The German life insurance industry—Europe’s third largest, with more than 85 million policies in force and annual premium income of $57 billion—faces hard times. Since the mid-1990s, gross margins and profits have been dropping steadily. More recently, premium income in major growth segments has started to decline as well. Whole-life insurance, the industry’s stalwart, has been hardest hit: new business has been ebbing continually, and the total number of current policies has fallen. Indeed, benefit payments on expiring policies can no longer be covered by premium income in this line. These developments are starting to hurt the industry-wide return on equity, which for all German life insurers has fallen from 27.2 percent in 1986 to 21.7 percent in 1997.

At the same time, Germany’s upward of 80 life insurance companies have found themselves increasingly entangled in a brutal "damn-the-torpedoes" competition for market share. Meanwhile, new market players such as banks, mutual funds, and securities brokers have become more than eager to enter the fray. Faced with all-out competition from within and without, the country’s life insurers have come under increasing pressure to restructure and consolidate. With entrance barriers to the protected German life insurance market gradually disappearing, strong and entrepreneurial financial services providers—domestic or foreign—are likely to benefit most from the industry’s rising wave of mergers, acquisitions, and strategic alliances.

Given the sheer size of the German market and its comparatively low penetration in terms of per capita insurance, it might easily become one of the hottest and most contested in Europe (Exhibit 1). In this process of stormy change, not only life insurance as a product but also the industry itself will be redefined and transformed. To accommodate the new environment, traditional life insurers must recast their value propositions. Three strategic options are beginning to emerge: striving for economies of scale in the existing business, becoming a global asset manager, and specializing in individual risk management.

Has the product outlived its usefulness?

Almost 56 percent of Germany’s people have at least one whole-life insurance policy.¹ The unquestionable market success of the product can be ascribed to three factors: its role as the sole widely available and safe option to provide for retirement, net returns that (because they are tax-exempt) are at least two percentage points higher than those of otherwise comparable investments, and the reliance of policyholders on advice from local insurance agents.

In recent years, however, the leading position of whole-life insurance has clearly eroded. Since 1993, when the government decided to increase the tax-exempt percentage of interest income earned by savings accounts, most people in Germany have ceased to regard whole-life insurance as their only choice for capital formation. As after-tax income stagnates and the savings-to-income ratio keeps dropping—from about 13 percent in 1991 to 10.9 percent in 1997—savers have started considering alternative products that do not tie up capital for years on end.

Why should 25- to 40-year-old customers purchase an investment product that can’t be modified as their lives evolve?

The increasing discontinuities of modern life—more frequent changes in business careers and lifestyles, higher divorce rates, the growing number of single-person households, and the end of lifetime employment—have also made ordinary whole-life insurance seem at odds with reality and spurred the move toward more flexible products. Why should 25- to 40-year-old customers buy an investment product that can’t be modified as their lives evolve? To an extent that was previously unknown, moreover, the German public is taking an active interest in national and international finance. As people learn to make financial decisions in a more sophisticated way, with an awareness of differences in performance and returns, they will probably become even more dissatisfied with the disadvantages of traditional whole-life insurance.

In response to these developments, new competitors have been offering such investment options as individual securities and equity funds. The returns they generate—at least if not adjusted for risk—far exceed the interest paid by whole-life insurance. Traditional competitors too are gaining ground: savings-and-loan associations offer high-yield products that enjoy tax preferences. To make things worse, the image of whole-life insurance has suffered from reports in the communications media of high commissions, high distribution and administrative costs, low dividend yields, and unfavorable buyback terms when policyholders terminate contracts before maturity. And only recently, some politicians have called for the complete repeal of the tax privileges enjoyed by whole-life insurance. This development makes it seem not only uncompetitive but also, for the very first time, risky.

The providers: Are they putting market share before balance sheet strength?

Whole-life insurance has long been the motor powering the industry’s growth; the cash value of coverage increased by 10 percent year after year. Now the tables have turned: in 1996 and again in 1997, the number of new whole-life policies fell by about 4 percent, and their share of the insurance market fell from 70 percent in 1993 to just 51 percent in 1997, the latest year for which reliable data are available. At the same time, the share of ongoing premium payments has plummeted too, from 64 percent in 1993 to 52 percent in 1997. Ongoing premium payments now run only slightly ahead of lump sum premium payments, which today account for 48 percent of premiums from new business. Since studies have shown that lump sum premiums rarely add genuine new business, this could become a serious problem for insurers.

To win over a more and more exigent customer base, insurers are marketing optimistic projections of expiry payments—the amount policyholders or their beneficiaries ultimately receive—as well as seeking the highest product or insurer ratings. In fact, many insurers are promising larger expiry payments than those of Allianz, the industry leader, while trailing Allianz in terms of net return in the long term. The media’s glorification of high consumer ratings and the insurers’ eager pursuit of them are adversely affecting the industry’s balance sheets.

Correlation analyses show that providers rated good or better by the communications media can increase premiums every year by 5 to 12 percent. Insurers with poorer ratings must often accept significantly slower premium growth (Exhibit 2). Every insurer thus tries to get a good rating, sometimes at any price. If the ratings aren’t good enough, a number of insurers dig into their reserves to improve returns. The consequences for creditworthiness and corporate value are only too well known.

Private old-age care: An emerging growth market

Private old-age care as provided by whole-life insurance has traditionally been one of three cornerstones of the German welfare system, along with public pensions and company pension plans. With the public pension system in decline and company pension plans no longer open to most employees, private pension schemes will probably take off. This will make the provision of private retirement income one of the largest and fastest-growing markets in the financial services sector. Experts estimate that Germans will continue to increase their investment in old-age care in coming years, from around $2,814 billion in 1997 to an estimated $4,870 billion in 2006.

These incentives for new growth probably won’t lead to healthy levels of profitability. First, the newly emerging market for private asset management will be uniquely attractive and accessible to a host of new market entrants—presumably, banks, investment funds, and, to a lesser extent, securities brokers. Thus, the stage is set for head-on competition among all the players involved.

Customers, knowing that they are plugging an ever-widening gap in old-age care, will have soaring expectations for returns

Second, secular changes in patterns of demand will exert relentless pressure on the margins and profits of insurers. Saving through traditional whole-life insurance mostly used to supplement statutory pension payments. In recent years, it has also become a favorite among high-income people, who use it as a long-term savings product that is not subject to taxation. In the future, patterns of demand will change dramatically. The new need for old-age care will originate primarily in the middle- and lower-income brackets. Private pension plans will slowly replace the basic old-age care hitherto provided by statutory schemes. These customers will have to invest an estimated 15 percent of their annual net incomes in these schemes—on top of rising compulsory premiums for state pensions. To do so, they will need to cut back on other expenditures, reduce private consumption, or both. These customers, knowing that they are just plugging an ever-widening gap in old-age care, will have soaring expectations for returns and expiry payments.

The insurers’ growing transparency will also nurture the rising expectations of customers: it will become easier to identify and compare actual performance on expiry. Even small differences in returns will decisively affect the failure or success of insurance products. If, for example, an employee spends 25 years saving $135 a month (including risk costs) for a whole-life insurance policy, he or she will receive expiry payments of some $94,200 given a net annual yield of about 6 percent, the German life insurance industry’s average for the past 20 years. If the yield were 7 percent annually, as with Hannoversche Life Insurance in recent years, the expiry payments, at $110,220, would be $16,020 higher!

Three options for strategic repositioning

Given the challenges confronting the industry, can life insurance companies offer customers a distinct, genuine value proposition that might also serve as a stepping stone for successful efforts to redefine and reposition the business? Surveys by the Allensbach Institute, one of Germany’s leading market research firms, show that the German people still see life insurance as the most secure way to save for retirement—and much more secure than corporate or government pension plans, which have been losing public confidence at a steady rate. In customer preference tests, only real estate consistently comes out (slightly) ahead of life insurance as the cornerstone of long-term retirement savings plans. Products such as derivatives or stocks, which offer higher returns but also higher risks, are still shunned for that purpose (Exhibit 3).

It would be wasteful not to build on the almost unassailable reputation of life insurance for security. Although this should be the leitmotif of any new marketing campaign, a rigorous repositioning of life insurance as a form of asset and risk management is needed to keep higher-yielding financial products at bay.

In doing so, insurance companies have three options for redrawing their market profiles. All trade on the intrinsic and still highly regarded value proposition of life insurance: protecting investments against such eventualities as death, occupational disability, and longevity, at attractive minimum returns. Which one (or combination) of these choices is realistic for each individual company depends entirely on its starting point and its access to financial and human resources.

Option A: Striving for economies of scale in the volume business

Supplemental life insurance for pensioners with mandatory social insurance coverage already accounts for two-thirds of the business of German life insurers. The most efficient way of presenting this value proposition to workers in low- and medium-income brackets will be to offer only standard, basic, and easy-to-explain products—both for asset accumulation and risk management—distinguished by a high level of investment security and flexibility over their life spans, but with no loss of transparency.

The acid test for market success is likely to be whether these products involve less medium-term volatility and better long-term results than products combining elements of protected-term life insurance and investment funds. As the record shows, whole-life insurance products have beaten their counterparts by a slim margin in cases of ordinary termination over an average duration of 25 years and by a larger margin in the event of death.

When policies are terminated prematurely, the picture changes in a dramatic way: today’s requirement that customers buy back their policies has the effect of automatically diminishing returns quite substantially. The earlier the policy is canceled, the higher the loss. Since the average term of all whole-life policies is just under ten years, the de facto pretax returns earned in the market are merely 2.3 percent a year. Combination investment products with the same term generate a return of 4.6 percent a year—twice as much on average.

Most whole-life contracts are terminated before maturity, with very negative consequences for purchasers

Yet more than half of all whole-life policyholders terminate contracts before they reach maturity, so what the contract design treats as the exception is actually the rule—with very negative consequences for purchasers of this asset accumulation product. Although the economics may benefit insurance companies, they pay a high price: consumer frustration and therefore a big long-term loss of reputation for the industry. In view of these deficiencies, German life insurers vying for economies of scale in the usually low-margin volume business must undertake a radical reorientation along three dimensions.

First, they have to redesign their sales processes rigorously to drive down costs and ensure profitability. Information technology must be brought to bear on the sales organization so that it targets the most promising groups through the most effective channels. Leaner sales management and optimized coaching—for example, more intensive and focused recruitment and training to cut attrition rates—can cut sales costs by up to 35 percent. In theory, this would be enough to eliminate most of the efficiency gap between life insurers and such best-practice competitors as investment funds.

Second, insurers must boost annual premium income significantly. If they opt for internal growth, they can use continuous-relationship marketing, a technique developed by consumer goods companies, to pursue a two-pronged strategy: increasing the initial hit rate (by systematically identifying leads) and increasing the renewal rate. Once limited to the high end of the market, continuous-relationship marketing can now be rolled out to the broader market thanks to advances in information technology. On average, about 50 to 60 percent of the benefit of a whole-life product on maturity is available for reinvestment, but insurers now keep an average of only 7 to 10 percent. If this rate could be increased to 20 percent, the premiums from new business for the industry as a whole would increase from $10.8 billion in 1996 to $18.9 billion.

Surveys show that brand awareness correlates well with a customer’s spontaneous willingness to take out a policy

Third, insurers must create stronger brands for the mass market, as they have already done in the high end. Surveys show that brand awareness correlates well with a customer’s spontaneous willingness to take out a policy; among the top five reasons for choosing an insurer, reputation ranks third, according to market research. Furthermore, correlation analyses of all market segments confirm that there is a significant statistical relationship between expenditures on brand-building advertising and growth in gross premiums earned. Branding, however, is very expensive; in all likelihood, only such large insurance companies as Allianz, AXA Group, and Generali could afford the enormous expenditures required.

Option B: Becoming a global asset manager

White-collar workers with above-average incomes have not been a target group for German life insurers. As the incomes of these customers rise, they begin to feel that they need retirement planning and asset accumulation services and seek ways of reducing their tax liabilities, especially if they have more than one source of income.

To serve this growth segment properly, insurance companies must offer a broad range of investment products—not only selected basic insurance products, but also attractive banklike products and funds. For sustainable success in this product and customer segment, providers will need clear competitive advantages: highly qualified sales teams with the social standing and financial expertise to gain relatively easy entrée, a range of innovative and flexible products reflecting the social and economic mobility of customers in this segment, and a world-class track record in asset management, for these sophisticated people will strongly prefer providers with outstanding products and services, as well as an international reputation.

Few German life insurers have the product range, the financial expertise, and the sales acumen to serve this segment successfully. Among Continental insurance companies, only Allianz, AXA, Generali, Credit Suisse/Winterthur, and Zurich Financial Services qualify as truly world-class asset managers, and some of these companies didn’t make it to the top until they completed major acquisitions. Industry participants estimate that an asset portfolio of at least $200 billion is needed for the gigantic investments in people, marketing, and information technology expected of global institutional asset managers.

Option C: Specializing in individual risk management

For quite a while, individual risk management, covering the professional and personal discontinuities of modern life, has ceased to be an issue only for those who own their own businesses or have other sources of private income; it has become increasingly important to such people as entrepreneurial employees. Typically, risk management products aim to provide coverage against two types of risk: longevity and occupational disability, including the resulting financial consequences. The growth prospects for private risk management business are prodigious—and fully comparable to those of asset management.

Awareness of the need for coverage against temporary risks is increasing as well; a telling example is insurance for corporate directors and officers against short-term unemployment when they make a major career change, such as starting their own businesses. Such people are also strong prospects for combination offerings that might include health insurance.

To meet this market’s demand patterns, companies must field a broad range of sophisticated products that can be adjusted flexibly over the contracts’ full terms. Insurers could, for example, offer customers the flexibility to vary the amount of the premium they pay into the investment, or health or death coverage, whenever they please.

Although this value proposition actually embodies the life insurers’ traditional core business, success will depend on factors that are not easily managed. Companies must undertake extensive and detailed analyses for each customer segment. To offer demonstrable and clearly distinctive value, they must deploy novel pricing concepts and use information technology to develop innovative products whose profitability and performance will have to be calculated with new approaches going far beyond mortality tables and actuarial rules. This will force companies to understand the needs and risks of specific customers and not only statistics about the whole population. In the marketplace, companies pursuing the individual risk management option must build brand awareness to create a profile different from that of competitors.

Tough choices ahead

Which of the three options should German insurance companies pursue? International groups such as Allianz, AXA, and Generali can certainly try more than one, if not all three simultaneously. But other companies in the industry will eventually have to choose a single approach.

Option A implies striving for market leadership in the volume segment. Success calls for operational excellence, supported by a platform of institutional skills, in each stage of the business system. Companies that have such a platform or build it quickly can look forward to evolutionary business growth made possible by their own strengths.

Option B requires companies to leave the realm of traditional insurance business. Given the evident need for economies of scale, the more rapidly and rigorously a company does so the better. Evolutionary development in this segment is nearly impossible, so option B is realistic only for Germany’s largest insurers. As an alternative, smaller companies might consider the idea of partnering with banks and investment funds that operate internationally.

Option C offers exciting opportunities for market renewal in one of the industry’s core businesses—risk management—especially for small and medium-sized insurers. Evolutionary business development is possible, since excellent institutional skills are more important than simple economies of scale. Well-versed niche players can certainly prevail here, even against much larger opponents. Strategic partnerships are possible, especially with banks and investment funds that have no particular risk management expertise of their own.