaction with the progress of life insurance companies, particularly when compared against shareholders original expectations, could lead to selected shareholders seeking to exit from their stakes. Shareholders own circumstances (partially due to domestic or international economic environment) might result in them needing capital which could be obtained through disposal of their stakes in life insurance companies. 8 towerswatson.com

6 A key lesson is to set realistic shareholder expectations and, in particular, that life insurance is a long term business and requires long term commitment. On the other hand, complete acquisition of one company by another is less likely in China as most companies are still in the developing stages and there are significant integration risks in any actual merger. Having said that, CIRC released regulations in 2011 that provided a mechanism for the transfer of business from one company to another. With some precedents, some multinationals are either considering exiting China (New York Life has already exited) or reducing their stakes (for example, Sun Life) or reassessing their business models. At the same time, there is still a range of multinationals eyeing entry opportunities, with joint venture approvals for foreign companies such as Korea Life, Prudential US, Dai-ichi Life having been provided in Conclusion The life insurance industry certainly faced significant headwinds in However, it is important to put these challenges into perspective. Compared to the last round of industry-wide challenges (the negative interest spread in the late 1990s), industry practitioners now have significantly improved their technical and managerial capabilities to address these issues and there are more ways to mitigate these challenges that were previously not available. While these challenges will remain significant in the short to medium term, the life insurance industry in China is still young and the potential is still significant due to low penetration, demographic changes, room for innovation in products and services as well as the increasingly sophisticated capital markets. Companies should consider these opportunities with a long term view, develop realistic long term business plans and take advantage of their own strengths. The new CIRC chairman emphasised that the coming year would be crucial for the development of the Chinese insurance industry. The regulator would focus more on how to improve industry image, strengthen risk control and increase overall levels of service. The Chinese economy is still in a strong growth phase, and the insurance industry is still fundamentally in a rapidly developing phase. Companies who can take advantages from lessons learned from recent challenges and adjust their strategies accordingly, will stand to benefit from the continued growth of the insurance industry. Contact Adrian Liu is the General Manager of Life Insurance Consulting, China, based in Beijing. Adrian has over 18 years of experience in the life insurance industry and has worked in a wide range of consulting assignments for clients based in China, including actuarial appraisal valuations for M&A transactions and initial public offerings; business strategy consulting including market entry assessment and analysis. Adrian Liu adrian.liu@towerswatson.com Jessie Li is a senior manager and consulting actuary of the Insurance Consulting practice, based in Beijing. Jessie joined Towers Watson in 2004, she has been actively involved in a wide range of projects for clients in China, including M&A transactions, TEV/EEV/MCEV valuations, market entry and solvency tests, etc. Jessie Li jessie.li@towerswatson.com towerswatson.com 9