Closed book portfolios of life insurance can be found across the globe. From the Netherlands to the rest of Europe, Africa, Asia, and the Americas, industry trends have emerged related to the creasing closed book size. If we look at the Dutch industry specifically, we can better understand what is going on.
From 1990 until 2007, investment and interest-linked insurances were popular products due to the favorable Dutch fiscal regime and were consequently sold in large quantities. Due to the 2007 economic crisis, changes in fiscal regime, and additional selling scandal, sales collapsed to near zero.
To address the decreasing size of the closed books, a consolidation is currently underway. A projection of the Dutch Central Bank shows that premium volumes are expected to drop faster than the number of policies, thereby reducing revenues faster than costs.
The problem with decreasing closed book size
Revenues are decreasing disproportionately compared to the actual costs due to shrinkage of the underlying portfolio. Cost reductions do not keep pace in the long run since fixed costs are independent of portfolio size.
On top of that, regulatory and compliance-driven investments are still required.
Under the assumption that no measures are taken, a break-even point will eventually be reached, as depicted in figure 1. Under Solvency II and the latest IFRS regimes, such a scenario implies that insurers are required to retain capital today for their expected future losses. Even when the expected loss is still many years away, it already affects the capital requirement and their ability to realise potential profit today.
Revisiting the profitability of a closed book portfolio
The profitability of a closed book portfolio has three sources: investments, mortality, and costs:
Through strategic asset management, an insurer may acquire a higher return than its obligation to the client. This profit source also explains the keen interest of private equity in the Dutch closed book market. Please note that capital requirements under Solvency II legislation limit freedom in strategic asset management. Therefore, the capital retained for balancing an expected future loss on costs impedes generating profit through strategic asset management.
Life insurance contracts always have mortality and longevity coverage. The profit source is the difference between mortality premiums and obligations paid to clients. Since the products have been sold in the past, this profit source is a `given.’
For the maintenance of the insurance, costs are withheld from the premiums and invested capital. The profit source amounts to the difference between charged and actual costs.
When an insurer can transform fixed costs to variable costs (scaling with the portfolio size), this will result in a release of capital. The capital release lowers the impediments for generating profit on investments.
Companies can follow three possible scenarios to avert or postpone negative cost-effectiveness—each with its own challenges.
Streamlining and digitising processes are typical examples to accomplish a lower and more flexible cost level. While optimising costs may provide relief in the short and middle term, this does not address the fundamental issue of a closed book in the long run. A drop in actual costs only postpones the break-even point and thus still implicates expected losses for which capital needs to be retained.
Merging portfolios or economics of scale
Consolidation through acquisition is a trend in the Dutch insurance market. By rationalising back offices and reporting functions, significant cost benefits can be achieved. Five players already dominate the bulk of the Dutch life insurance market.
Merging portfolios is complex and not without risk. Service and legal obligations to clients need to be respected, and financial reporting needs to be ensured throughout the migration process. Complicating factors are the typical broad product diversity within the closed books and that life insurance contracts cannot be changed unilaterally by the insurer. Moreover, these products are built in legacy IT systems with a significant level of ‘technical debt.’
In managed services, the business processes are outsourced to a specialised organisation. Such organisations – provided that they have sufficient volume – can offer a price-per-policy. This model has significant benefits under Solvency II, and IFRS since the fixed costs are reduced to a minimum. Closing such a deal provides immediate capital relief for the insurer since the future loss on profit source costs is lowered to a minimum.
In managed services, migrations are also critical. New technology enables a more flexible parametrization of a diverse set of products typically found in closed books. This accelerates the migration process significantly and even makes complex migrations possible, previously deemed “unachievable.” Hereby an economy of scale can be achieved, old legacy IT systems can be decommissioned, and the ‘key person risk’ is significantly reduced.
In summary, life insurers with closed book portfolios will take action to ensure cost-effectiveness and endured profitability. Cost optimisation and consolidation provide relief for the short and middle term, and these steps are underway in the Dutch closed book marketplace. However, this is not expected to lead to the end state. The benefits of capital release by using managed services are simply too attractive to ignore.
Contact us today to speak to one of our experts regarding closed book portfolios and how our experiences can help you cope with the inherent challenges related to these portfolios.
Harry Huisman – Principal Consultant insurance
Luca Geurds – Senior Consultant insurance
Wouter Pijl – Head Digital & Performance