sigma Unit-linked life insurance in western Europe: regaining momentum?

Transcription

1 sigma No. 3/2003 Unit-linked life insurance in western Europe: regaining momentum? 3 Summary 4 Introduction 6 Some basics about unit-linked business 11 The market for unit-linked policies in western Europe: a success story that has come to an abrupt end for the time being 20 The risk landscape for unit-linked providers 29 Growth prospects and strategic challenges 35 Appendix: tax treatment of life insurance products, with an emphasis on unit-linked products

2 Published by: Swiss Reinsurance Company Economic Research & Consulting P.O. Box CH-8022 Zurich Telephone Fax New York Office: 55 East 52nd Street 40th Floor New York, NY Telephone Fax Hong Kong Office: 18 Harbour Road, Wanchai Central Plaza, 61st floor Hong Kong SAR Telephone Fax Authors: Rainer Helfenstein Telephone Mike Barnshaw Telephone sigma co-editor: Aurelia Zanetti Telephone Managing editor: Thomas Hess, Head of Economic Research & Consulting, is responsible for the sigma series. The editorial deadline for this study was 5 March sigma is also available in German, French, Italian, Spanish, Chinese and Japanese. sigma is available on the Swiss Re website: (under Research & Publications, sigma insurance research ) English version by: Swiss Re Group Language Services Graphic design and production: Swiss Re Logistics/Media Production Swiss Re All rights reserved. The content of this sigma edition is subject to copyright with all rights reserved. The information may be used for private or internal purposes, provided that any copyright or other proprietary notices are not removed. Electronic reuse of the data published in sigma is prohibited. Reproduction in whole or in part or use for any public purpose is only permitted with the prior written approval of Swiss Re Economic & Consulting and if the source reference Swiss Re, sigma No. 3/2003 is indicated. Courtesy copies are appreciated. Although all information used in this study was taken from reliable sources, Swiss Reinsurance Company does not accept any responsibility for the accuracy or comprehensiveness of the information. The information provided is for informational purposes only and in no way constitutes Swiss Re s position. In no event shall Swiss Re be liable for any loss or damage arising in connection with the use of this information.

3 Summary Unit-linked life insurance has assumed an important role in the average household s financial planning Premium volume rose sharply in the 1990s, only to fall again in There were signs of recovery in 2002 Unit-linked providers are faced with financial, operational and regulatory risks Opportunities and challenges In the 1990s unit-linked life insurance assumed a major role in the average household s financial planning. It was at this time that the share of unit-linked premiums as a percentage of total life insurance premiums increased from 21% (1997) to 36% (2001) in western Europe. By the end of 2001, life insurers had EUR 1020 billion of assets invested in unit-linked products. This corresponds to 11% of the GDP of western Europe. Between 1995 and 2000 premium income of unit-linked business increased annually by 24% (adjusted for inflation), compared to 5% for traditional policies. While sales of unit-linked business declined in 2001 against a backdrop of falling equity markets, products with guaranteed returns suddenly looked attractive. Provisional figures for 2002 indicate a recovery of unit-linked sales after many providers added capital protection features to their products. Unit-linked providers are often faced with financial, operational and regulatory risks. Financial risks result from various options which are added to the policies and which are difficult to price because of their long-term horizon. A further factor is the volatility of the financial markets, which has an impact on earnings and profits. Furthermore, unit-linked providers generate a substantial amount of their earnings from asset management fees, which are in turn dependent on the value of the accumulated funds. Meanwhile, besides offering a life insurer more opportunities, regulatory changes can have negative consequences for the business environment: changes in the tax regime, the introduction of expense caps or prescribed capital guarantees can have a significant impact on revenues and profits. The outlook for unit-linked business in Europe is positive. Unit-linked products returns present the policyholder and life insurer with an interesting alternative to traditional products. Not only do unit-linked products incur no investment risk for the life insurer, they also need to be backed by less solvency capital. Policyholders find themselves with a transparent product and can participate in a stock market recovery. The highest growth is expected in markets where unit-linked penetration is still low and where pension reforms are currently under way or are under discussion. The strategic challenge faced by unit-linked providers is the increased pressure on asset management fees, which is their main source of revenue. Large life insurers, which have so far held only a small share of unitlinked business in some markets, are expected to adopt aggressive strategies. This will lead to more competition and to increased product innovation. Swiss Re, sigma No. 3/2003 3

4 Introduction Different product structures in the UK and continental Europe UK, German and Swiss insurers most affected by the stock market crash The shift towards unit-linked life insurance combined with more conservative investment behaviour meant that French, Italian and Spanish life insurers were far less affected by market conditions Unit-linked policies an alternative to policies with guaranteed returns and withprofits policies The current landscape for life insurance savings products in western Europe can be divided into three parts: with-profits policies (UK), policies with a minimum guaranteed return (continental Europe) and unit-linked policies. Withprofits policies usually provide a very low guaranteed return (at least 0%), a variable annual bonus and a terminal bonus at maturity, the latter two of which depend on the performance of the life insurer's asset portfolio. Investment decisions are left to the life insurer. As returns can be smoothed over time, the company can afford to invest a certain share of assets in equities. Products with a minimum guaranteed return work in a similar way. However, the guaranteed return is usually considerably higher, thereby reducing the scope for equity investments. In contrast to the above life insurance policies with a savings element, the investment risk of a unit-linked policy is borne fully by the policyholder. However, the policyholder can determine the asset categories in which premiums are invested. European life insurers have been recently dealt a blow by the stock market crash and the low level of interest rates. UK, German and Swiss life insurers have been hit particularly hard. The reasons are manifold. UK life insurers writing with-profits policies have always invested a large portion of their assets in equities. 1 In recent years, German and Swiss life insurers have allocated high guaranteed returns and promised high surpluses to their policyholders, while investing an increasing share of their assets in equities. 2 The sharp decline in equity markets thus depleted their capital base. Products with guaranteed returns are also sold in other large continental European life insurance markets. However, in the second half of the 1990s, French, Italian and Spanish life insurers started to promote unit-linked policies. The huge success of these products allowed companies to mitigate their investment risk, thereby reducing the impact of the stock market crash. Their traditionally conservative investment policies with a strong focus on bond investments was an additional factor in their favour. The concept of policies with return guarantees and with-profits policies has recently come under increasing scrutiny. Consequently, unit-linked policies may prove to be an interesting alternative to policyholders and life insurers in Germany, Switzerland and Austria. In the UK, investors have recently started to switch from with-profits policies into unitised with-profits policies and unitlinked products. 1 At the end of 2001, UK life insurers had 37% of their non unit-linked assets invested in equities. 2 At the end of 2001, German and Swiss life insurers had 26% or 18% (based on book values) of their non-linked assets invested in equities. 4 Swiss Re, sigma No. 3/2003

5 What is a unit-linked policy and how does it differ from a traditional participating policy? The differences between a unit-linked policy and a traditional participating policy are shown in the table below. Table 1 A unit-linked policy compared to a participating policy Traditional participating policy Unit-linked policy Investment risk Borne by the life insurer to the Borne mainly by the policyholder extent of what the life insurer has guaranteed A substantial part, however, is borne by the policyholder via bonus fluctuations Asset allocation Determined by the life insurer Determined by the policyholder Death benefit Guaranteed death benefit plus Higher of guaranteed death accumulated bonus (depending benefit or value of accumulated on profit distribution method) funds; sometimes varies (such as death benefit plus accumulated funds or minimum death benefit plus accumulated funds) Endowment benefit Guaranteed living benefit plus Value of accumulated funds accumulated annual bonus and terminal bonus (based on investment performance) Surrender benefit Mathematical provision plus Value of accumulated funds less accumulated bonus (depending surrender fee on profit distribution system) less surrender fee There has been a significant change in the design of unit-linked policies over the past few years. Unit-linked products with capital protection features have attracted a lot of attention over the last two years. 3 With this type of product, the policyholder usually, upon expiry of the policy, receives back at least the premiums he or she has paid. If the underlying assets increase in value, the policyholder participates proportionally. With these hybrid products, the life insurance company takes on a certain investment risk. Companies can either assume this risk themselves or transfer it to the capital market. Structure of the study This study provides, firstly, a short overview of the design of unit-linked products. Secondly, we analyse the market trends by region and by individual market. Thirdly, we discuss the risk landscape for unit-linked providers. We conclude by examining the outlook for unit-linked business in western Europe. 3 In the UK, new single-premium unit-linked products with capital protection features increased by 56% (adjusted for inflation) in In contrast to this, new single premiums for with-profit bonds declined by 33%. Unitlinked bonds increased by 15%. In Italy, new premiums from unit-linked products with capital protection features increased by 87%, while new premiums from unit-linked products without guarantees declined by 52%. Swiss Re, sigma No. 3/2003 5

6 Some basics about unit-linked business Definition A unit-linked policy can be described as an insurance contract in which the savings benefit is linked directly to the value of units in a mutual fund or in a company s own internal fund, where the investment risk is borne by the policyholder. There are also other types of investment-linked life insurance products, one example being the index-linked contract, where the benefits are linked directly to an equity index, bond index or other reference value. Another type of policy is a guaranteed equity-linked contract, where the benefits are linked directly to an equity index whilst still guaranteeing a certain minimum return or the payback of the premiums paid in during the life of the policy. For simplicity- s sake, in this study we use the term unit-linked policy when referring to unitlinked, index-linked and guaranteed equity-linked policies. What are the attractions for life companies? Shift of investment risk to the policyholder Unit-linked business absorbs much less equity capital than traditional products. Unit-linked policies offer a large number of attractive features to life insurers. Life insurers have found it increasingly difficult to deliver the returns that they had guaranteed on traditional policies. Unit-linked products allow them to shift the investment risk to the policyholder. Unit-linked business can be very capital efficient. The solvency requirements laid down for traditional life business require life insurers to hold 4% of mathematical reserves, plus 0.3% of the sum at risk (which is the difference between the sum assured and the mathematical reserve of the policy). The requirements are much lower for unit-linked policies (1% of the fund value plus 0.3% of the sum at risk). However, if life insurers allocate a capital guarantee to the unitlinked policy, the reserve requirement can be up to 4%. Life insurers with a large portfolio of pure unit-linked business are thus required to hold less solvency capital. Given the increasing scarcity of capital in the life insurance industry, such business is becoming increasingly appealing to life insurers due to its positive impact on their return on equity. A recent study 4 examines new business profit margins 5 for participating policies and unit-linked policies in the UK, France, Italy, the Netherlands, Germany and Belgium. The study reveals how margins for unit-linked business sold via traditional sales and bancassurance channels are substantially higher in the continental European markets than in the UK. The authors argue that this difference can be attributed to the existence of a double-charging structure, high asset management fees (Italy) and the lower costs of solvency (Belgium, France, Italy and Germany) for unitlinked business. 6 The asset management fee is in the range of 1 1.5% for participating business. In unit-linked business, the management fee is in the 0.8 1% range, with a mutual fund charge of between 1 1.5%, thus resulting in a double charge. Profit margins for participating (or with-profit) policies in the UK are higher than for unit-linked business. This can be explained by the absence of a double-charging structure for unit-linked business and by the fact that the authors did not consider solvency costs for participating business. 7 4 Schroder Salomon Smith Barney (2001), European Life Insurance An examination of profitability. 5 New business profit margins are expressed as the net present value of future profits as a percentage of first-year premiums. 6 For Germany, the authors of the study assumed no costs for solvency capital of participating policies as German life insurers could rely in the past on hidden reserves and free assets (freie RfB) as a source of financing. As hidden reserves and free assets have since been used up, this is no longer a valid assumption. 7 The authors assumed is that life insurers could finance their new business strain to a large degree with free assets from policyholder funds. As free assets in the UK have declined sharply, this assumption is no longer entirely valid. 6 Swiss Re, sigma No. 3/2003

7 Access to retail asset management market Unit-linked product offerings have provided life insurers with the opportunity to gain a foothold in the rapidly growing retail asset management market. Insurance companies have been able to attract new clients with these products, in addition to retaining those looking for higher yielding investments, who otherwise would have surrendered their participating policies and invested the proceeds in mutual funds. What are the attractions for consumers? Unit-linked products looked very attractive to clients during the years of booming equity markets, as they offered them direct participation in the soaring equity markets. The example of the UK shows that stock market performance and (single-premium) unit-linked sales are closely related. A simple regression analysis shows that a 10% rise in the stock market led to a 15% increase in single-premium unit-linked sales. Figure 1 Single-premium unit-linked life sales and stock market performance in the UK, Single-premium unit-linked sales, logarithmic values UK stock market index (FTSE 100), logarithmic values Source: ABI, Swiss Re Economic Research & Consulting Tax advantages In contrast to investments in mutual funds, investments in unit-linked products offer tax advantages in most European countries. Policies usually have to fulfil certain requirements, such as a minimum duration and death benefit, in order to qualify for their favourable tax status. In several countries capital gains and investment income which accrue during the life of the policy are tax-free. However, the benefits paid out are taxed as income (sometimes at a reduced tax rate). 8 Regression result: single premium volume = ( stock market index), R 2 = 0.73 Swiss Re, sigma No. 3/2003 7

8 Some basics about unit-linked business Protection element in policy High degree of transparency Fund switches are possible In order to qualify for a tax advantage, a protection element has to be added to the policy, which is usually in the form of a death benefit. In the event of the policyholder's death before the policy expires, the company has to pay either a fixed sum (the death benefit) or the value of the accumulated funds, plus a usually small minimum death benefit. In the face of growing competition, many companies have developed products with other features and guarantees, for example, a guarantee on the value of the premiums paid. At maturity, this feature offers the policyholder the higher of the value of the fund or the sum of the premiums paid over the life of the policy. Another example is a contract which guarantees the fund value or the premiums paid, plus an annual rate of interest, whichever is higher. Faced by ever fiercer competition, many companies have not charged for these features, which in turn has made them even more appealing to clients. Unit-linked policies generally enjoy a high degree of transparency, particularly when compared with with-profit policies in the UK and with participating policies in the continental European markets. In the latter case, investment returns are managed on a pooled basis, whereby their allocation to shareholders and policyholders is often not clear-cut. It remains very much at the discretion of the company how to allocate reversionary and terminal bonuses to policyholders. In contrast, the allocation of returns on unit-linked policies is very transparent. Clients have the choice of switching between funds. While holders of participating policies do not have much if any say in how their premiums are invested, unit-linked policyholders can change the asset allocation during the life of the policy. Most life insurers allow a limited number of switches between funds at no extra cost. Categorisation of unit-linked products Table 2 Different types of unit-linked products Unit-linked products can be categorised according to various criteria: Type of reference unit-linked index-linked equity-linked Underlying investments equities, bonds, real equities, bonds, equities estate, money market money market Embedded options guaranteed minimum death benefit (GMDB), and guarantees guaranteed minimum income benefit (GMIB), guaranteed minimum accumulation benefit (GMAB) and others Type of premium payment regular premium, single premium Type of business savings business with some mortality protection, immediate and deferred variable annuities Premiums predominantly flow into equities Premiums for a unit-linked policy are usually invested in equity funds. In the UK, for example, 70% of unit-linked funds were invested in equities in The asset allocation was similar in other western European countries. There was a slight shift from equities into bonds in Against the background of crumbling equity prices, people shifted their funds from equities into bonds, with some of the new unit-linked premiums also being invested in bonds. 8 Swiss Re, sigma No. 3/2003

9 Figure 2 Investment split of unit-linked assets in the UK 100% 80% 60% 40% 20% 0% Source: ABI 100% 80% 60% 40% 20% 0% Equities Bonds Loans Real estate Cash and other Figure 3 Investment split of non-linked assets in the UK Equities Source: ABI Bonds Loans Real estate Cash and other How does a unit-linked policy work? In order to illustrate the basic structure of a unit-linked policy, let us examine a unit-linked policy with annual premiums and a death benefit. The life insurer usually pays most of the acquisition commission (the initial commission) upfront to the sales agent and pays the rest over the course of the following years. The company creates a balance sheet item (DAC, deferred acquisition Swiss Re, sigma No. 3/2003 9

10 Some basics about unit-linked business cost), which is amortised over the life of the policy. At the beginning of the policy, the company has a considerable amount of outgoings, as most of the acquisition costs have to be paid upfront to the agent; these costs are recouped from the policyholder over the course of several years. 9 Administrative costs and mortality risk premiums are either depending on the country deducted directly from the annual premium or financed by selling fund units. Figure 4 Basic cash flow for a unit-linked policy Proposer Total premium Unit growth Allocated premium Unallocated premium Interest Risk premium Unit fund RoW RoD Non-unit fund MF Death benefit Withdrawal benefit Expenses Maturity value Beneficiary Source: Swiss Re The diagram above illustrates the simplified cash-flow structure of a unit-linked policy in the UK market. The cash-flow structure varies depending on the design of the policy (charging structure, design of the funds, etc). The policyholder pays a premium at the start of the month. This premium is split into two components: one is allocated to buy units on behalf of the policyholder; the other belongs to the life insurer and is paid into the nonlinked fund. The mortality risk premium is financed out of the unit fund by cashing in units. At the end of the month, a return is paid on the units (unit growth) and a management fee (MF) charged on the unit fund before being passed on to the life insurer to cover expenses. At the end of the month, interest is credited to the non-linked fund from which administrative expenses are paid out. In the event of death or withdrawal, the amount invested in the unit fund is released and used to pay death claims (release on death, RoD) and surrender benefits (release on withdrawal, RoW). 9 One should bear in mind that costs are also incurred when issuing traditional participating policies. 10 Swiss Re, sigma No. 3/2003

11 The market for unit-linked policies in western Europe: a success story that has come to an abrupt end for the time being Falling interest rates and booming stock markets fuelling growth of unit-linked products Data sources Falling interest rates and booming stock markets in the late 1990s were two of the key factors contributing to the rise in popularity of unit-linked products in western Europe. Given such an environment, even the most cautious of investors started to search for greater returns on their savings and investments. Consequently, people started to convert deposits, bonds and traditional participating life insurance policies into equities and equity-linked products, such as mutual funds or unit-linked products. The tax advantages offered in some western European markets led people to invest in unit-linked insurance products instead of mutual funds. As a lot of continental Europeans prefer to invest their savings in fixedincome products rather than in equities, guaranteed products have traditionally dominated the life insurance market, with unit-linked products in very short supply. It was only recently that investors were tempted to look at equity-style investment products. In the UK, in contrast, which has boasted a highly developed equity culture for decades, unit-linked life insurance products have represented a very important segment of the life insurance market since the 1960s. Below, we describe the growth dynamics of unit-linked business in Europe. As market statistics on unit-linked business are often only available from 1995, we have limited our analysis to the period. The data on unitlinked premiums and assets are derived from national supervisory authorities or insurance federations/associations. Figures on premium volume and assets are given in euros (EUR). In order to allow for conversion into USD, the ECU/USD (for the years prior to the euro s introduction) and the EUR/USD exchange rates (end of period) are provided: 1995: : : : : : : : Strong growth in Europe until 2000, followed by the collapse of the unit-linked market Between 1996 and 2000, unit-linked business grew by an annual 24% (adjusted for inflation). Traditional participating business, in contrast, increased only by an annual 5% in the same period. Unit-linked premium income grew from EUR 40 billion (1995) to EUR 240 billion (2000). This corresponds to an increase from 16% to 45% of unit-linked premiums as a percentage of total life insurance premiums. Investors view unit-linked policies as being more of a savings instrument than a protection product. Premium payments for unit-linked policies are therefore often in the form of a single premium, whereas participating life policies which have a stronger protection element often involve regular premium payments. When equity markets started their downward spiral in mid-2000, the growth in unit-linked business began to slow. As the stock market plunged further in 2001, demand for unit-linked business plummeted. As most of the premium payments had been made in the form of single premiums in previous years, the steep fall in new purchases of unit-linked products brought about a dive in premium income. Policies with guaranteed returns, in contrast, looked attractive again in 2001 and (suddenly) were in wide demand. Preliminary 2002 sales figures indicate that life insurance sales have picked up: in Germany by 4% (adjusted for inflation), in Italy by 15%, in Switzerland by 5% and in Spain by 13%. This shows that people have paid little attention to the intense discussions that are under way as regards the financial stability of Europe s life insurers, thereby demonstrating their continued confidence in life insurance markets. Swiss Re, sigma No. 3/

12 The market for unit-linked policies in western Europe: a success story that has come to an abrupt end for the time being Figure 5 Real growth of unit-linked and non-linked business in western Europe 60% 50% 40% 30% 20% 10% 0% 10% 20% 30% Real growth of unit-linked premiums Real growth of non-linked premiums Source: Swiss Re Economic Research & Consulting Figure 6 Volume of unit-linked and non-linked business in western Europe, in EUR bn % % % % % 0 0% Linked premium volume Non-linked premium volume Share of unit-linked business (rhs) Source: Statistical yearbooks of national supervisory authorities and insurance federations, Swiss Re Economic Research & Consulting 12 Swiss Re, sigma No. 3/2003

13 Development in the individual markets Between 1997 and 2000 unit-linked business grew much more rapidly than traditional business in the western European markets. In Italy, Belgium, Spain, Austria and Finland, premium income from unit-linked products actually even more than doubled each year, while traditional participating business registered only a moderate increase, or even negative growth rates in some markets. New business acquisition and substitution of existing business The strong growth rates registered by unit-linked business can be attributed to two developments: the acquisition of new business and substitution of existing business. In times of booming stock markets, unit-linked policies offer the investor direct exposure to equity markets as well as tax advantages over mutual fund products. This triggered a huge inflow of new capital, especially since, in most markets, it was possible to switch from traditional participating policies into unit-linked products free of charge. Another fillip for life insurers came in the form of the more attractive profit margins they could earn on unitlinked products in most markets. Figure 7 Real growth of unit-linked premiums compared to non-linked premiums in Europe, UK Italy France Netherlands Ireland Belgium Germany Sweden Spain Luxembourg Portugal Switzerland Austria Finland Greece Denmark Norway 25% 0% 25% 50% 75% 100% 125% 150% 175% 200% Average annual growth of unit-linked premiums, Average annual growth of non-linked premiums, Source: Swiss Re Economic Research & Consulting Swiss Re, sigma No. 3/

14 The market for unit-linked policies in western Europe: a success story that has come to an abrupt end for the time being Premium growth drivers: increasing popularity of bancassurance and strong single-premium business Table 3 New single unit-linked premiums as a percentage of total new unit-linked premiums in seven European markets, 2001 France 96% Italy 96% Spain 90% UK 80% Switzerland 46% Netherlands 43% Germany 0% 2001: strong decline in unit-linked business; policies with guaranteed returns celebrate a rebirth In the markets of southern Europe, Belgium, Finland and Sweden, the growth in unit-linked business was fuelled by the increasing popularity of bancassurance. 10 Bancassurers can be distinguished between banks which set up their own insurer (or even insurers who set up their own bank) and those who merely act as a distributor. Given the high costs associated with the tied-agent channel, insurers started experimenting with different forms of distribution in an attempt to reduce overall costs. By co-operating with banks (which often resulted in a joint venture or take-over) they gained access to the formers broad branch networks. The banks were keen on getting into relationships with insurers in order to increase the proportion of their income which came from fees rather than from interest margins, especially given the current low interest environment. The southern European markets have a substantially higher density of banks than, for example, the Netherlands or the UK. 11 It is therefore not surprising that bancassurance has proved to be a success in the markets of southern Europe. Once they had established co-operation with life insurers, banks encouraged their clients to switch from traditional deposit accounts into insurance-related savings products, such as life insurance contracts and pension plans offering tax incentives. This allowed them to increase the likelihood of retaining client funds over the long term and of offering products with higher profit margins. Unit-linked business was driven by single-premium business in a number of markets (see Table 3). Investors perceived unit-linked policies as being more of an investment than a protection product. Premium payments are thus often in the form of single premiums. In France, Italy, Spain and the UK, the unit-linked market largely comprises single-premium policies. The dominance of single premium business has helped boost unit-linked sales in these markets. In the UK, the volatility in unit-linked premium income, which increased by 26% pa from , only to fall by 30% in 2001, is largely explained by fluctuations in the amount of unit-linked single-premium institutional pension business written by one company. As a lot of companies realised to their dismay in 2001, this feature makes the unit-linked sector particularly vulnerable to changes in market conditions. When global equity prices crumbled further in 2001, unit-linked policies with high exposure to equity markets suddenly lost their allure, which sent business volume plummeting in most countries. In France, Spain and Finland, unit-linked business declined by more than 40%. In Spain, the strong decline can largely be traced back to changes in the tax regime. Despite the adverse developments in global equity markets, in-force unit-linked premiums continued to grow in Germany, Portugal, Austria and Denmark (although new business premium growth slowed in Germany, for example). Policies with guaranteed returns celebrated a rebirth in most of the western European markets in 2001, where guaranteed returns of around 3% suddenly looked very attractive to clients. This can be attributed to two factors. Firstly, legislated minimum returns on guaranteed contracts were higher than what could be earned on alternative investments. Secondly, the double-charging structure in an environment of low returns had a negative effect on unit-linked business. When investors can earn 10 LIMRA (2002), Bancassurance in Europe 11 ibid 14 Swiss Re, sigma No. 3/2003

15 a return of 10% on unit-linked business, they are not averse to paying a 1% asset management fee, as their net return is still 9%. When the return on unitlinked policies decreases to 2%, the net return (ie after deducting the asset management fee) drops to 1%, which reduces the attractiveness of unit-linked business. Figure 8 Real growth of unit-linked business in force, compared to non-linked business, UK Italy France Netherlands Ireland Belgium Germany Sweden Spain Luxembourg Portugal Switzerland Austria Finland Greece Denmark Norway 60% 40% 20% 0% 20% 40% Growth of unit-linked premiums, Growth of non-linked premiums, Source: Swiss Re Economic Research & Consulting Mature unit-linked markets tend to have strong bancassurance and broker/ifa distribution channels Europe s unit-linked clients vary greatly. This is due to the fact that unit-linked policies are used for a variety of purposes, ranging from life-long insurance cover or retirement provision to tax-efficient short-term investments in mutual funds. The reason why people purchase unit-linked products depends on the regulatory environment and other market factors, such as the popularity of other savings and insurance products. There is a correlation between markets where bancassurers and independent financial advisors (IFAs) are well entrenched and where unit-linked business accounts for a large share of total premium income. Bancassurers have a vested interest in promoting unit-linked products, as they can combine protection with a mutual fund product. Banks can use co-operation to capture a portion of the funds that would otherwise have flowed to life insurers. Bancassurers are the dominant distribution channel in Spain, Italy, France, Finland, Belgium and Sweden. IFAs are generally well trained and are likely to have more investment expertise than tied agents or a company sales force. They can also provide prospective policyholders with sound advice on their investmentlinked products. IFAs hold a dominant position in the UK and Ireland. Swiss Re, sigma No. 3/

16 The market for unit-linked policies in western Europe: a success story that has come to an abrupt end for the time being Figure 9 Strong bancassurers and brokers in mature unit-linked European markets, 2001 Share of life insurance premiums distributed via banks and brokers 90% 80% 70% 60% 50% 40% 30% 20% Spain Sweden France Finland Germany Denmark Switzerland Belgium UK Netherlands Italy 10% 0% 0% 20% 40% 60% 80% 100% Share of unit-linked premiums Source: Swiss Re Economic Research & Consulting Unit-linked business is an asset accumulation business Despite falling stock markets, only moderate decline in the value of unit-linked assets The growing importance of unit-linked business is also reflected in the assets held by life insurers on behalf of policyholders. The growth dynamic looks somewhat more moderate, as strong premium growth translates only partially into asset growth. Between 1998 and 2001, unit-linked assets increased by an annual 18% (adjusted for inflation), while non-linked assets increased by 5%. Growth in unit-linked assets was strongest in 1999, increasing by more than 35%. Given the background of falling stock markets and lower or even negative premium growth, growth rates were much more moderate in 2000, and even negative in Although stock markets plummeted in 2001, the value of unit-linked assets declined only moderately. This can be explained by new premiums written, and by the fact that a portion of equity investments is capital protected (often hedged by the life insurer), while another portion is invested in bonds. 16 Swiss Re, sigma No. 3/2003

17 Figure 10 Real growth of unit-linked and non-linked assets in western Europe 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 5% Unit-linked assets Non-linked assets Sources: Statistical yearbooks of national supervisory authorities and insurance federations, Swiss Re Economic Research & Consulting 20% of life insurers total assets in unit-linked policies The share of unit-linked assets as a percentage of life insurers total assets increased from 12% in 1997 to 20% in At the end of 2001, Europe s life insurers held assets amounting to EUR 5,200 billion, EUR 1,020 billion of which was unit-linked business. In other words, 20% of life insurers total assets was devoted to unit-linked policies. Figure 11 Development of assets held by the western European life insurance industry, in EUR bn % 20% % % % Unit-linked assets Non-linked assets 0% Share of unit-linked assets (rhs) Sources: Statistical yearbooks of national supervisory authorities and insurance federations, Swiss Re Economic Research & Consulting Swiss Re, sigma No. 3/

18 The market for unit-linked policies in Western Europe: a success story that has come to an abrupt end for the time being Wide variations in the share of unit-linked business in Europe There are wide variations in the share of unit-linked business across Europe. This is demonstrated by the proportion of unit-linked assets in life insurers total assets. Figure 12 Unit-linked and non-linked assets as a percentage of total life insurers assets in western Europe, 2001 Western Europe Ireland Luxembourg 12 UK Italy Netherlands Portugal France Greece Finland Belgium Sweden Spain Austria Switzerland Norway Germany Denmark 0% 20% 40% 60% 80% 100% Unit-linked assets Non-linked assets Source: Swiss Re Economic Research & Consulting High share of unit-linked business due to important cross-border business or to a long unit-linked business tradition The markets at the top of the above chart are those where more than 20% of total life assets was generated by unit-linked business in This group includes countries which have a high share of tax-driven cross-border business (Ireland, Luxembourg) and those which have a well-developed unit-linked market (UK, Netherlands). This group also comprises markets where bancassurers occupy a strong position and where unit-linked business has expanded rapidly in recent years (Italy, France, Portugal). The second category comprises markets in which unit-linked assets constitute around 15% of total business; these are markets where unit-linked business was introduced only recently and which registered great demand for this type of product up to 2000, only to watch it decrease sharply in 2001 (Spain and Belgium). The third group comprises markets where unit-linked business is still in its infancy (Austria, Switzerland, Norway, Germany and Denmark); the reason for this being that insurers and distributors in these 12 The large share of unit-linked business in Luxembourg can be traced back to the country s large amount of cross-border business given its favourable tax regime and cost structures. 18 Swiss Re, sigma No. 3/2003

19 countries have a vested interest in traditional insurance, while consumers have been too cautious to invest in (risky) unit-linked products. In Switzerland and Germany, unit-linked business has virtually no tax advantages over traditional life business and mutual funds, as capital gains are not taxable. Figure 13 National shares of unit-linked assets in Europe, 2001 Finland 0.3% Switzerland 0.8% Spain 1% Germany 1.2% Luxembourg 1.7% Belgium 1.7% Sweden 2.4% Ireland 3.4% Austria 0.2% Portugal 0.3% Norway 0.2% Greece 0.1% Denmark 0.1% UK 56.7% Italy 7.4% Netherlands 8.1% France 14.4% Source: Swiss Re Economic Research & Consulting UK the largest market for unit-linked business The UK is by far the largest market for unit-linked business. 57% of total assets for unit-linked business are held with companies doing business in the UK. Thanks to its long history of unit-linked business, the UK is also advanced in terms of product development expertise. For this reason, the UK is expected to retain its leading position, especially now that the unit-linked segment s main competitor, traditional with-profits insurance, is subject to strict regulatory scrutiny. Swiss Re, sigma No. 3/

20 The risk landscape for unit-linked providers This study has identified three risk factors related to unit-linked policies: financial risks, operational risks and regulatory risks. A short description of this risk landscape is provided below. Financial risks Embedded options in life insurance contracts are difficult to price given their long time horizon Unit-linked products with capital protection features becoming more widespread Generally, life insurers pass on investment risk to the policyholder. However, given today s fierce competition, a lot of companies often allocate embedded options to their products, thereby passing on only a part of their investment risk. Depending on the specific design of the products in question, life insurers can find it difficult to price these guarantees appropriately, and, if the market environment undergoes a rapid change or heads in a direction which the insurer has not anticipated, these guarantees can have a major influence on its profitability. Life insurance contracts are long-term contracts. In Germany, for example, the average duration of a life insurance policy written in the year 2000 was 28 years. 13 With such a long time horizon, it is difficult to price options appropriately. By definition, embedded options are contractual rights given to the policyholder which allow him or her, under certain conditions and at a certain point in time, to alter the cash flow of the contract in terms of time, amount or occurrence probability. 14 The following provides a description of the most common options used: Guaranteed minimum accumulation benefit (GMAB) In Germany, Riester products (named after the German labour minister who was behind the development of these pension products offering tax advantages) can take the form of unit-linked products. In order to qualify for tax advantages, one of the requirements made of the product s design is its fulfilment of a capital guarantee (at the age of 60, the value of the accumulated funds must be at least equal to the total premiums paid in). This involves some financial risk for the providers of such policies. Suppose a policyholder buys a unit-linked pension product for EUR 5,000 three years prior to his or her retirement. He or she chooses to invest the money mainly in equity funds. Suppose the stock market drops sharply over the remaining three years until retirement. In such a case, the difference between the premiums paid and the current value of the mutual fund must be borne by the insurer. Such a product design can be found in other markets. In the past, AEGON, for example, sold a unit-linked product in the Netherlands with a duration of at least ten years which provided a guaranteed return of the higher of a) the market value of the assets 15, or b) a rate of 0 4% over the term of the entire contract. 16 Life insurers in Belgium and Italy used to sell singlepremium bonds which provided the higher of either a money-back or marketperformance guarantee. It is assumed that most companies hedge such guarantees with derivatives. The policyholder is therefore exposed to limited downside risk, as he or she receives the higher of the value of the accumulated funds or the premiums paid, plus a minimum interest rate GDV (2000) 14 Dillmann, Tobias (2002), Modelle zur Bewertung von Optionen in Lebensversicherungsverträgen, ifa-schriftenreihe, p The underlying asset allocation is 55% in bonds, 35% in equities and 10% in real estate and other instruments. AEGON established (30 September 2002) a reserve of EUR 184 million. 16 CSFB, Life hurts, 12 November 2002, p Russ, Jochen (1999), Die aktienindexgebundene Lebensversicherung mit garantierter Mindestverzinsung in Deutschland, ifa-schriftenreihe, p Swiss Re, sigma No. 3/2003

21 GMDBs are widespread in the US; in western Europe, however, mortality risk premiums can be adjusted over time Guaranteed minimum death benefit (GMDB) GMDBs are particularly widespread in the US. Western European life insurers also add a death benefit to their unit-linked policies, although, in contrast to US practice, the mortality risk premium is not guaranteed. In western Europe, the death benefit is guaranteed, but the mortality risk premium can be adjusted over time. Consequently, there is much less exposure to GMDB in western Europe than in the US. 18 In western Europe, premium payments for unit-linked policies are usually deducted on a monthly basis. The mortality risk premium is calculated each month and charged accordingly. An insurer can therefore adjust the mortality risk premium each month in line with the current value of the accumulated funds. In such a case, the life insurer runs only the risk that the premium charged does not correspond to its exposure. In cases where premiums are paid annually, the life insurer has an exposure of one year s duration. The company must make assumptions as to the expected performance of the underlying funds. If the value of the underlying funds undergoes an unexpected fall and the policyholder dies, that part of the cover that is unfunded must usually be borne by the life insurer. Experience with GMDBs in the US The US life insurance industry is being increasingly confronted by the growing costs of GMDB (guaranteed minimum death benefit) options that are embedded in many variable annuity contracts. CIGNA announced in September 2002 that it would be taking a USD 720 million charge to immunise itself against additional GMDB expenses. Over the past decade, life insurance companies in the US have often added GMDB options on variable annuities to their offerings and have guaranteed the mortality risk premium for the whole duration of the policy. In other words, companies have been charging a premium for mortality risk at the outset on the basis of the expected future performance of the underlying fund value. If the assets underlying the variable annuity contract do not perform as expected (and therefore the sum at risk turns out to be bigger than expected), life insurers cannot merely adjust the mortality risk premium. A simple example: let us assume the policyholder pays in a USD 100,000 single premium and chooses a GMDB of USD 100, If he or she dies after the market has fallen by 35%, the surviving dependants will receive USD 100,000 and the company has to cover the loss of USD 35,000. The life insurer s exposure to the GMDB takes the form of total death benefits minus the current value of the variable annuity accounts. This amount represents what the insurer s liability would be if all policyholders holding variable annuities died at the same time. In the event of a stock market crash triggering a plummet in the value of the accumulated funds, life insurers would not be able to adjust the premium for mortality risk. US life insurers are therefore increasingly confronted with an unexpected negative spread between the fund value and GMDB. Accounting standard-setters are keen to reflect the potential liabilities arising from GMDB in future balance sheets. The rules governing accounting practice in the US for GMDB reserves will be clarified in the near future. 18 The only European market with substantial GMDB exposure seems to be the French market. According to Moody s, 57% of the unit-linked products outstanding at the end of 2000 carried GMDBs. Companies had made provisions of EUR 124 million for GMDBs. 19 For illustrative reasons, this example does not take administrative, acquisition and mortality costs into account. Swiss Re, sigma No. 3/

22 The risk landscape for unit-linked providers Guaranteed minimum withdrawal benefit (GMWB) A GMWB premits the policyholder to withdraw up to the stated percentage (typically 7% to 10%) of total premiums paid each year, irrespective of the current value of the underlying funds. Guaranteed annuity conversion option With a guaranteed conversion option, life insurers promise the insureds that they have at maturity the option of receiving a lump sum or of converting the maturity benefit into an income payment at a predefined conversion rate. 20 In some markets, these guaranteed conversion rates are offered on unit-linked policies. As the period between the purchase of the policy with a guaranteed conversion rate and the policy s maturity can be very long (more than thirty years), the life insurer assumes substantial investment and longevity risk. If longevity increases and/or interest rates decline during the term of the contract by more than the life insurer predicted at the time the contract was priced, this may considerably increase its liability. Guaranteed period of pension payment Some variable annuity contracts guarantee to pay a monthly pension over a specified time period, independent of whether the insured dies before its expiration (in which case the pension is paid out to the surviving dependants). Option to surrender the policy This is the most common option. The policyholder has the right to surrender the policy. Usually, if the policyholder chooses to do so, he or she has to pay a surrender fee. This fee compensates for the fact that the commission which has been paid to the agent and which is usually amortised over several years could not be recouped. The surrender fee usually declines with the increasing duration of the policy (for example, 7% of mathematical reserves in the first year, 6% in the second, 5% in the third, and so on). However, surrender fees are not charged in some markets (in France, in the UK for stakeholder pensions and in Germany for Riester products). In most markets, it is possible to surrender the policy a number of years prior to maturity (for example, five years). Without paying a surrender fee, the life insurer therefore carries the risk of losing some of the initial acquisition commission which was supposed to be amortised over the life of the policy. Other options are illustrated below. As most of these options are of short duration, the insurer s financial risk is generally moderate. Conversion option: some companies allow unit-linked policyholders to convert their unit-linked policy into a term life or an endowment policy. The life insurer bears the antiselection risk. The holder of a unit-linked policy with a low death benefit can decide to convert the policy into a term life or an endowment policy with a considerably higher death benefit. In this case, the sum at risk may increase considerably. 20 The life insurer will state in the policy that the accumulated capital will be converted into a pension at, for example, the rate of 7.2%. If the insured has accumulated EUR 100,000 under the policy, he or she will receive an annual pension of EUR 7, Swiss Re, sigma No. 3/2003