Emphasis. Life Insurance in India: Strategic Shifts in a Dynamic Industry. Telematics: The New Auto Insurance

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1 Emphasis Issue towerswatson.com The Changing Winds in Florida: Property Insurance Implications Insurance Market Profitability: It s Predictable The Manager s Role in M&A: Implications for the Insurance Industry Inflation Hedging With Inflation- Linked Bonds Telematics: The New Auto Insurance Life Insurance in India: Strategic Shifts in a Dynamic Industry

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3 Contents 2011/1 Publisher Martha A. Winslow Editors Michael Arkins Nancy Connors Linda Hassett Art Director Steve DeMasi Design John Reynolds Project Manager Nancy Adriance Production Manager Aetna Dowst Brennan 2 The Changing Winds in Florida: Property Insurance Implications Florida s experiences over the past six years provide a window into the impact of natural disasters when combined with fluctuating capital market conditions. What should government and insurers do? By Bob Betz, Judith Durdan, Lloyd Stofko and Brian O Neill 8 Insurance Market Profitability: It s Predictable While past profitability is a poor indicator of future profitability, it s possible to determine future profitability by examining the structure of the insurance market. By George Maher, Andy Staudt and Ryan Warren 12 The Manager s Role in M&A: Implications for the Insurance Industry While Towers Watson research shows that the U.S. insurance industry is doing well in retaining and engaging employees after a merger or other transaction, better use of managers during the pre-merger and integration process can improve results. By David Dean and Mary Cianni 16 Inflation Hedging With Inflation-Linked Bonds In Emphasis 2010/3, we outlined the risk of elevated inflation to P&C insurers. In this follow-up, we examine the viability of various inflation-hedging instruments. By Dan Lomelino, Kim Gillett and Marko Komarynsky 20 Telematics: The New Auto Insurance Telematic technologies are approaching a tipping point as obstacles to their widespread application are overcome in rapid succession. How are these technologies changing insurance pricing and value-added services for customers? By Alex Laurie 26 Life Insurance in India: Strategic Shifts in a Dynamic Industry The Indian life insurance sector has grown to be the world s 11th largest in just 10 years. A younger workforce, a rise in personal incomes, market competition and regulatory initiatives make this a market to watch. By Rajagopalan Krishnamurthy 32 The Last Word Life Financial Reporting: A Balanced Scorecard? By Paul Whitlock A Note From the Publisher We are thrilled that Emphasis returns to publishing quarterly in In each issue, Towers Watson is committed to supporting insurance company executives worldwide in their efforts to manage risk and capital. The lead article for the first issue of 2011, The Changing Winds in Florida, focuses on the property insurance market in Florida. A combination of forces, including exposure to hurricanes from the Atlantic Ocean and the Gulf of Mexico, a state government involving itself in insurance availability and affordability, and insurers and reinsurers expecting to earn a profit, have created a market with multiple lessons. Insurance Market Profitability: It s Predictable explains how a combination of measures from classic economic theory can be used to predict the profitability of an insurance market such as the U.K. motor market. This issue moves farther around the globe with Life Insurance in India: Strategic Shifts in a Dynamic Industry, which describes how life insurers can succeed in this developing market. The remaining articles explore themes crossing operational boundaries in areas such as people management, investment strategy and product management trends. Martha Winslow On the Cover The changing winds sweeping the Florida property insurance market are a far cry from the the gentle breezes that spin a pinwheel, but conflicting forces are creating a market dilemma that is every bit as colorful Towers Watson. All rights reserved. Emphasis is a publication of Towers Watson. To request permission to reprint Emphasis articles or to obtain extra copies, contact Martha A. Winslow at or martha.winslow@towerswatson.com. For change of address, contact Ann Field at or ann.field@towerswatson.com.

4 The Changing Winds in Florida Property Insurance Implications By Bob Betz, Judith Durdan, Lloyd Stofko and Brian O Neill Florida s experiences over the past six years provide a window into the impact of natural disasters when combined with fluctuating capital market conditions. What should government and insurers do? Government and insurers need to work together to effectively shield consumers from unanticipated changes in price while limiting interference in private markets, which delays long-term recovery. As the previous administration exits office and a new political wave of elected officials starts to work, the Florida business and insurance community will be focused on the 2011 legislative session. During 2010, critical legislative changes were just one pen stroke from being enacted, but were ultimately vetoed by then Governor Charlie Crist. Thus, the property insurance legislation so desperately needed to help stabilize the market was defeated. A Little History In 2004 and 2005, Florida was hit by multiple storms that were devastating and significantly changed the way modelers view the frequency and severity of storms. The development of a near-term view of hurricane risk, along with increased scrutiny by rating agencies, dramatically altered the amount of capital reinsurers needed to support the transfer of risk for the world s most highly exposed wind zone. The cost to reinsure Florida exposure soared and was passed to consumers through rate increases. The marketplace melted down as capital market needs and consumer pricing came head to head. Consumers naturally reacted negatively to rate increases, and politicians responded with rushed legislation conceived during a special session in January HB1A, legislation that implemented sweeping changes to Florida s insurance industry, was signed into law within the first three weeks of a new administration with many new legislators, as Florida s term limits forced out many experienced lawmakers. This legislation, compounded by regulatory pressure for wind mitigation credits, had major unintended consequences and set in motion insurance company failures in 2008 and HB1A and mitigation credits are estimated to have reduced 20% to 25% of the personal and commercial habitational premiums for companies, with no corresponding change in costs. 2 towerswatson.com

5 One unintended consequence was the establishment of legislative language that allowed the insurance system to be manipulated by some public adjusters. After a majority of the 2004 and 2005 storm losses were adjusted, many claim personnel were without work. With a failing economy and a liberal legal system, public adjusters became very creative regarding claims. Five years later, Florida continues to have new claims from 2005 s Hurricane Wilma. While public officials were questioning insurance companies for rate increases due to these claims, they created a mindset with some insureds that insurance abuse was acceptable. There are lessons to be learned here: Beware the impact of term limits and inexperienced lawmakers on insurance legislation, whether state or federal. Once there is intrusion of inappropriate legislation on contract language, it is difficult to correct without making it worse, and the judicial system can compound the problems with case law. Beware the impact of a significant number of unemployed claim adjusters. The legislative process is one of the greatest risks that companies face in Florida. Changes in statute can radically alter companies business plans, and negatively affect the availability and affordability of the reinsurance that is critical to the survival of most carriers. Without proper management of the reinsurance portion of the insurance equation, carriers cannot retain exposure for Florida property. What affects the availability and affordability of reinsurance for Florida? Florida Hurricane Catastrophe Fund In 1993, following the devastation of Hurricane Andrew, an experienced group of insurance executives and legislators created the Florida Hurricane Catastrophe Fund (FHCF) to help stabilize Florida s property insurance market, and insulate consumers from the enormous effect of rising reinsurer and capital market costs. The premise was to provide catastrophe reinsurance for private insurance companies writing personal and commercial residential property insurance through a state facility. FHCF coverage is mandatory, with several purchase options. The coverage is limited by statute to cash on hand and debt raised post-event. The cost is approximately 70% to 80% less than open market reinsurance for the same coverage. The plan s architects were looking for a minimal solution that would have the least effect on private insurance transactions while stabilizing the market and maintaining affordability for carriers and their policyholders. They recognized that this facility would rely on cash, debt and, ultimately, all of Florida s insureds to pay the bill. But the 2004 and 2005 storms caused reinsurance costs to rise, and carriers again raised their rates. Consequently, HB1A expanded coverage of the FHCF, increasing its exposure from $16 billion to $30 billion. It introduced the Temporary Increase in Coverage Limits (TICL) layer, which provided companies with the option to purchase additional $1 billion tranches of coverage above the original FHCF layer, up to $12 billion. TICL pricing was approximately 10% to 15% of corresponding private market reinsurance rates. The legislative process is one of the greatest risks faced by Florida insurers. Changes in statute can affect the availability and affordability of reinsurance. Emphasis 2011/1 3

6 Bob Betz Specializes in the Florida property insurance market. Towers Watson, New York Judith Durdan Specializes in business development planning and government relations. Towers Watson, Philadelphia This additional coverage was not mandatory. However, in an effort to reduce property insurance rates, companies could not forgo TICL, then buy private reinsurance and pass that cost along to policyholders. Rather, companies had to purchase the optional coverage and pass along the savings to their insureds. Florida s government fully involved itself in the private market by expanding reinsurance capacity and coverage. It is noteworthy that this expansion of capacity and coverage relies on cash and future debt for ultimate payment. In the event of a loss, the insurance consumer would repay the debt through future assessments over as many as 30 years, while the government was holding down rates to policyholders. Ultimately, this potential debt dependence would prove to be a fi nancial disaster. As the credit markets disintegrated in 2008, it became clear that the FHCF would not be able to meet its obligations if an event occurred, given its cash reserves and estimated bonding capacity. Recognizing the potential implications of this burden on the taxpayers of Florida, the 2009 legislature embarked on a six-year strategy to reduce TICL, increase premiums charged and stabilize the potential assessment burden. Although companies pay premiums to the FHCF each year, if a loss causes a depletion of cash reserves, the FHCF relies completely on bonding funded by assessments to nearly all insurance lines. While these assessments have been manageable to date, the potential inability of the FHCF to pay losses in a credit crunch has changed the current political winds within Florida. Citizens Property Insurance Corporation After Hurricane Andrew, legislators and the industry worked together to establish the Florida Residential Property and Casualty Joint Underwriting Association (FRPCJUA), which would write risks abandoned by the market due to insolvencies and carrier withdrawal. The Florida Windstorm Underwriting Association (FWUA) was originally created in 1970 to provide windstorm coverage to those coastal areas not able to obtain open market coverage primarily in Monroe County. However, by the mid-1990s, it was expanded to include 29 of the 35 coastal counties. The objective was to limit these residual market entities. However, over time, they were affected by political pressure, so that coverage was increased while rates were never allowed to rise appropriately. In 2002, the Florida legislature combined the two existing property residual markets into a single entity, creating Citizens Property Insurance Corporation. Citizens mandate was to provide property insurance coverage only to those applicants who could not otherwise obtain coverage in the private market. This included a requirement that Citizens rates not be competitive with rates charged by the admitted market. 4 towerswatson.com

7 That all changed following the 2004 and 2005 storm seasons. HB1A legislation was imposed by newly elected legislators and a regulatory body pressured by a populist governor. These changes included: Rolling back and freezing Citizens rates for four years Removing language that required Citizens rates to be noncompetitive (now the primary competition to carriers) Requiring that Citizens recommended rate at the end of the rate freeze be actuarially sound, without defining the term Allowing Citizens policyholders to remain with Citizens even if a private insurance company offered coverage Expanding Citizens to include multiperil commercial nonresidential property insurance Because Citizens is a quasi-governmental entity relying on the FHCF, policyholders consider it an A-rated company backed by the full faith and credit of Florida. Instead of being the insurer of last resort, Citizens is now the largest carrier in the state, with nearly 1.3 million policies, 22% of the personal lines market and 62% of the commercial habitational market. How does Citizens affect the availability and affordability of reinsurance? It relies on the FHCF and its own cash and debt structure with pre-event notes and post-event bonding to pay for catastrophic events. Citizens dramatically increases the potential size of FHCF assessments and creates its own assessments in the event of a significant loss. This means that Citizens will be competing in the same bond market as the FHCF. Although Citizens has explored purchasing private reinsurance, it has not done so because the legislatively imposed rate freeze makes it impossible for it to absorb the cost. This places Citizens in an unfair competitive rate position because admitted carriers need to purchase reinsurance to control their exposure to loss. Absent any changes to reduce the size of Citizens, it will continue to grow even though it is intended to be the insurer of last resort. When a major storm makes landfall in Florida, Citizens relies on a complex assessment mechanism to pay for losses when cash on hand is depleted. The tiers of potentially onerous assessments of its three separate operating accounts, along with FHCF assessments, must all be absorbed by insurance consumers. This assessment issue brings to light a real problem that many will not face until after a major storm, when the real cost to consumers will become clear. Florida s new leaders have the advantage of hindsight, including experiencing the collapse of the capital markets, to help them recognize the issues inherent in a debt-ridden structure. In 2011, positive legislation and the desire of incoming Governor Scott to reduce the debt of the FHCF and the size of Citizens could move exposure back into the private market. The new administration and legislature will need to recognize the capital markets volatility, the pressure on consumers and the need to balance paying now versus paying later in order to get Florida s house in order. The state s previous actions have set in motion case law that affects insurance contracts, resulting in the need for additional legislation to correct some judicial decisions. Lloyd Stofko Specializes in the Florida property insurance market. Towers Watson, New York Brian O Neill Specializes in the Florida property insurance market. Towers Watson, New York Because Citizens relies on the FHCF, policyholders consider it an A-rated company backed by the full faith and credit of Florida. Emphasis 2011/1 5

8 Figure 1. Florida population, (predicted), in millions Decline in population is small and temporary State population growth is expected to resume in Population will hit 20 million by 2016 and will increase by 2.5 million between 2010 and Despite the recent crash in real estate markets and higher unemployment, Florida will add millions of new residents in the years ahead, putting more strain on the state s fragile insurance markets. Source: University of Florida, Bureau of Economic and Business Research; U.S. Census Bureau; Insurance Information Institute Even with slow economic recovery, the wave of baby-boomer retirees will provide insurers with an expanding market. The Marketplace Florida continues to provide significant opportunity for growth (Figure 1). Population growth has been the engine of Florida s economy for many years, and even with slow economic recovery, the wave of baby-boomer retirees will provide insurers with an expanding market. Figure 2 illustrates the drop in premiums since the passage of 2007 s HB1A. This has set the stage for a number of insolvencies and abandonment of the market by some carriers, despite the lack of storm activity over the last five years. This is a function of rate reductions mandated by the Office of Insurance Regulation (OIR) for wind mitigation efforts and increased coverage within the FHCF forcing artificially lower rates for both the FHCF and Citizens. Rates are beginning their climb back to 2007 levels (Figure 3), and major rate increases have been approved by the OIR since mid-2010, which should improve carriers earnings throughout Florida s OIR, legislature and new cabinet recognize the inherent weakness in the current structure and its heavy reliance on debt. The question is whether they can correct the problems before the next hurricane event. Figure 2. Average homeowner s insurance premium in Florida, 2007:Q2 2009:Q4, in billions $2,000 $1,900 $1,800 $1,915 $1,914 $1,857 The state has required rates to be reduced, even though they were not adequate to begin with. Discounts don t make actuarial sense unless the discount is applied to an actuarially sound rate. Both factors have led most private insurers to reduce their presence in the state. $1,700 $1,770 $1,710 The average homeowners insurance premium as of 12/31/09 is down $274, or 14%, since 3/31/07. $1,600 $1,666 $1,647 $1,655 $1,634 $1,630 $1,641 $1,500 Q Q Q Q Q Q Q Q Q Q Q The passage of HB1A in January 2007 and the requirement to provide full mitigation discounts since March 2007 have caused a dramatic loss in premium income and caused many insurers to lose money, even without a major hurricane strike. *HO-3 policies, excluding Florida Citizens Source: Quarterly Supplemental Reports filed with the Florida OIR, prepared by Security First Insurance; Insurance Information Institute 6 towerswatson.com

9 Figure 3. Personal residential multiperil rate history (2003 to present) Average change rate dollars $300 $250 $200 $150 $100 $50 $0 Top 20 (2003) Top 20 (2004) Top 20 (2005) Top 20 (2006) DP-3 MHO-3 HO-3 HO-6 HO-4 Actuarial (2007) Rate rollback (2007) FHC presumed factor (2007) WMC (2008) Actuarial (2010) By peril (2011) Source: Citizens Property Insurance Corporation Where Will the Wind Take Us? Other catastrophe-prone jurisdictions have had the advantage of observing Florida and should recognize the pitfalls of overreacting. Given the attitude of the new legislature and cabinet, the winds of change are shifting to a decidedly more conservative fiscal view. An aggressive plan to deregulate business and a platform pushing tort reform bode well for the industry. Florida needs an overhaul of its regulatory entities to improve responsiveness to market conditions, and to deliver a message of stability that will allow insurers and reinsurers to effectively use their capital and encourage investment in Florida s insurance market. For comments or questions, call or Bob Betz at , bob.betz@towerswatson.com; Judith Durdan at , judith.durdan@towerswatson.com; Lloyd Stofko at , lloyd.stofko@towerswatson.com; or Brian O Neill at , brian.l.oneill@towerswatson.com. The industry is organizing to support reforms and pricing processes to establish a more appropriate balance between pre- and post-event financing in a stable environment, and needs to effectively educate the newly elected officials on these issues. The major lesson to be learned in the long run is that neither the state nor its politicians can ignore the need for a balance between paying now and paying later. The state s economic engine cannot run without insurance, reinsurance and capital market support. Emphasis 2011/1 7

10 Insurance Market Profitability It s Predictable By George Maher, Andy Staudt and Ryan Warren While past profitability is a poor indicator of future profitability, it s possible to determine future profitability by examining the structure of the insurance market. One of the principal determinants of profitability is the relationship between supply and demand. In general, the profitability of any given mature insurance market is directly related to the structure of that market. And because the future structure of an insurance market is often easily enough understood, it is possible to project the profitability of that market over the next three to five years. This will be of interest to senior executives making decisions as to where to grow or shrink product offerings and how to evaluate strategies in which knowledge of expected profitability is paramount. It will also help regulators identify and understand leading indicators of capital erosion. We draw on classic economic theory and our knowledge of insurance to show how the future profitability of an insurance marketplace can be predicted. Specifically, we consider several defining characteristics of markets, and discuss the relationship between these characteristics and market profitability. Figure 1 highlights each of the market characteristics we consider, the statistic by which we measure that characteristic and each characteristic s relationship to profitability. To illustrate the fundamental application of this macroeconomic approach, we ve exhaustively analyzed a single market U.K. motor with the ultimate intention of commenting on its future profitability. Equilibrium Supply and Demand One of the principal determinants of profitability is the relationship between supply and demand. When supply is high and demand is low, insurers are forced to charge a low price just to retain a sufficient quantity of business, thus driving down profits. But when supply is low and demand is high, insurers can charge more and increase profit margins. Demand is generally measured using some industry proxy, such as labor hours for workers compensation or sales for product liability; however, there is often a disconnect between these aggregate industry proxies and the actual demand. Supply is often measured using industry capacity; however, it is often difficult to allocate capacity to a line of insurance. Because of these difficulties, and to neatly bundle together the concepts of supply and demand, we look instead at the penetration index (PI), which is given as the ratio of gross written premium (GWP) to gross domestic product (GDP). In the U.S., this statistic is generally between 3% and 4%, and in the U.K., somewhere between 5% and 6%. Although the PI technically measures the relative importance of insurance in the economy, it can also be interpreted as a proxy for profit margins. To understand this, note that the denominator of GDP is most generally a proxy for demand, while the numerator is the Figure 1. Relationship between market structure and profitability Market characteristic Statistic As Profitability Equilibrium supply and demand Penetration index (PI) PI Competition Herfindahl index (HI) HI Information asymmetry Qualitative Asymmetry Product differentiation Advertising intensity (AI) AI 8 towerswatson.com

11 Figure 2. Relationship between penetration index and profitability 1.2% 1.0% 10% 0% Penetration index 0.8% 0.6% 0.4% 0.2% 10% 20% 30% 40% Profitability 0.0% % 2009 Penetration index Profitability Source: Based on Towers Watson analysis of data from the International Monetary Fund and the Financial Services Authority (U.K.). equilibrium point where supply equals demand. Thus, when this ratio is close to its empirical upper-bound, we can assert that the profit margins implicit in the GWP are in excess of the long-term average. When this ratio is close to the empirical lower-bound, we can assert that the profit margins are less than the long-term average. Figure 2 demonstrates the importance of this statistic by plotting it against profitability for the U.K. motor market. With the exception of poor returns in 1990 and 1991, the graphs are nearly identical. Competitiveness of the Market (and Bargaining Power) Supply and demand only scratch the surface of the problem. To really understand the relationship between the market structure and profitability, it is necessary to delve deeper into the exact structure of the demand as well as of the supply. Specifically, we must consider the relative concentration and bargaining power on both the sell-side and buy-side of the deal. insurance) have little buy-side bargaining power. And with the ability to bargain, of course, come profits for the seller or a good deal for the buyer. However, in insurance, market concentration is often not a signal of bargaining power, but rather a symptom of profitability. Markets that are profitable will attract new entrants, thereby increasing the competitiveness of the market. Competitors in unprofitable markets will leave, decreasing the competition for market share. In markets like insurance that are inherently competitive (i.e., that have a significant number of buyers and sellers), decreases in the HI should generally be attributed to increased competition driven by industry profitability. However, in buy- and sell-side oligopolies, measures of competitive structure are often more useful in assessing the bargaining power of the parties to the transaction. Bargaining power is essentially the ability of a party to negotiate a favorable price. For example, in situations where the buyer has more bargaining power than the seller, profits are generally low. We measure bargaining power using an index of market concentration or competition, with the most common measure being the Herfindahl index (HI). Typically, sellers in highly concentrated industries have little buy-side bargaining power because buyers can choose from many different sellers. Similarly, industries with lots of buyers (i.e., personal lines Emphasis 2011/1 9

12 Figure 3. Relationship between Herfindahl index and profitability 14% 140% Herfindahl index 13% 12% 11% 10% 9% 8% 7% 6% % 120% 110% 100% 90% 80% 2009 Combined ratio Herfindahl index Combined ratio Source: Based on Towers Watson analysis of data from the International Monetary Fund and the Financial Services Authority (U.K.) Figure 3 overlays the U.K. motor HI with the combined ratio for the period 1985 through Focusing just on the first panel, the period prior to 2002, note the cyclic relationship between the combined ratio and the HI with periods of relative profitability accompanied by market competition. In fact, the correlation between these two statistics historically is about 60%. Generally, in our analysis of other geographies and markets, we see correlations of about 40% to 60% for the more competitive markets, such as property, motor and financial lines, and correlations of about 20% to 40% for the less competitive markets, such as accident and health, aviation, marine and goods-in-transit. However, everything changed in But we are skipping ahead to the next chapter, where we will look at the relationship between the buy- and sell-side market concentrations. Information Asymmetry Information asymmetry is the branch of economics that considers markets in which the seller knows more than the buyer. To somewhat misunderstand George Akerlof s seminal paper, The Market for Lemons, consider the simple example of buying a used car. We can assume that the omniscient To really understand the relationship between the market structure and profitability, we must also consider bargaining power. used-car salesman knows not only the true value of the car, but also has information on what previous buyers have paid and what potential buyers might pay. Potential buyers, however, not only do not know what sellers are willing to accept, they also don t know whether the car is a cherry or a lemon. Here, we would say there is asymmetric information, and because of this, the buyer is likely to be ripped off. This particular situation, however, has changed significantly since 1970 when the paper was first published. Now, if anything, there is almost too much information available to buyers. The prices of used cars are published in similar detail to that of baseball cards. What s more, the prices others have paid are also available, along with expert opinion on those prices, ranging from excellent to you got a sore deal. The same story is true for insurance. Twenty years ago, brokers controlled access to the product and offered a price that maximized their kickback while keeping buyers happy enough that they didn t shop around. This situation was extremely asymmetrical because the insured was really only aware of the final price quoted, not the seven or eight quotes a broker s sheet might actually contain. In an effort to cut out the middleman, many insurers started switching to direct sales, and the majority of personal lines business in many mature markets is now placed by phone or over the Internet. Since potential insureds can readily access most insurers quotes, the information between buyer and seller has become less asymmetric. However, because there is a cost of time and effort to obtaining this information, there is still some leeway between a fair price for insurance and a fair price someone will pay. 10 towerswatson.com

13 For U.K. motor, this all changed in 2002, when the first aggregator appeared on the scene. An aggregator is a website that allows insureds to type in their details and get price quotes from many insurers simultaneously. This creates a relatively symmetrical situation where buyers can select between nearly identical products based solely on price. Although aggregators were initially hailed in the industry as a major breakthrough, in the past eight years, they have effectively been the death of price competition in U.K. motor. The second panel of Figure 3 highlights the extent of the problem. Here, the relationship between the combined ratio and the market competition is almost perfectly negatively correlated. We are also seeing a similar trend in U.K. property, although it has lagged a few years because aggregators have been slower to catch on. Luckily, the U.S., for whatever reasons, has been hesitant to adopt this technology, and it would be better for everyone if it didn t. Product Differentiation Recently, there has been considerable debate, especially with regard to health care economics, as to whether insurance is a commodity. Speaking generally, commodity markets are those in which participants can differentiate only on the basis of price, and non-commodity markets are those in which participants can differentiate not only on price, but also on other aspects of their goods or services, such as product offering, product quality, marketing and brand recognition. While profitability in a commodity market is determined entirely by expense efficiencies, profitability in a non-commodity market is dependent primarily on the ability of a company to carve out a niche market. To some extent, this is an extremely useful result because it dictates the type of business plan a potential market entrant should adopt one based on efficiencies derived from economies of scale and/or scope, or one based on a unique product offering. In this regard, it is necessary to explore measures of the commoditization of the market or, conversely, the degree of differentiation. The simplest of such statistics is the advertising intensity (AI), which is usually computed as the ratio of advertising to written premium. Also interesting, but exceptionally more difficult to compute, especially at an industry level, is the R&D intensity, the implication being that industries that spend more on R&D typically are more competitive because they are looking for that extra edge. After 2002, there was an explosion of advertising in the U.K. auto market. Until then, advertising as a percentage of written premium had remained relatively constant since the mid-1980s as competition for direct sales stabilized. However, since the advent of aggregators, the amount spent on advertising has doubled. This supports our thesis that aggregators are encouraging price competition and driving down industry aggregate profitability. The Future of U.K. Auto The moral of our story is clear: The U.K. motor market is currently not profitable. It is in a situation similar to the airline industry, where competition is making profitability elusive. Overall rate increases are not likely to have a lasting effect on the market. Rather, the situation will not improve until some consolidation occurs, aggregators are done away with or someone comes up with a new business model. A recent survey of CEOs noted that one of the worst parts of their job was sifting through all the meaningless information that crossed their desk each day to identify what actually mattered. * And what really matters is profitability. So while the actuary s job is to ensure all the micro-level pieces are in place (i.e., the overall rate level is adequate), it might be nice to take a step back and focus on what we can say about the market over the next few years. Is it a game we want to be playing? And if it is, how do we win? For comments or questions, call or George Maher at , george.maher@towerswatson.com; Andy Staudt at , andy.staudt@towerswatson.com; or Ryan Warren at , ryan.warren@towerswatson.com. * Interestingly enough, loneliness was the worst aspect of the job. George Maher Specializes in strategy for P&C insurers. Towers Watson, London Andy Staudt Specializes in reserving and pricing for P&C insurers. Towers Watson, London Ryan Warren Specializes in pricing, value and strategy for P&C insurers. Towers Watson, Reigate Emphasis 2011/1 11

14 The Manager s Role in M&A Implications for the Insurance Industry By David Dean and Mary Cianni While Towers Watson research shows that the U.S. insurance industry is doing well in retaining and engaging employees after a merger or other transaction, better use of managers during the pre-merger and integration process can improve results. As markets continue to improve in 2011, the rationale for deals will shift from financial to strategic. The View From Europe According to SNL Insurance M&A, the number of insurance industry mergers and acquisitions around the world, which increased significantly in 2010, is expected to grow further in Insurance companies depend heavily on their employees, and how these employees respond to the turmoil and uncertainty from when a deal is announced through the integration is key to the transaction s and the company s success. The tools and training a manager draws on to help employees can make all the difference, but our research shows that, at least in the U.S., insurance companies are not providing managers with the support they need. Towers Watson recently conducted two surveys, the 2010 Global Workforce Study and the 2010 M&A Role of the Manager survey, that shed light on Although the data on the manager s role in M&A for the insurance industry was gathered from U.S. companies, our extensive consulting experience with European insurance companies indicates that many of the same challenges exist there. We found that senior managers, for example, are equally overburdened with M&A work, and that companies could make better use of mid-level managers and supervisors. What s more, European companies are no more likely to provide adequate tools and training for managers to help ease the transition for employees. However, we do see that serial acquirers are doing more in this area. As is the case in the U.S., human resource departments could provide much-needed help, but they are not yet widely perceived as having capabilities in M&A training or communication. Retention of top talent is also seen as a potential issue in Europe, but we ve found that companies are most successful at retaining top talent when they successfully communicate the rationale for the merger, the strategic direction of the new company and individual employees performance objectives. insurance company employees reactions to an M&A and how U.S. insurance companies have prepared their managers to help employees through integration. Why Merge As markets continue to improve in 2011 and the volume of transactions grows, the rationale for deals will shift from financial (taking advantage of the recession to buy undervalued lines of business or entire companies) to strategic. Respondents to the M&A Role of the Manager survey said the primary reasons for their company s merger or acquisition were to consolidate and strengthen their competitive position (63%) and to expand into new geographic markets (57%). Cost management (28%) and expansion into new lines of business were also cited as important deal drivers. The good news for acquirers is that most respondents said their transaction was mostly or highly successful in meeting its objectives (Figure 1). Although, as the number of transactions proliferates, gaining a competitive edge from an accelerated and more effective transaction will become even more important. Employee Response to a Merger: Positive, but With Possible Land Mines M&A activity has a double-edged aspect: It breeds higher engagement among insurance company employees, compared to engagement levels for those who did not participate in a merger or acquisition (Figure 2). However, major changes such as M&A activity weaken the connection employees have with their company and can create retention risks. Employees who have experienced a merger or acquisition generally feel positive (66%) or enthusiastic at work (62%) about the same percentages as employees who have not experienced a major transaction. Well over half of employees who have experienced an M&A also 12 towerswatson.com

15 Managers are a crucial element in successfully bringing employees through a transaction, keeping levels of engagement high and retaining key talent. said they are motivated to help the organization succeed, support the organization s values and believe in its goals. However, 47% also report feeling frustrated at work, and 42% believe they will need to leave their employer to advance their career. While some organizations have expressed less concern about retention during the so-called jobless recovery from the recession, losing key employees happens even in bad times which is often when they are most needed. Many key employees, buffeted by organizational uncertainty and lack of clarity, may look for other job opportunities. And as the economy improves and the job market opens up, these retention risks are likely to increase. Managers whether senior leadership, mid-level managers or direct supervisors are a crucial element in successfully bringing employees through a transaction, keeping levels of engagement high and retaining key talent. But the complexity lies in how that s done and which level of management takes on what roles. The Critical Role of Managers in an M&A Organizations going through a transaction rely heavily (perhaps too heavily) on senior leadership to play critical people-oriented roles in deals, including participating on integration teams to help develop new unit or team structures, implementing new HR processes, identifying employees for reduction or reassignment, and even formally communicating with employees. While having senior leaders who visibly and actively champion the deal sets the right tone, their actions alone may not be enough. In fact, middle managers and supervisors may be playing too small a role throughout the integration. Respondents to our survey, who were overwhelmingly middle managers or supervisors, reported that they were minimally involved in the integration process or for 36% of respondents played no role at all (Figure 3, next page). If given a larger role to play, middle managers and supervisors can have a positive effect on employee engagement and retention. Their established relationships with employees provide them with insight into how individual employees are adjusting to the changes under way. They can provide needed Figure 1. Success of transaction in achieving objectives* 0% 20% 40% 60% 80% 100% To transform the way we do business (n = 11) 0 9 To consolidate and strengthen competitive position (n = 58) To acquire talent/new capabilities (n = 17) To expand into new geographic markets (n = 51) 2 To optimize cost infrastructure (improve economies of scale) (n = 27) To expand into new lines of business (n = 26) To acquire new technology (n = 10) Mostly/highly successful Somewhat successful Not at all/not very successful 18 *Percentages exclude Don t know/too soon to tell. Figure 2. Engagement levels at acquiring and non-acquiring companies No M&A Activity 24% 8% 18% 50% Engaged Enrolled Disenchanted Disengaged 60 Source: Towers Watson 2010 Global Workforce Study insurance sector M&A Activity 30% 77 7% 26% % Emphasis 2011/1 13

16 Figure 3. Percent of leadership involved in integration activities 0% 5% 10% 15% 20% 25% 30% 35% 40% Provided input/advice to integration team(s) Had a formal communication role with employee group 25 Informally coached employee group 24 Developed/provided input on new unit or team structure 21 Was a member of one or more integration teams 21 Identified employees for termination and/or reassignments 12 Implemented new HR programs and processes 6 Other 2 None of these Companies can best leverage the power of managers by clearly defining the roles of the three levels of manager senior leader, middle manager and supervisor support, answer basic questions about how to continue day-to-day operations, and even make senior executives communications and decisions relevant and understandable at the unit or team level. But to do this, managers themselves may require additional support and training. Our 2010 Global Workforce Study suggests that employees who have gone through an M&A have mixed views of their immediate manager: 55% of respondents said their manager does what he or she says; 65% indicated that their manager acts honestly and fairly, and 66% said they are informed of changes. But only 49% responded that managers are good at explaining the reasons for change, and just 48% said they helped employees adapt to change. What s more, according to our M&A Role of the Manager survey, insurance industry managers aren t being given the right tools and programs to help employees weather the transaction: 53% reported receiving communication toolkits such as FAQs to help with integration, but well under half participated in regular leadership calls or HR training sessions on new programs or benefits, or had access to an integration website. Less than a third said their company held employee surveys or focus groups, or offered change management seminars for managers or employees. Only 20% reported getting training in how to increase employee adaptability and resilience, which is key to smoothing employee transition and helping them adapt quickly to new ways of working, new colleagues and new supervisors. Each of these tools would be helpful to frontline managers and could enable them to become the go-to resources for employees. And the tools are especially critical for managers who have acquired employees from the other company or who have direct reports working in other offices. Making the Most of the Three Levels of Management Companies can best leverage the power of managers during a transaction by clearly defining the roles and actions of the three levels of manager senior leader, middle manager and supervisor. Senior leaders tend to be most involved in the early days of the deal, leading or participating on integration teams, developing new unit or team structures, implementing new processes, formally communicating with employees and identifying employees for reduction in force or reassignment. They should also clearly communicate the primary factor that will drive success during the transition. Is it maintaining great client service? Ensuring efficiency of operations? When senior leaders are very clear about what s most important, they pave the way for managers to direct their employees to focus on the strategies and tasks that will support success. Employee communication also needs to be broken out by manager level. For example, senior management communication might focus on a combination of major announcements such as senior- and boardlevel appointments, or the new company s business strategy, while mid-level managers roles might focus on determining and communicating lower-level appointments, and providing information on how the business strategy will play out in their divisions or regions. Supervisors primary roles would be to provide more tactical information about the transaction, be a conduit for information that cascades from senior and mid-level management, and address individual employees concerns. Once plans are under way, middle managers and supervisors take on the responsibility for driving change, focusing on three critical activities: stabilize, secure and sustain. 14 towerswatson.com

17 Stabilize. Clear the obstacles that stand in the way of employees doing their jobs. Conveying what s changing and what s not changing in the early days lessens ambiguity and confusion. Secure. Help employees feel confident and a part of the new organization by giving them basic directions for dealing with customers, creating and communicating a departmental or functional decision-making chart, watching for and addressing problematic behavior (e.g., fear or anger), and informing those identified as critical or top talent of the opportunities for them in the new organization. Sustain. Make the deal work over the long run and sustain engagement levels by translating what employees are hearing from senior leaders, communicating the benefits of the deal at the departmental level and maintaining communication. Immediate managers and supervisors are best suited to connect with employees on a personal level, and explain employees roles in the new organization. Organizations that can direct the three levels of management into their most appropriate roles can make a significant difference in the smooth progression of a deal: how key talent will be retained, how quickly and efficiently the company decides who it will keep and who it will let go, and how quickly the retained employees refocus and reengage. Keeping Top Talent: What Works and What Doesn t Beyond the need to help all employees successfully make the transition into the new organization, companies must also take steps to retain top talent. Insurers use a number of tactics to keep key players, including lateral moves to new roles (used by 54% of respondents), participation in integration task forces (46%), personal outreach by leaders or managers (43%) and relocation (37%). Among the least used tactics are retention bonuses (21%), promotions (18%) and equity grants (10%). Not surprisingly, respondents said it is the most expensive options (and the least used) that are most effective. Fully 100% of respondents said retention bonuses are highly effective and reported that equity grants are highly effective (50%) or somewhat effective (50%). But other retention tactics were also given good marks, including one that costs nothing: personal outreach by leaders and managers, which was deemed highly effective by 81% of respondents and somewhat effective by 15%. Promotions were called highly effective by 67% and somewhat effective by 33%. Other ways to retain employees include coaching and change management sessions for managers, effective use of promotions and communication about how the transaction could open up more opportunities. Then middle managers must reinforce critical success factors in employees day-to-day activities. An ongoing focus on retaining top talent is critical for success. Our research shows that, in addition to coaching and change management sessions for managers, the following factors influence retention: Senior leadership s effectiveness at leading the organization through integration. Ongoing communication from senior leaders that the integration is on target and working well will help employees see the transaction s benefits. Early involvement by managers and supervisors in identifying employees for reduction in force or reassignments. The earlier that managers understand the number of employees they will lose, the better they re able to manage the remaining staff and plan their integration work. They should also be given direction on how to reassure employees who remain. Effective use of promotions to a more senior level. Promotions are an effective way to retain key employees, and they send a signal to other employees that the transaction could open more opportunities than were available at the legacy organizations. As the number of transactions in the industry continues to grow and the economy improves, companies that can make the best use of their managers and focus on retaining key talent will find their integration process goes more smoothly and the new organization is up and running quickly. For comments or questions, call or David Dean at , david.dean@towerswatson.com; or Mary Cianni at , mary.cianni@towerswatson.com. David Dean Specializes in organization effectiveness and M&A integration. Towers Watson, Atlanta Mary Cianni Specializes in global M&A integration and related change management implications. Towers Watson, New York Emphasis 2011/1 15

18 Inflation Hedging With Inflation-Linked Bonds By Dan Lomelino, Kim Gillett and Marko Komarynsky In Emphasis 2010/3, we outlined the risk of elevated inflation to P&C insurers. In this follow-up, we examine the viability of various inflation-hedging instruments. Inflation-Linked Bonds When discussing inflation hedging, the first instrument that usually comes to mind is inflationlinked bonds (or linkers). According to Barclays Capital, 13 of the 20 largest countries in terms of GDP have an inflation-linked market. The largest market for linkers in the world is the Treasury Inflation-Protected Securities (TIPS) market, issued by the U.S. Treasury. Since its inception in 1997, the TIPS market has grown to approximately $600 billion in outstanding debt, or roughly 40% of the global inflation-linked market. A U.S. TIPS coupon is a fixed rate determined at auction. The coupon is applied to an inflationadjusted principal dependent on the nonseasonally adjusted Consumer Price Index for All Urban Consumers (CPI-U) with a three-month lag. The inflation-adjusted principal is then paid out at maturity. Unlike the nominal Treasury, the dollar amount of the coupon payment is unknown at the time of purchase because the principal amount is adjusted monthly based on realized inflation. At maturity, the owner of the TIPS coupon receives the principal back from the government based on the cumulative total inflation that occurred over the life of the bond. It s important to note that the principal amount can increase or decrease depending on inflation or deflation. However, the principal paid at maturity will not fall below par value. This principal protection that U.S. TIPS provide can also be thought of as a deflation put or deflation floor. The world s largest market for inflation-linked bonds is the TIPS market, issued by the U.S. Treasury. Linkers Around the World U.S. TIPS use the Canadian model, with a deflation floor. The U.K. was the last of the G7 nations to adopt the Canadian model, in Most developed countries now also include a deflation floor in their inflation-linked bonds. The U.K. has a long history of issuing linkers, dating back to 1981, and they currently make up 33% of the U.K. gilt market, according to Barclays Capital, while U.S. TIPS are less than 10% of the U.S. Treasury market. U.K. gilt linkers use the Retail Price Index (RPI) as their inflation index. However, since 2003, the Bank of England has used the U.K. CPI as its inflation target. Recently, the U.K. government announced plans to require that U.K. CPI be used for future private pension liabilities. As of yet, there are no plans by the U.K. Debt Management Office to issue gilt linkers indexed to U.K. CPI. Given the expected increased demand by pension funds for the CPI linkers, it s logical to expect there might be a change at some point in the future. Until that time, many believe the gilt linker market will suffer from supply-and-demand imbalances. Sovereign linkers in the Euro-zone are generally issued with the reference index of the Harmonized Index of Consumer Prices excluding tobacco (HICPx). In Europe, France was the first to issue inflation-linked bonds, and France and Italy are the largest issuers in the European market. Germany was relatively late in issuing linkers, and the German market has been slow to develop. Greece has also issued linkers, but its market is less liquid, and its linkers were taken out of the Barclays indices at the end of Because of Japan s recent history of deflation, Japanese linkers have not been as popular among domestic investors as in the U.S., U.K. and Europe. The Japanese suspended issuance of inflation-linked bonds in the fall of 2008 during the financial crisis. In 2009, the Ministry of Finance embarked on a 16 towerswatson.com

19 Figure 1. Historical U.S. TIPS breakevens Breakeven inflation rate (%) 4% 3% 2% 1% 0% 1% 2% 3% June 2003 Dec June 2004 Dec June 2005 Dec June 2006 Dec June 2007 Dec June 2008 Dec June 2009 Dec June 2010 Dec Dan Lomelino Specializes in fixed-income investments and U.S. asset manager research. Towers Watson, Chicago Five-Year Seven-Year 10-Year 20-Year 30-Year Source: U.S. Treasury buyback program that retired 40% of the original issuance, and it recently announced that there would be no new issuance of inflation-linked bonds in fiscal year Australia also suspended its inflation-linked bond program in 2003, but unlike Japan, it did so because of budget surpluses. In 2009, the Australian government reintroduced its Treasury Indexed Bond program and appears to be committed to its success. The long history of Latin America linkers was precipitated by the devaluations and hyperinflation that some of that region s countries have experienced. The region s overall success weathering the recent global financial crisis has given Latin American governments more freedom in terms of what type of debt they can issue. Some in the region, such as Argentina, have stopped issuing linkers, and others, such as Mexico, have linker markets dominated by domestic investors. Brazil, on the other hand, is the fourth-largest issuer of inflation-linked bonds in the world. Latin America has probably the least homogeneous market. Latin American countries do not entirely follow the Canadian model, and each country has unique aspects to its inflation index. Breakevens and Risk Premiums The yield to maturity on a TIPS is considered a real yield the yield earned over the life of the bond over and above the level of inflation that investors can lock in today. The difference in yield between the nominal 10-year Treasury and the 10-year TIPS is called an inflation breakeven rate. An investor who expects inflation to be higher than the breakeven rate would prefer TIPS over nominal bonds, and vice versa. If you sell out of your position before maturity, there are many factors beyond the market s inflation/ disinflation view that can drive the breakeven rate. For instance, the relative value of nominal Treasuries is considered to be adversely affected by an increase in the inflation risk premium or the risk associated with increased inflation volatility. Conversely, nominal Treasuries are seen as having a liquidity premium that makes them more attractive; they are preferred by the market during flight-to-quality episodes. The liquidity premium was an especially prevalent issue in late 2008 and early 2009 in the U.S. During the crisis, investors across the globe had a strong preference for on-the-run nominal Treasuries because they were seen as the ultimate safe-harbor investment in the world s reserve currency. The market consensus is that this flight to safety was the largest factor in TIPS underperformance relative to nominal Treasuries in However, the massive flight to quality that so negatively impacted TIPS breakeven spreads were compounded by 2008 s economic reality: heightened deflation fears resulting from the shock the credit crisis had on the economy. Overall, 2008 showed that TIPS breakevens can be driven by both technical factors, such as liquidity, and by fundamental factors, such as deflationary fears. Using the relative share of each factor (technical and fundamental) to compare the performance of TIPS against nominals can be notoriously difficult and highly dependent on assumptions. Kim Gillett Specializes in fixed-income investments and U.S. asset manager research. Towers Watson, Chicago Marko Komarynsky Specializes in fixed-income investments and leads U.S. asset manager research. Towers Watson, Chicago Emphasis 2011/1 17

20 Figure 2. Historical secular trends in nominal U.S. yields and inflation 16% 14% 12% 10% 8% 6% 4% 2% 0% 2% CPI-U Year U.S. Treasury Inflation Hedging Inflation-linked bonds are relatively straightforward instruments that provide a direct hedge against inflation. If a liability is based on the same reference inflation index, the effectiveness of a hedge is limited only by any timing mismatch between the liability and the bond portfolio. If there is a serious timing mismatch, the hedge is exposed to real interest rate risk as well as fluctuations in the liquidity and inflation-risk premiums. Source: Bureau of Labor Statistics, U.S. Federal Reserve Inflation-linked bonds are relatively straightforward instruments that provide a direct hedge against inflation. The inflation-risk premium is also very difficult to measure precisely, but it is an important economic concept that has been the subject of numerous empirical economic studies. Studies that have measured inflation-risk premium over a long period of time in the U.S. and U.K. show that the inflationrisk premium can vary considerably. More recent studies in the U.S., U.K. and Euro-zone that used data from inflation-linked bond markets estimate that the inflation-risk premium has been smaller and relatively more stable. The notion that the inflation-risk premium is smaller and more stable might be the result of a belief that the major central banks have gotten better at fighting inflation. The best example of this is probably the U.S. Federal Reserve. After a long period of stagflation, the U.S. started to experience relatively benign inflation in the early 1980s. The move to a lower level of inflation corresponded with a decrease in both nominal and real yields (Figure 2). It is also believed the inflation-risk premium has decreased. If the inflation-risk premium has, in fact, come down as a result of improved inflation-fighting performance by central banks, the implication is that inflation-risk premium could rise if the central banks started to lose some of their credibility. That is to say, if the Fed is currently in the early stages of an easy-money policy that is sowing the seeds of future increased inflation, not only would TIPS do well from increased realized inflation, they would also outperform most other assets due to an increase in the inflation-risk premium. Currently, real yields in many countries still remain historically low. Even if rates do normalize, Towers Watson s long-term expectation is a 10-year real rate of only 2% in the U.S. Given this low rate of return, some might choose to look at other potential inflation-hedging instruments. Figure 3 shows some of the positives and negatives of popularly mentioned inflation hedges. As Figure 3 illustrates, while commodities and equities do have their advantages, they are fundamentally incomplete hedges. For instance, a future increase in the CPI could be the result of higher medical costs because of demographic shifts. Equities are also mentioned predominantly as an inflation hedge, but in a stagflation scenario, it is unlikely that many equity sectors will perform well. Some equity sectors, such as financials, will most likely underperform under any inflation scenario. Other sectors, such as industrials or technology, might do well under some inflation scenarios, but not necessarily under every inflation scenario. There are economic arguments for using commodities, equities or real estate as an inflation hedge. But these assets are more risky and more volatile than inflation-linked bonds, with greater upside potential and downside risk. Ultimately, if the primary goal is to hedge inflation, inflation-linked bonds should provide a greater level of protection because a linker is the only nonderivative security that has an explicit link with inflation. That should imply that linkers offer a larger measure of protection against inflation over a greater number of economic scenarios. 18 towerswatson.com