Insurers need some respite from perfect storm

By Donna Glasgow | August 17 2012 08:01PM

Les Herr, president and CEO of Empire Life says he would like to fully focus his energies on his renewal plan to grow the insurer’s business, increase profitability and bring the company closer to its customers. However, a “perfect storm” of regulatory and accounting pressures, as well as difficult market conditions means that he is obliged to spend much of his time navigating the complexities of a changing and stressed business environment. “I think the biggest obstacle we’ve faced in the last four years is the business environment. That’s pretty clear. I think everyone is feeling those strains,” Mr. Herr told The Insurance and Investment Journal in an exclusive interview at the insurer’s Montreal offices in late June.

First, he pointed to the changes in accounting rules that insurers have been dealing with as the new IFRS rules (International Financial Reporting Standards) are phased in. In Mr. Herr’s view, the accounting rules that the industry now faces today are inconsistent with the long-term nature of the Canadian insurance business. This is creating challenges for the industry as stock market volatility persists and interest rates stay at historically low levels.

These rules provoke the appearance of extreme volatility in Canadian insurers’ results because each quarter they must report their future contract liabilities at their fair market value.

In addition, insurers’ must deal with increasing regulatory pressure on capital both in Canada and internationally.

“You’ve kind of got a perfect storm and that is why you are seeing other companies decide not to sell products, to withdraw, to change products dramatically, to increase prices...”

Mr. Herr says he is forced to spend way too much of his time battling this storm. “There are days when I feel that we’re not in the financial services business, we’re in the regulatory business. That’s how bad it is. That’s how I feel.”

Number one risk

He is particularly worried about new rules being driven by regulators internationally. “If you ask any of the CEOs in North America what is the number one risk? The number one risk to our business is regulation. That’s exactly what it is. So instead of spending all my time really focused on our strategic objectives and meeting customer and distributors’ needs, we’re getting diverted over here to do things whether it is stress tests or quantitative tests…It is onerous.”

Despite these distractions, Mr. Herr emphasizes that his company’s business goals must still be accomplished. “We have an agenda that our shareholder wants us to continue to get done, so we’re getting it done.”

In 2011, Empire Life’s net income was $32.3 million up from $19.8 million a year earlier. But this is still significantly lower than the $53.8 million reported in 2009. Can the company’s results be improved under today’s market conditions?

Mr. Herr underlines that Empire Life’s overall results are down because of its life insurance business. The insurer’s employee benefits product line had a strong year in 2011 with $15.1 million in net income, up from $12.8 million the year before; its wealth management results were up with $16.2 million in net income from $9.6 million in 2010. However, the low interest rate environment impacted profitability of the non-participating individual insurance business resulting in a net loss for this line of $33.8 million.
Mr. Herr says the key on the life insurance side is that it is a counter cyclical business. If interest rates were to cycle back towards the historical average, then the company would be back to having exceptional years, he says.

“Right now, for most of us, the life insurance business is sinking the boat and all because of the current business environment, the low interest rates and how we account for that now. And, we still don’t know what the standard will be for determining liabilities in the future (IFRS II) and Solvency II rules (new capital rules from the international Basel Committee based in Switzerland). So, we’ve got a lot of uncertainty around that.”
Mr. Herr says most of the strain on capital today is level term 100. “The other products are not driving that boat. What’s driving that challenge is those long-term guaranteed insurance solutions and to some degree stronger capital requirements for segregated funds and GMWBs. But they pale in comparison to the life ones…”

This is why some companies are dropping or modifying some products and moving toward solutions that have better capital treatment. He doesn’t judge any insurers for making such decisions. It is a very logical approach in the current situation, he says.

“If you’ve got a product that is excessive in terms of the amount of capital you need to hold and you can’t make a return, then it is an absolutely normal behaviour to get out of it.”

This is also why we are seeing some Canadian insurers focusing on other markets, such as Asia, or different product lines such as mutual funds, group insurance or pensions. “The accounting rules will be more consistent with those businesses because they’re shorter term businesses, they’re repriceable.”
Mr. Herr says what insurers need is a better or what he calls a “normal” business environment. “We can handle ups and downs, but we’re in a very stressed environment…and one has to ask the question whether the accounting and the regulatory rules are appropriate and whether all these (product) exits are appropriate.”

He would like public policymakers to clarify their position. He would like to know whether they want insurers to sell long-term guaranteed solutions or not? This is a question that regulators and public policymakers need to ask themselves, he says.

If the current accounting and capital rules are maintained, one solution for insurers might be the introduction of long-term products with adjustable pricing as opposed to the fully guaranteed products, suggests Mr. Herr.
Adjustable pricing would allow insurers, after a stated period of time, to review and change pricing. The policy premiums could be adjusted either up or down to reflect the interest rates at the time of review, for example after a five-year-period. This would allow insurers to share interest rate risk with the consumer. If interest rates rise, premiums could go down, if rates sink lower, premiums could increase.

Mr. Herr says he thinks adjustable premiums would be a better solution than continually cranking up pricing. He says Empire Life is considering such a solution. “We’ve looked at that absolutely. I would think everybody’s probably looking at adjustable (products).”

As a CEO of an insurance company, Mr. Herr says his job is to find solutions that work for the consumer and also for his company. He says he must also think ahead and make decisions for the person who will be in his job 20 years from now. “I don’t want to put them in the position that I’m in today, having to react to my inforce and not having a whole lot of options, right? You need to deal with that so that in the future your organization continues to be strong, not only so that the consumer is protected but the company is too. It’s not good if our companies are getting stretched everytime we get into a cycle.You have to be able to withstand good and bad situations with the rules that we have.”

Again, Mr. Herr would like to know if policymakers want the industry to go in the direction of adjustable pricing. “But if you ask, they’ll say, ‘Our job is really not to focus on that. Our job is to focus on the solvency of the company’. I’m saying, ‘Yes but now your accounting rules and regulatory rules are changing the business models of the insurance industry…and we’ll all have to adjust because we all have to deliver solutions to consumers.”

Remains optimistic

Mr. Herr adds that despite the difficult business environment, he remains optimistic and says that industry stakeholders are looking for solutions. “I do believe the regulatory environment needs to consider the interaction of the capital rules, the accounting rules and what that means for the industry…

” In June, Mr. Herr, was appointed Chairman of the Canadian Life and Health Insurance Association. He declined to comment specifically on what the CLHIA is doing in regards to these issues, but did say that insurers and the association are working with regulators and taking a positive approach to their dialogue. “They have a job to do as regulators and we have a job to do to make sure that we work together to have good regulation. We’ve always had good regulation in Canada, so we want to continue to have it.”

He adds that it is an exceptionally challenging environment for everyone. “You can’t hang all that on the regulators and all that on the accountants either. It is a really tough environment and probably most people would never have predicted that it would get to this point. So I think we have to be careful that we don’t point the finger everywhere else.”