The now likely passage of financial services reform legislation means plenty of change on the life front. Cynthia Crosson reports.

When US life insurers pay out death benefits or lump sums on variable annuities, where does the money go? It usually goes right into the pocket of the banks and mutual fund companies the industry is now competing with as the financial services marketplace converges.

Just two life insurers have determined that they pay out about $2.7 billion a year in death benefits alone. Imagine if the industry figured out how to hang on to all these assets.

This realization - plus the now likely passage of financial services reform legislation - has focused the US life insurance industry's attention not just on asset accumulation but also on payout or distribution products that could determine their ability to differentiate themselves and remain competitive in the new financial services marketplace. This new focus, however, will demand superior risk management capabilities that only a select group of organizations are in a position to provide.

On the legislative front, Congress now appears likely to deliver the final blow to boundaries separating insurers from banks and securities firms by passing financial services reform as early as this year - quite a comeback from last year, when the legislation was pronounced all but dead.Global market forces have kept the pressure on Congress to eliminate the Depression-era regulatory structure that separates banks from insurers and other industries. Both houses of Congress passed legislation earlier this year, and a joint conference committee is now working out differences and coming up with a final bill.

While the outlook is bright, one stubborn issue which could still cause problems is the turf battle between the Treasury and the Federal Reserve Board over who will have primary control over the activities of the operating subsidiaries within a bank holding company structure. The Federal Reserve Board, chaired by Alan Greenspan, wants control to reside in a holding company, which would oversee separate insurance and banking affiliates. Only the insurance affiliate could conduct insurance activities. The Treasury, headed by Lawrence Sommers, wants the bank affiliates within the holding company structure to have the authority to write insurance business through the bank affiliate.

Regardless of what happens this year, it is only a matter of time before life insurers lose their exclusive right to manufacture insurance products with significant tax advantages. This legal and regulatory protection has been a significant competitive advantage for the industry, but it is one that companies cannot control. Many life insurers, however, have leveraged this protection through variable annuities and other tax-advantaged insurance products to gather assets and redefine themselves as asset accumulation companies, not risk management companies. It has been a successful strategy, with strong cooperation from a robust stock market. Variable annuities, the performance of which is tied to a large extent to the stock market, have grown steadily for the past 10 years, reaching $98.8 billion at year-end 1998.

The shift in focus from risk management to asset accumulation has put life insurers into direct competition with other asset gatherers, such as banks and mutual fund companies, and it is getting harder to tell these organizations apart.

The now likely prospect that life insurers will lose their exclusive rights to manufacture insurance products, combined with powerful demographic forces, could cause the pendulum to swing back toward risk management as a core competency differentiating insurers from other financial services providers. It also could be a sustainable competitive advantage, because the life insurers would have control over it. It would not be vulnerable to legislative changes. This trend toward a level playing field and away from a protected environment for life insurers is driving significant consolidation, as inefficient companies are weeded out and others merge and acquire each other, creating ever-larger organizations. The more aggressive entry of large European financial services firms into the US market also has heightened competition, adding to the pressure to pass legislation allowing banks, insurers and securities firms to acquire each other.

All of these players are fighting for the same thing- the assets of the consumer, particularly the large segment of baby boomers. The oft cited statistic that someone turns 50 every 8 seconds in the United States has focused attention on the fact that this huge population is approaching retirement, when the distribution of assets becomes as or more important than the continued accumulation of assets. That, coupled with the fact that this generation is expected to live longer than any previous generation, has prompted some in the industry to begin offering products which have the potential to retain the assets they normally lose to banks or mutual fund companies.

As part of this trend, insurers have set up trust services or have established thrift charters that allow them to conduct most banking activities. These entities can help capture death benefit payouts.

In addition, some insurers are now touting the advantages of annuitization - regular guaranteed payments for life - over lump-sum payouts in an effort to hold onto the substantial assets accumulated in variable annuities. Annuitization also transfers the risk to the insurer to provide a lifetime of income. Fixed annuities have always offered a guaranteed payout, but they have also accumulated at a relatively low rate, making them less popular in the era of the bull market. What is new is that a few companies are beginning to offer a minimum guaranteed payment as part of variable annuities, which up to now have offered only death benefit protection against market swings. This death benefit has often been attacked in the mainstream press as not being sufficient to justify the additional fees associated with annuities.

The newer products are designed to address the fact that only about 1% of variable annuity contract holders now choose to annuitize, because they do not want to give up control over their assets or to have uncertain payment streams in retirement. A few companies are therefore offering a floor or minimum payment, while offering the upside potential of market improvements.

This approach clearly answers a need in the market and could help life insurers use their risk management skills to differentiate themselves. The question is, how many life insurers have the superior risk-management skills that will be required to profitably manage products like these? The answer is only a few. One reason for the shrinking number of successful life insurance players in the industry is the fact that the convergence of financial services has made the various components of financial products, including life insurance and annuities, more transparent. There is more knowledge about the costs of mortality and morbidity risks as well as commissions to producers and the actual investment returns being credited to a contract holder. Technology and the internet have also made it easier for consumers to do comparison shopping, putting pressure on the fees a company can charge.

Life insurance has always been a spread management business. The traditional life products, however, were long-term liabilities that allowed significant room for errors in judgement - whether in the area of mortality risk, investments or expenses. The newer products, however, have unbundled these components, requiring insurers to manage them on a competitive basis.

The promise of lifetime payout products with the benefits of upside market potential without the risk of a market-related loss significantly raises the ante to the rest of the financial services industry. However, it also would dramatically alter the risk profile of life insurers. The jury is still out on whether the industry has the risk management capabilities to make it work.

Cynthia Crosson is a senior financial analyst in the life/health division of A.M. Best Company.