The insurance and reinsurance industry should expect further disruption as financial sectors with inefficient cost structures and high capital usage face threats from new entrants, business models, technology and alternative sources of risk capital, according to Oliver Wyman.
The financial services industry is becoming "modular" and sector participants and value chains are being "fundamentally reshaped," thanks to disruptive forces such as digital distribution platforms, new product providers, outsourcing trends and alternative sources of capital, Oliver Wyman, the management consulting arm of finance, insurance, reinsurance and advisory group Marsh & McLennan Companies (NYSE:MMC), said in a new report today.
The report titled 'Modular Financial Services: The New Shape of the Industry' looks at how the financial services sector is being generally disrupted by new business models, technology innovation (Fintech), more efficient, mobile and fungible sources of capital, as well as other factors.
"Modular financial services are emerging at different speeds across markets. Currently, banking in the US is more modular than in Europe and Asia. Property & Casualty insurance has become more modular than Life insurance. Now, the modular industry structure will go deeper and spread to new markets," commented Oliver Wyman Partner and co-author, Matt Austen. "Since the crisis, most firms have focused on optimizing their existing, integrated business model. Now, the industry is going to move towards a new, modular structure."
It's interesting that alternative capital is seen as one of the key disruptive factors for financial services, as it becomes increasingly modular, not just for insurance and reinsurance although that is clearly one of the most evident places new and efficient capital providers have affected to date.
Oliver Wyman's report explicitly names inefficient cost structures and high cost-of-capital as two elements threatening finance, with reinsurance, personal lines insurance and catastrophe insurance all areas of the market at risk of being severely disrupted.
Inefficiency and cost-of-capital are the two areas where alternative capital and the insurance-linked securities (ILS) fund manager business model are able to exert their advantage. The efficiency of the capital and the model, alongside a lower cost-of-capital due to investors motivations, diversification benefits and the desire to break down the insurance-reinsurance value-chain, all threaten the traditional incumbents in re/insurance.
Oliver Wyman defines modular financial services as: "A new structure for the industry: moving from large one-stop shops to a variety of firms competing at different points in the value chain."
This is what we've seen in property catastrophe reinsurance, with the advent of the catastrophe bond and insurance-linked securities (ILS) in the mid to late 1990's. Followed by the growth of ILS, collateralized reinsurance and the ILS fund manager business model.
The development and constant improvement of technology and risk models has also played an important role, enabling new players and alternative capital to access risks that previously could not be well understood. This step in the shift towards a modular re/insurance financial service still has some way to go, as technology continues to improve rapidly.
More recently, the ability of ILS capital to get closer to the ultimate source of the risk highlights firms moving further along the value chain, with the disruption broadening its reach.
Finally the impact on reinsurance pricing and now into commercial insurance pricing signals that the disruption caused by this modular shift is moving ever more deeply into both insurance and reinsurance.
The shift in financial services towards a modular industry will provide huge opportunities for winners as well as huge threats for losers to content with.
Oliver Wyman explains; "This is a change to the whole structure of a $5.7 trillion industry. There will be sizeable shifts across the value chain and we have identified $1 trillion of revenues and costs that might be up for grabs."
It's clear that in insurance and reinsurance the alternative capital trend and shift towards efficient business models, as well as the disrupting of the risk-insurance-reinsurance value chain presents a huge sum that could shift to new players.
"As an industry moves towards "modular demand" the distribution platforms take a cut, prices become more transparent and new providers can emerge," Oliver Wyman continues, which accurately portrays one of the effects of the growth of ILS in reinsurance today.
The cost base increasingly comes into play, as an industry shifts to a more modular approach to doing business, resulting in an increased need for efficiency and also the need to cut costs, the report also notes.
This shift towards a modular financial services industry also enhances transparency and new players will need to be prepared.
"The value that a firm provides will become transparent. Any weaknesses in the product offering, services provided or cost inefficiency is brutally exposed," Oliver Wyman warns, which is worth heeding by ILS managers as this additional transparency will be evident in their relationships with their investors and clients.
"Alternative capital providers such as loan and hedge funds have an advantage with riskier assets where regulation disadvantages regulated institutions: sub-prime loans and catastrophe risk insurance for example," Oliver Wyman continues, explaining an advantage it sees with new capital providers entering incumbent sectors.
The report notes that issues such as alternative capital entering insurance and reinsurance are eventually bound to result in some level of regulatory oversight, and rulings may one day be required, as this trend shifts advantage across the value chain.
The report cites wholesale insurance as an area where alternative capital providers are having an impact, as well as reinsurance and catastrophe insurance. As increased capital requirements and compliance costs could make doing business ever more costly for incumbents, alternative capital can wield an advantage at times, based on efficiency and lower-cost capital.
Alternative capital in finance provides an example of "modular supply" in financial services, Oliver Wyman's report explains, resulting in large parts of the risk and balance sheet being passed through to other entities.
The report states; "In insurance, large pension plans have increased their appetite for P&C risk and have become significant providers of capital. Life insurers are also looking to third-parties to off-load certain risks which are difficult to diversify."
Again, this is exactly the effect in reinsurance and more recently insurance, as ILS players and alternative capital providers seek increasing access and penetration into risk markets, while moving further along the value chain.
Oliver Wyman described alternative capital as a "new supply chain configuration," with providers that may benefit from different regulatory burdens, funding costs or diversification benefits, again reflective of some of the advantages that ILS investors can have over incumbents.
Generally in re/insurance Oliver Wyman's report explains that disruption is set to continue, due to alternative capital.
"Insurers themselves face similar competition from alternative capital providers, many of whom are willing to accept lower returns because of diversification benefits. We expect continued worsening of the already difficult environment for current suppliers of risk capital," the report states.
But these new capital providers are not the enemy and incumbents can find competitive advantage by gaining the ability to deploy capital in a smart way, as well as knowing when to leverage the new capital providers for their own benefit.
Again, this is a trait we've discussed at length, that the winners among traditional reinsurers will be those that learn how to effectively leverage the capital markets and ILS investors to their own benefit, while putting their own balance-sheet capital to best and most profitable use.
Oliver Wyman explains; "Rather than attempting to defend low return assets to retain market share, banks and insurers are positively seeking out alternative capital providers willing to buy these assets, thereby profiting both parties."
Finally, the report explains that the shift towards a more modular financial services industry and the disruption this will continue to cause does not signal the death knell of traditional firms.
"This is not the end of the bank or the insurance company, but successful firms will operate alongside new distribution platforms, product providers and suppliers of capital and infrastructure," the report says, again reflecting the important message that incumbents need to embrace new sources of lower-cost capital and new distribution mechanisms.
Once again, this is a demonstration that the impact of alternative capital is being widely felt, being noticed as a disruptive force in finance today and a trend that is happening also outside insurance and reinsurance.
As capital in the world becomes increasingly mobile and efficient, while technology advances, distribution is enhanced, supply chains change and value chains are broken down, it is penetrating traditional industries and causing significant change.
In reinsurance and insurance we can expect this change and disruption to continue, perhaps even accelerate.
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