“Top business risks in the insurance industry” by Lucy Lim-Chan (October 11, 2010)

SUITS THE C-SUITE By Lucy Lim-Chan
Business World (10/11/2010)

In last week’s column, we previewed the top 10 business risks culled across 14 industries globally by Ernst & Young and featured in its 2010 Business Risk Report.

For the insurance industry, the risks identified are: regulatory intervention, model risk, financial shocks, emerging markets, managing the nonlife underwriting cycle, demographic shift in core markets, channel management, competition for capital, climate change and catastrophic events, as well as uncertainty caused by new taxes.

In the Philippines, the insurance industry is faced with a number of strategic business risks. This article will focus on what appears to be the top two risks that confront Philippine insurance companies: regulatory risk and competitive risk.

Regulatory intervention

Even at the global level, regulatory intervention tops the list.

Due to the recent global financial crisis and widespread company failures, many have questioned the effectiveness of the regulatory system. This is expected to trigger significant changes in the regulatory landscape as the regulators introduce new directives to strengthen the capital base and solvency of insurance companies.

In the European Union, the move towards Solvency II, which becomes effective this Oct. 31, has posed huge challenges for insurance companies as they prepare for its impact not only on their capital and solvency amounts, but also on their underlying systems of governance, risk management, control and disclosure, and reporting.

Considering that the industry consists of more than 100 companies, with a relatively few big multinationals and domestic companies on one hand, and numerous medium- and small-sized domestic companies on the other, it appears that the top business risk facing the Philippine insurance industry is regulatory risk, particularly compliance with the increasing capital requirements imposed by the Insurance Commission (IC).

In 2006, the Department of Finance (DoF) issued Department Order (DO) #27-06 in an attempt to recapitalize the whole industry and improve solvency positions.

For domestic companies, it prescribed increasing levels of minimum paid-up capital and minimum statutory net worth that should reach P250 million and P500 million, respectively by 2010. For entities with foreign ownership of at least 60%, this will be as high as P1 billion and P500 million, respectively.

In the same year, the IC issued Insurance Memorandum Circular (IMC) #6-2006 and #7-2006, which prescribed the adoption of a risk-based capital (RBC) framework for life and nonlife companies.

In November 2006, the regulator issued IMC #10-2006 which integrated fixed capitalization and risk-based capital frameworks under previous IMCs. This provided some relief to the insurance companies, as the next level of scheduled capital increase under the DO #27-06 is deferred to the following year for as long as the industry RBC ratio compliance rate and the RBC hurdle rate are met. For example, the scheduled capital increase for 2007 has been deferred to 2008 after the regulator determined that the industry has met the industry RBC ratio compliance rate.

Moving forward, the industry is expected to continue to face challenges in meeting capital requirements, particularly for smaller companies. A yearly increase in capital requirement for a niche business (that is not expected to expand at the same rate) would threaten its existence. Moreover, the relief provided under IMC #10-2006 will not last indefinitely. Under this IMC, both the industry RBC ratio compliance rate and the RBC hurdle rate are based on an annual schedule of progressive rates where the RBC hurdle rate can reach as high as 250% while the industry RBC ratio compliance rate will be at 90% on the fifth year.

Competitive risk

The other significant risk for the local industry is competitive risk. The existing industry structure and the country’s state of economic development contribute to heightened competition among the players.

Industry players consist of 35 life and 86 nonlife companies. The significant number of players (especially in the nonlife sector) has resulted in cutthroat competition characterized by offering lower premiums to attract or retain policyholders. There have even been cases where insufficient premiums were being charged for certain types of risks, as revealed during the recent natural catastrophes.

While the impact of these pricing strategies may not be visible in the short-term, these will affect a company’s long-term financial results and growth. Certainly, there have been attempts to curb these pricing practices through the regulator or the industry associations, yet we continue to see companies shedding off premiums in exchange for increased volume.

In the life insurance sector, there are fewer players. Competition, however, takes on a different form as companies compete with other financial institutions. Given the inequitable wealth distribution in our country, over 80% of the population is in the low-income bracket where money is spent on basic necessities like food, clothing and shelter. Only about 14% of our total population has life insurance coverage.

To compensate for minimal real market growth, life insurance firms have had to embark on aggressive selling of investment-type products (bundled with insurance coverage) in an attempt to increase business volume and compete head-on with banks, UITFs and mutual funds. The unit-linked /variable products introduced by multinationals in the local market showed remarkable take-up for a number of years as investors became attracted to the high yields reported, which led other major players to follow suit and market their own version of unit-linked products.

When the financial crisis struck, a number of unit-linked holders found themselves with account values substantially below their original investment and a dim realization that the product is not guaranteed. This affected the sales volume of unit-linked products of life insurance companies drastically, prompting them to shift their focus back to traditional insurance products. However, as the economy improves, life insurance companies may start to reprice and redesign their investment-type products to once more attract the investing public.

(As of publication, Lucy Lim-Chan is an Assurance Partner of SGV & Co.)

This article was originally published in the BusinessWorld newspaper. It is for general information only and is not a substitute for professional advice where the facts and circumstances warrant. The views and opinion expressed above are those of the author and do not necessarily represent the views of SGV & Co.