Manufacturing Profitability & Growth

The Productivity Imperative For US Life & Annuities Carriers

Productivity is a vital element of economic value creation; Research reveals what makes top performers different

Excerpts from a new study by McKinsey & Company, an industry research and consultancy company, measure the impact of continued low interest rates, slow premium growth and yes, COVID-19, on industry growth going forward. Access the full report here.

The US life and annuities industry is searching for value after a decades-long struggle to achieve profitable growth. Driven by slow premium growth, lower investment returns, and rising costs, industry returns once again dipped below the cost of equity at the start of 2020, bringing the 35-year average of returns in excess of capital to –0.1 percent. The ongoing economic fallout from the COVID-19 crisis has greatly exacerbated these challenges, with industry analysts projecting that revenue declines of 4 percent and sustained low interest rates could result in a 3 to 4 percent earnings headwind for life insurers for year-end 2020.

In these conditions, addressing structural expenses has become an important source of value. In a proprietary McKinsey survey conducted before the onset of the COVID-19 pandemic, senior life-insurance executives estimated the industry needed to reduce its costs by 35 percent in the medium term, far higher than the typical 10 to 15 percent reductions realized in most cost-cutting programs. Our experience and research confirm that an average carrier can shed 30 percent or more of its current costs—but such structural cost improvements can be difficult to achieve and sustain.

Our research shows that productivity—profits as a function of inputs—is positively correlated with both growth and economic value, which is defined as the difference between a carrier’s return on equity and its cost of equity. While most carriers struggle to meet their cost of equity, there are huge disparities in performance among the top performers and the rest of the industry. From 2004 to 2018, average top-quintile carriers returned 2.3 percent of economic value, while bottom-quintile carriers lost 4.1 percent. Data from our annual life and annuities insurance benchmarking explain part of the story: top-performing carriers can have cost efficiency ratios that are half that of bottom performers across the value chain (see sidebar, “McKinsey North American life and annuities insurance benchmarks”).

Growth is a crucial part of the productivity equation. Indeed, leading carriers have accelerated their growth by improving distribution effectiveness and emphasizing innovative, capital-light products while making ambitious structural changes to their business models and organizations. In today’s low-growth environment, public carriers that fail to achieve lasting improvements to their cost structure will continue to face economic challenges and be at risk from activist investors who want to accelerate progress or push for strategic alternatives.

High Structural Costs, With Stark Differences Between Over And Under Performers

While life and annuity carriers have focused on cutting costs during the past decade, few have done so in an effective and sustained way. Total expenses relative to total revenues (including invest­ment income), expressed as an index, increased by 20 percent from 2003 to 2019 for the life and annuities industry, even as expense ratios fell in other industries. For example, property-and-casualty (P&C) insurance carriers managed to contain expense ratio growth to 6 percent, while players in the asset management, automotive, and telecommunications industries successfully reduced their total expense ratios by 15 percent or more.

Productivity—profits as a function of inputs—is positively correlated with both growth and economic value, which is defined as the difference between a carrier’s return on equity and its cost of equity.

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Areas Of Increase

The reasons behind US life and annuity carriers’ increased costs start to become clear when looking at the evolution of the industry’s expense ratio, which measures administrative and operating expenses relative to net written premiums (NWP). From 2014 to 2019, the expense ratio increased to 18.1 percent from 15.8 percent, fueled largely by 2.5 percent annual growth in general expenses (60 percent of total expenses). Commissions and brokerage expenses (30 percent of the total) declined relative to NWP, while the remainder—taxes, licenses, and fees (less than 7 percent of the total)—grew in line with general expenses.

The primary areas of increasing general expenses were labor (salaries, wages, and related items) and IT costs. Labor costs accounted for just more than half of total general expenses during that period and grew 2.6 percent annually. IT and equipment costs (about 10 percent of the total) grew by a significant 5.6 percent annually, which may be the result of investments in technologies such as digital tools and automation whose efficiency gains are yet to be realized.

Behind the industry-wide escalating costs were stark differences in economic performance among carriers. An analysis of 22 publicly traded US life and annuities companies shows the few carriers that reduced their expense ratios the most from 2014 to 2018 had the fastest growth in NWP and created the greatest economic value over that same period—a virtuous circle fueled by carriers’ ability to direct cost savings to fund their growth.

Strategies For Boosting Productivity

Each carrier is unique, but industry leaders should begin the process to improve productivity by establishing the trajectory and full performance potential of the business across the value chain—including sales and distribution, product development, operations, technology, and corporate functions.

Reevaluate And Support Sales And Distribution

The lifeblood of the business is also the most expensive part of the value chain: sales and distribu­tion account for more than half of all expenses for most life and annuities carriers. The difference between the bottom quartile (highest sales and distribution cost) and top quartile (lowest sales and distribution cost) is stark. The carriers with the highest costs spend 15.4 percent of their GWP on sales, while those with the lowest costs spend only 8.3 percent. In annuities, the comparison is 14.2 percent versus 9.5 percent. In fact, as a percentage of GWP, bottom-quartile carriers spend more on sales alone than the top-quartile carriers spend altogether.

This variation in cost for sales and distribution reflects strategic differences in carriers’ distribution models, product mixes, sales agent commission rates, and the cost of sales support and distribution management. For example, agent commissions as a percentage of new business premiums for life-insurance products are three times higher for independent agents than for captive agents, but the cost of sales support—driven primarily by field rewards and field support—are greater for carriers with captive distribution.

Nevertheless, there are opportunities to improve effectiveness in all of these areas. In sales, carriers can assess whether their approach to commissions optimizes for long-term value. For example, incentives should account for product economics instead of simply the value of new business, the latter of which is the dominant approach in the industry.

Access the full report here.


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