Megatrends in the Insurance and Financial Sector

321 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector CHAPTER 17 Megatrends in the Insurance and Financial Sector RAIMO VOUTILAINEN & LASSE KOSKINEN Takeaways for Leading Change Megatrends are complex in nature, and a good understanding of them requires new skills and perspective. This chapter discusses megatrends in the context of the insurance and financial sectors. It argues that leaders and managers in the insurance and financial sector must be ready to rise to new challenges, from managing businesses in complex environments to operating in fields that are fundamentally changing and in a transition phase. In connection with these developments, more information is available now than ever before, and that information must be managed effectively. Analysing changes in terms of industry specific megatrends and trends presents one possibility to do this. Globalisation has opened new opportunities and brought new risks for businesses. This chapter outlines how leaders and managers within insurance and financial enterprises can endorse the complex character of such transformations as well as the dynamic nature of these changes. 322 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector Megatrends and trends offer a fruitful approach to analysing change. The term “megatrend”, as defined by John Naisbitt (1982), describes the significant social, economic, political, and/or technological movements that shape our lives. Megatrends are larger in magnitude, longer in duration, and deeper in their effects than normal trends. They are complex combinations of factors and huge in their effect, in both time and space (Mittelstaedt, Shultz, Kilbourne, & Peterson, 2014). Megatrends can best be identified and analysed in relation to more detailed grassroots trends. We examine how contemporary megatrends are visible in the insurance and financial sector, alongside key trends that have altered the landscape in this area. We show that managing this change has become a major challenge for the top management of financial enterprises and point out ways in which companies in these sectors can respond to the challenges arising from contemporary megatrends. At both the European and global levels, the insurance and financial sector has experienced profound structural change in recent decades. One key factor in these developments has been the banking sector and insurance sector competing with each other while at the same time also cooperating with each other (Voutilainen, 2006). Competition has taken place in the form of financial convergence. This means insurance companies launch products that perform nearly or exactly the same task as products from banks, or vice versa. Another manifestation of financial convergence is a company in one of these sectors establishing a new company in another sector or acquiring a company in that sector. Finnish banks have been especially active in establishing or acquiring insurance companies, which is why the chapter focuses on examples from Finland. As for cooperation, alliances have been formed between banks and insurance companies. The most preferred alliance model from the executive management point of view is a financial conglomerate – banks and insurance companies operating under common ownership. The benefits of this arrangement is the increased potential for effective crossselling and diversification of business portfolios. The drawbacks include high capital costs and often significant upswings and downswings in business results (e.g., Voutilainen, 2006). Here too, expansion beyond the financial sector can be seen, with banks and insurance companies starting 323 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector joint operations in other fields (e.g., OP Group, 2018). At the same time, non-financial companies have entered the insurance and financial sector. We then identify various (micro) trends in these fields, providing both Finnish and international examples and discussing the benefits and drawbacks associated with the individual trends. The discussion also examines each of these trends in light of societal megatrends. Figure 1 summarises the relationship between individual and macro trends. At the upper level there are the three megatrends: (M1) More complex regulation and taxation, (M2) Technology and demographic transition, and (M3) Fundamentally changing business models. We introduce them on the basis of their magnitude, duration, and effects on the insurance and financial sectors. At the lower level we classify individual trends under applicable megatrends. MEGATREND 1 MORE COMPLEX REGULATION AND TAXATION MEGATREND 2 TECHNOLOGY AND DEMOGRAPHIC TRANSITION MEGATREND 3 FUNDAMENTALLY CHANGING BUSINESS MODELS • Increasing financial regulation • Changes to taxation and tax policy • Products being tailored customer-specifically • Digitalisation • New health-care products (old age and other) • Hybrid products • Incentive-based insurance products • Cybersecurity • Financial convergence • Non-financial convergence • Cross-selling • One-stop shopping • Opening of value chains Megatrends and individual trends FIGURE 1: Individual trends and corresponding megatrends 324 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector This chapter proceeds in the following way. First, we discuss the megatrend, more complex regulation and taxation. We then examine the technology and demographic transition megatrend. This is followed by a discussion on fundamentally changing business models. We then examine the role of risk management The Trends and Megatrends Observed Trends in the insurance and financial sector are partly exogenous but are also influenced by the actions of the industry. On the basis of observed industry practice and reports, we have identified several trends: • Increasing financial regulation • Changes to taxation and tax policy • Products being tailored customer-specifically • Digitalisation • New health-care products (old age and other) • Financial convergence • Non-financial convergence • Incentive-based insurance products • Cross-selling • One-stop shopping • Hybrid products • Cybersecurity • Opening of value chains Proceeding from scientific findings, we further classify these fundamental trends in terms of societal megatrends. The trends listed above can be best categorised as part of three megatrends: The first of these is a megatrend of more complex regulation and taxation; the second is demographic and technology transition. The third refers to fundamental changes in business models. While the individual trends could be classified in several ways, the authors find this approach to be most logical for the reason that each trend can easily be attached to its corresponding megatrend. 325 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector More Complex Regulation and Taxation Complexity of the financial sector is a well-known phenomenon. Nicola Cetorelli, James McAndrews, and James Traina (2014) have shown that bank holding companies have grown in size and also become substantially more complex. The findings suggest that greater complexity is a natural adaptation to a new model of finance oriented toward securitisation. It is an important one indeed. Åke Freij (2017) has demonstrated the great significance of regulatory change for firms and entire industries and the difficulty in managing the implementation of new requirements arising from such change. The financial sector well exemplifies the type of boundary-spanning phenomenon this book focuses on. Changes occurring in the financial sector are an outcome of actions and interactions of public authorities and private actors. These actions and interactions are also multiscalar in the sense that their origins are in local, regional, national or supranational environments. The strongest shapers of trends and changes in economic life are the actions of public authorities, particularly in relation to regulation and taxation. Decisive movement in this area is especially strong in the insurance and finance sector. Manifested principally in stricter rules, this clearly qualifies as a megatrend. This section describes the emergence of a more complex regulation and taxation landscape. It dissects this megatrend into two trends: We first examine the effects of increasing financial regulation on the actions of companies. We then detail trends in taxation and taxation policies. In the insurance sector, the EU Solvency II regulations have been in force since the start of 2016. The new rules are risk-based and entail much more precise risk estimates than earlier regulations, for both the investments and technical reserves of insurance companies. At the same time, with the new Basel rules, capital and liquidity requirements for banks have increased. The Basel rules were set up by the international Basel Committee and regulate mainly capital and liquidity requirements for banks. Many bigger banks apply internal models for capital adequacy calculations, but the Basel committee seems to be heading towards prohibiting the use of internal models (expected with the so-called Basel 4). 326 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector The European Insurance and Occupational Pensions Authority (EIOPA) is the authority for regulating solvency requirements for insurance companies and occupational pensions companies in the EU. It has provided instructions for several stress tests (e.g., European Insurance and Occupational Pensions Authority, 2016) to assess the resilience of European insurance companies against adverse macroeconomic developments. The new Solvency II rules are so strict, in fact, that several European insurance companies have opted to take advantage of transition arrangements made possible by supervisory authorities and terms of Solvency II. The capital requirement associated with traditional and with profits life insurance are one important example of how rigorous the new solvency rules are. In traditional life insurance, there is a capital guarantee and a limited profit guarantee. The capital guarantee obligation requires the firms to hold a large amount of solvency capital. An alternative to the traditional life product, unit-linked life insurance involves no guarantee. The insured decides how to invest his or her money and retains full responsibility for profits and losses during the insurance period. It is natural that the solvency capital requirement for unit-linked insurance is only a small fraction of the capital requirement for traditional insurance. However, with Solvency II, this difference becomes even larger. Consequently, insurance companies are shifting their businesses from traditional life insurance to unit-linked offerings (see Ruuskanen & Voutilainen, 2015). For regulatory reasons, customers are no longer able to obtain guaranteed policies. They are obliged to make investment decisions they are not qualified to make or at least often dislike. As a response, life insurance companies have started to produce compromise products combining features of traditional and unit-linked life products: so-called variable annuities with a limited guarantee (Ruuskanen & Voutilainen, 2015). In this product, the insurance company may be obliged to pay back at least the amount of the premiums – for example, as a death benefit or as savings at a certain time. The solvency capital requirement of a variable annuity is less than that of traditional life insurance but greater than the amount of capital required for unit-linked insurance. Supervision of large financial conglomerates is particularly challenging, especially in cases of cross-border groups. Pekka Korhonen, Lasse Koskinen, 327 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector and Raimo Voutilainen (2006) brought together Finnish banking and insurance supervisors to ascertain which model for alliance between banks and insurance companies they most preferred. The supervisors chose a loose cross-selling agreement, citing supervisability and management of system risk as the most important criteria in their decision. The second element in the megatrend of increased regulatory complexity is the taxation environment. Taxes on financial products have profound effects on customer behaviour and, thereby, on product development. Below, we illustrate the effects of shifts and complexities in taxation, which is highly country-dependent, by looking at developments in Finland. This is an interesting example of how public and private actors behind change dynamics interact. The Finnish state has reformed the tax treatment of individual pension insurance several times over the last two decades. The lowest possible retirement age has been raised and tax deductions for premiums have decreased. Before the latest tax reform, there were 700.000 pension insurance customers, but few have been interested in the product since then. Currently, the lowest retirement age allowed is 68 years and the pension must be paid out over a span of not less than 10 years. Information on Finnish taxation system can be found in Finanssivalvonta (2017). As changes in the state’s taxation policy have made individual pension products unattractive for customers, life insurance companies have developed other products suitable for long-term savings purposes. For example, Nordea, which is the biggest financial group in the Nordic countries, has launched a capital redemption plan that pays out regularly. The product, called Target Saving, can supplement the mandatory pension, but it can also be used to finance studies or any time when there is no actual salary, thanks to the regular outpayments. As changes in the state’s taxation policy have made individual pension products unattractive for customers, life insurance companies have developed other products suitable for longterm savings purposes. 328 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector The product has no tax-deduction benefits like those for the individual pension, but its taxation is neutral. This is considered satisfactory since there are no restrictions on withdrawals as with individual pension plans (for a closer description of the product, see Nordea, 2017). It is clear that, because of the adverse tax treatment of individual pension insurance, customers are turning to alternative long-term savings products developed by life insurance companies. While lacking tax deductability of the premiums, they do not impose restrictions on withdrawals of savings. Another part of the picture is mortality cover – life insurance with death as insured event. The term “mortality protection gap” refers to the shortfall between the amount of coverage and what is necessary for maintaining the living standards of dependents. The size of this gap is calculated as follows: resources needed minus coverage in place through individual policies and employer-sponsored group life coverage. The reinsurance company Swiss Re (2015) has estimated the mortality protection gap in the Asia–Pacific region has increased sharply, amounting to 58 trillion US dollars, or 255% of the region’s gross domestic product. Unsurprisingly, a large mortality protection gap is a sign of sales potential for life insurance companies. In Finland the death sum (i.e., the amount payable upon death) has enjoyed certain benefits in inheritance taxation. However, these benefits ceased at the beginning of 2018. This change affects individual and group policies alike, also encompassing policies sponsored by the employer. The new legislation has led to great disappointment (expressed by consumer organisations and labour unions), because there are compelling social reasons for favorable tax treatment of mortality coverage. One advantage of unit-linked insurance is that the value change of investment objects (most often investment funds) does not result in taxable capital income. The tax is not collected before the end of the insurance term, which could be called a tax postponement benefit. A working group under the leadership of the Finnish Ministry of Finance is reviewing the possibilities for taxing this benefit, as is done in Sweden. The Finnish insurance industry is lobbying heavily against this because insurance already has disadvantages when compared to other forms of saving. In Finland, there is double taxation, at least in part, for almost 329 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector all types of life insurance. The only exception is risk life insurance which is not mortality insurance and in which the claim amount is paid out as a tax-free lump sum. This megatrend includes changes in both regulation and taxation. The regulation trend has affected the product offerings of life insurance companies. The taxation trend has made certain products unattractive to customers which in turn has affected product development and offerings of life insurance companies and banks as their agents. The Finnish Government has introduced a new banking product – the investment savings account – for equity saving. The product has the same tax-postponement property as unit linked insurance. Technology and Demographic Transition Breakthroughs in such fields as artificial intelligence and the Internet of things are making a huge impact on industry, on both the technology and the business fronts. At the same time, the aging of populations contributes to everything from economic shifts to changes in societal norms. In our analysis, the combined effect of technological developments and demographic transition constitutes a megatrend. This megatrend is transforming society radically. We have dissected this megatrend into several smaller scale trends (see Figure 1). Evidence of this megatrend can be seen in the digitalisation of the insurance and financial sector where the interface between company and customer is moving to the Internet. Jobs are vanishing in large numbers while new jobs emerge. Peter Weill and Stephanie L. Woerner (2013) discuss optimisation of digital business models. While many are pessimistic about the loss of jobs, others are less worried, stating, for example, that “Booz & Company’s econometric analysis estimates that, despite the unfavourable global economic climate, digitalisation provided a USD 193 billion boost to world economic output and created 6 million jobs globally in 2011” (p. XIV, Sabbagh, Friedrich, El-Darwiche, Singh, & Koster, 2013). Either way, financial-services enterprises should respond by investing in developing the abilities of their employees to deal with change. 336 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector and insurance industries through a complex network of relationships that changes on multiple time scales. Financial crises such as those of 1998, 2001, and 2008 highlight the need for holistic risk management and risk-based capital requirements. In response, Solvency II and Basel II–IV regulations permit insurance companies and banks to use internal (in-house) models for risk management and for calculating the solvency capital requirement. However, weak internal models were one cause of the crises in 2008. The main objectives and potential benefits of using internal models for regulatory purposes include risk management that is more risk-sensitive and innovative, along with greater efficiencies in terms of capital and costs. Statistical modeling is a key part of any internal model attempts to forecast the probability distribution for the profit-and-loss account and the funds available internally (European Insurance and Occupational Pensions Authority, 2014). As for the solvency capital requirement of insurance companies, a forecast looking one year ahead to the 99.5th percentile (VaR) is the calibration target. The modeling areas are addressed by the statistical quality test and calibration test in the Solvency II framework. For an overview, we direct the reader to the key articles of the directive and the aspect of internal models that they address: • Art. 113: Policy for changing of the model • Art. 114: Governance and management • Art. 118: The use test (addressing whether the model is relevant for and used in risk management) • Art. 119: Statistical quality standards • Art. 120: Calibration standards • Art. 121: Profit and loss attribution • Art. 122: Validation standards • Art. 123: Documentation standards Senior management understanding of internal model and its uses is one of the key principles guiding the use test. Leaders should have an overall understanding of the internal model, as well as specific areas they use the model. 337 Leading Change in a Complex World: Transdisciplinary Perspectives Megatrends in the Insurance and Financial Sector All of these standards are useful in the development and application of internal models in today’s changing world, with the aim of better risk management. 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