If one word describes the Asian markets it is volatility. The region's economies are under increasing pressure as the global economic slowdown weakens exports and creates manufacturing overcapacity, while gross domestic product contracts and unemployment rises. The effects of the slowdown are compounded by volatility in the equity markets, and the fact that the insurance industry in Asia is clearly in transition, as it adjusts to rapid developments in the global marketplace. The unprecedented number of insolvencies in the last few years, even in countries where regulators have been diligent in their oversight and reforms, is evidence of the risk inherent in these markets.

In the more developed countries, regulators are pressed to keep pace with the convergence of financial services. Since the economic crisis of 1997, many regulators in the region have been working towards greater transparency in financial reporting, tightening of solvency margins, opening markets to foreign insurers and lowering compulsory cessions to government-controlled and domestic reinsurers. While the amount of progress varies by country, overall there is still a long way to go to meet international standards.

There is no question, however, that regulatory changes are accelerating the pace of convergence and retrenchment. Some Asian insurance regulatory regimes are moving toward risk-based capital systems and risk-management methodologies such as Value-at-Risk, which are expected to result in a substantial increase in capital requirements.

Many small insurers will exit the market, as larger groups look for ways to manage capital more efficiently.

A new era
Indeed, the next several years will be a deal-making era for financial services in Asia. Every major investment bank in the region is beefing up its financial services capacity and manpower, and looking for deals in the insurance and fund management sectors. Most of the activity is in the life sector in northern Asia – Japan, Korea and Taiwan – where negative investment spreads present opportunities for providing financial solutions, such as securitisation, and where a growing focus on wealth management for the affluent is opening the market to a variety of asset accumulation products. In China, several private equity deals in advance of Initial Public Offerings are currently underway. As the deal momentum takes off in the banking sector, it will ripple through the insurance sector, as many leading Asian insurance companies are part of larger banking groups.

Just a few years ago Asian insurers offered only a handful of products – motor, home, endowment life, and marine insurance – all protected by heavy tariffs. With deregulation of rates and competition increasing both domestically and from abroad, Asian insurers are launching new products, including medical insurance, unit-linked variable life products, D&O, E&O, title insurance, product warranty and trade credit. A focus on generating underwriting profit is driving much of the change.

Demographics also are affecting the market. As in most of the world, Asia's population is aging, and pension reform is an issue for political leaders who are looking to the private sector, including the insurance industry, for solutions.

The trends are leading to fragmentation in every Asian market, where unprecedented numbers of new entrants are transforming the competitive landscape. Bancassurance alliances are being formed, monoline underwriters and niche companies are being set up, and non-life and life companies are getting into each other's turf and competing with each other. Large local players are expected to weather the storm, but a number of smaller insurers will likely disappear. Consolidation is not taking place to the extent it should be, because a number of the smaller insurers are financially so weakened that they are not considered viable takeover targets, especially when valuations are questionable.

In the non-life industry, in particular, the deteriorating credit quality of the lower-tier insurers is creating ‘negative risk transfer,' which occurs when financially strong commercial corporations buy insurance coverage from smaller, financially weaker insurers. In these situations, the credit risk premium is greater than the hazard risk premium for the insurance buyer.

The Asia reinsurance market also is in the midst of a fundamental transition. Despite the previous industry talk about creating a mega pan-Asian reinsurer, the Asian market is still fragmented. Each domestic market is dominated by the local quasi-national reinsurance company, alongside global reinsurers. With limited growth potential and the looming foreign competition in the domestic market, Asian reinsurers are looking elsewhere, in the region and internationally, for growth opportunities.

Most of the deal making, including pre-IPO private equity investment activities, are occurring in northern Asia, as investors are drawn by the size and risk diversification opportunities in each of these markets.

Japan, as the largest insurance market in Asia, is a bellwether for what is happening in the rest of the continent, as the country continues its rapid transformation at the hands of deregulation, financial reform and a weak economy. These conditions are forcing on the insurance sector unprecedented cost-cutting and consolidation. Foreign competitors also are forcing changes in terms of product differentiation and lower prices.

The life industry is in much poorer condition than the non-life sector. Seven insolvencies have occurred since 1996, and approximately one-third of Japan's 45 life insurers are believed to have serious financial problems due to the negative interest rate spreads on long-term savings and individual life policies sold during the 1980s. Many of these policies, purchased at the height of the economic boom in the 1980s, have guaranteed interest rates in the 5.5% range with maturities of 30 to 40 years, while insurers are now earning 2% or less, even on the riskiest investments. Asset liability matching is also a significant problem, since the availability of long-term assets is very limited.

Under current law Japanese insurers are not allowed to lower the guaranteed rate on these policies unless they are bankrupt. The Financial System Council is proposing that life insurers be allowed, with policyholders' approval, to lower yield guarantees as one measure to prevent insolvency. This controversial proposal is not widely accepted by the Japanese life insurers, some of whom fear a further deterioration in public confidence in the industry, as a rate cut would amount to a partial credit default. Even if insurers attempt to cut rates, mutual life company policyholders, under the 1996 Insurance Business Law, are deemed to be debt holders rather than mutual company owners, and therefore are unlikely to be willing to accept reduced payouts in order to save their companies. A rate cut also could trigger a liquidity crisis, if large numbers of policyholders decide to cancel their contracts. The government also is considering whether investors in life insurers should share the burden of the rate cuts.

Japanese non-life insurers also are facing negative interest spreads on their ‘maturity refund' insurance products, although the products have shorter durations of approximately five years, making asset-liability matching a bit easier. Maturity refund products, which account for more than 50% of the total liability for the non-life industry, provide asset accumulation with a guaranteed return. Under current conditions, these products carry enormous interest rate, credit and liquidity risks.

Although the Japanese non-life industry has had only one insolvency – Dai-ichi Mutual Fire in May 2000 – more insolvencies are possible. Japan's Financial Services Agency, however, retains approval power over both rates and forms in the personal lines business, thereby limiting the unbridled competition that led to large numbers of bankruptcies in other deregulated markets. Also, the non-life industry's access to capital markets and the short-tailed nature of Japan's liability business have helped to keep balance sheets relatively stronger than the life insurance business.

Most companies maintain significant unrealised gains, which, until fiscal 2000, were reported as an off-balance sheet item. Fiscal year 2000 saw the introduction of mark-to-market accounting, which also served to significantly enhance the reported surplus levels of most property/casualty insurers. In September 2001, however, huge capital writedowns are expected due to stock market losses. Life insurers are not expected to be affected until March of 2002. Deflationary pressures created by the government's zero interest rate policies also are eroding investment income, as well as repressing premium growth.

The chief beneficiary of the government's interest rate policy is the banking industry. By this measure, the insurance industry's recovery would have to depend on the recovery of the banking sector. One potential risk to the Asian insurance industry is that lingering economic instability might prompt other governments to follow Japan's interest rate policies.

South Korea
South Korea is the second-largest insurance market in Asia, and the seventh-largest insurance market in the world measured by total insurance premiums. It also has the fourth highest insurance penetration rate in terms of percentage of personal income. Like Japan, the industry's emphasis on volume has led to over-development of long-term savings products, which are a combination of insurance and a savings account. Some of these products, both life and non-life, offered fixed guarantees up until the 1997 financial crisis, after which variable rates were introduced.

Due to the fixed-interest payment guarantees on older savings products, much of the performance of the major Korean insurance companies is dependent on investment results. Insurance companies registered huge profits in 1999, and incurred huge losses due to the crisis in 1998, and again in 2000, due to the high-tech sell-off. The long-term savings business also presents challenges in asset-liability matching and liquidity. Other lines of insurance are evolving, however, due to the influence of major foreign reinsurers operating in the market and the introduction of bancassurance.

Both the life and non-life segments are highly concentrated, and about one-half of the non-life insurers and two-thirds of the life insurers failed to post profits in fiscal 2000. The insurance market also is experiencing uncertainty because of the distractions of a national election that could short-circuit further reforms.

Before the financial crisis in 1997 the tied agency force was the only meaningful distribution channel. This remains true, even though the Korean government has opened up the brokerage and independent agent markets. However, it is still difficult for foreign companies to fully penetrate the Korean market, given the high cost of developing a comparable captive agency force, and that bancassurance still is not officially sanctioned. Possibilities abound, however, for e-commerce. Korea has one of the highest rates of online investment and shopping, and many Korean insurance companies are seriously assessing the potential impact of e-commerce on their bottom lines.

The Korean market is going through a fragmentation phase, with businesses fleeing to quality insurers, and the emergence of monoline and niche carriers. Consolidation is expected in the small to medium sized company sector, driven by foreign investors. As one of the most volatile financial markets in the region, and with an evolving regulatory and accounting regime, risk quantification for Korean insurance companies is a challenge.

With the removal of tariffs and declining interest rates in Korea, insurers will continue to have difficult years ahead. However, some leading companies are implementing positive business strategies that are expected to bear fruit; for example, the separation of the long-term savings and insurance portfolios, development or implementation of enterprise risk management systems, and more disciplined underwriting.

For many large insurance multinational groups and financial investors, Korea offers economies of scale for their franchise value and capital investment, as well as risk diversification. Given its relatively well developed financial services industry, Korea also offers marketing opportunities for one-stop shopping platforms for delivering insurance, investment and banking services.

Hong Kong
Hong Kong, the fifth largest market in northern Asia, offers two strong competitive features for global financial services groups: it is a major regional financial hub in Asia, and it is very, very close to mainland China. Hong Kong has more than 200 companies, about evenly split between domestic and foreign, all eyeing the huge China market. Foreign insurers are making further inroads into the Hong Kong market by partnering with local banks to sell insurance.

Given its transparent regulatory regime, Hong Kong is often considered one of the freest economies in the world, as well as one of the most competitive. Its strategic position as a gateway to China has transformed Hong Kong to a service-denominated economy. This role, however, is expected to diminish as economic development in China improves with its entry into the World Trade Organisation. With this in mind, Hong Kong is taking actions to strengthen its niche markets, particularly its well-developed and sophisticated financial services market.

Given the large number of insurers in Hong Kong, the market is sometimes irrationally competitive. Insurers are practising cash-flow underwriting, especially in the non-life market, and premium rates for some loss-making lines of business, such as employers' liability, continue to remain low despite calls for better underwriting.

The non-life market experienced marginal growth of 6% in 2000, after negative growth of -8% and -7.8% in 1998 and 1999 respectively. Employees' compensation insurance and motor business continue to be the leading lossmakers. Significant losses in compensation business, in particular, have raised concerns in the non-life market. The price war in this compulsory line has pushed rates so low that it is no longer profitable to write the line. Many insurers also appear unaware of the need for adequate reserves to cover the exposures of this line, especially with the lack of claims cost controls. Hong Kong is becoming more litigious, and third-party bodily injury claims are getting substantially higher. Faced with these significant liability exposures, many non-life insurers are starting to realise that it is fundamentally important to price appropriately for underwriting profit under the current weak investment environment.

Compared to the non-life insurance market, the life insurance market is relatively stable. It achieved a robust growth of 13.9% in 1999, surpassing the 11.5% growth in 1998.

China, as it anticipates entry into the WTO and hosts the 2008 Olympic Games, is expected to remain the second-largest foreign direct investment country after the US for the foreseeable future. For the insurance industry, especially the life sector, the potential for profit and asset accumulation appears enormous, particularly given China's population and economic future. At present China offers opportunities in start-up operations, joint-venture investment and pre-IPO private equity investment in the domestic players.

China's insurance market reported a 14.5% year-on-year increase in premium income in 2000. About 37.5% of the income, 59.8bn yuan, came from property/casualty insurance, and the balance of 62.5%, was from life insurance, according to the insurance regulatory body, the China Insurance Regulatory Commission (CIRC). Yet despite robust growth, insurance is still only a small part of China's economy, at around 2%, compared with 11% in Japan and 8% in US. The potential growth is tremendous, and has attracted many foreign players to set up representative offices and joint ventures in the two ‘approved' cities of Shanghai and Guangzhou.

To cope with the growth, the CIRC has expanded its supervisory role by establishing 31 local offices in all 30 regions and Shenzhen, and begun a crackdown on foreign insurers and reinsurers that it believes are operating outside the country's fluid and confusing regulatory framework.

Potential changes include allowing foreign property/casualty firms to insure large-scale risks nationwide, permitting foreign insurers to venture into group health and pension businesses, now under the privilege of domestic players, and gradually phasing out geographical sales restrictions.

Domestic players are aware of the risks of foreign competition, and fear that the inherited state protection will vanish leaving all players to compete on a level playing field. Their operational criteria, disclosure of information, and service quality will be pressured to improve to meet the international standards. Realising this, Chinese insurers are stepping up recruiting efforts for insurance professionals from Taiwan and Hong Kong.

The rapid growth in the non-life market prior to 1992 has slowed substantially due to competitive rates offered in fire and engineering lines, the restructuring or closure of many loss-making, stated-owned enterprises, and the lack of innovative products. Motor dominates, followed by fire and marine insurance. In the future the p/c sector is expected to pick up gradually, but will be less exciting than the life market. Demand for non-life cover will come mainly from infrastructure projects throughout the nation, natural catastrophe and agricultural risks, and the increasing popularity of private home ownership.

The life market is expected to flourish, with more international players participating, and could be the main driver for the future growth. The low penetration of life insurance, coupled with continuous rising income per capita, could increase the affordability of life insurance. Furthermore, the introduction of variable interest rate products with an investment or dividend-sharing component is improving the transparency of life insurance plans, and allows the general public to participate in the stock market. Most insurance sales are transacted through agents and brokers. Bancassurance deals are not allowed by regulation in China, however, increasing numbers of joint marketing agreements are being forged.

Faced with global competition, especially following entry to WTO, China is under great pressure to open up its domestic market. However, the licensing process will still follow strict prudential criteria in order to prevent the sudden influx of foreign players into the market. International players will certainly be in a privileged position to achieve a significant market share if they are able to establish a fully-operational branch as early as possible in China.

A world-class manufacturing base for electronics and semiconductors, Taiwan escaped the Asian financial turmoil of the late 1990s, and is now facing an economic slowdown directly affected by the weak US and Japanese economies. The government has been easing interest rates to stimulate the local economy, but this has had a negative impact on the growth of the insurance market, especially of life insurance.

Political tension is the main obstacle to entry into the mainland Chinese market for Taiwanese companies. Nevertheless, many Taiwanese entrepreneurs have prepared themselves by indirectly investing in China, and have aligned their business strategies with China's entry into the WTO, and a few major Taiwanese insurers have been allowed to set up representative offices in mainland China.

To liberalise the insurance market the Ministry of Finance has revised the insurance law to include full disclosure, introduction of a risk-based capital system, and more emphasis on internal auditing. The MoF also has liberalised investment restrictions, allowing insurers to invest in insurance-related businesses and a wider range of commercial paper and derivatives.

The life market is the third-largest in Asia. However, with the low interest rate environment and deteriorating stock market performance, many life insurers, as in Japan and Korea, are facing negative investment spreads. The introduction of more stringent solvency measures further increases the capital requirement of small life offices. The life market, however, is expected to open up with more innovative products as tariffs and other forms of control are gradually deregulated.

The non-life market also is relatively concentrated, with about 28 non-life companies. Unlike the life business, where foreign entrants have changed the market significantly, foreign influence over the non-life market has been minimal. The challenge is to compete in the fire and motor businesses on a profitable basis. Due to fierce competition, rates have declined to uneconomical levels, and profit margins are reduced to minimum level.

The insurance sector in Taiwan is undergoing a period of change caused by consolidation, regulatory amendment and technological innovation. With the opening of China, the MoF is challenged to provide a more business-friendly and robust regulatory environment to attract foreign investment.

Southeast Asia
In general, the Southeast Asian insurance markets, given their smaller size, are at a competitive disadvantage compared to their northern Asian neighbours in terms of business opportunities for global financial services groups and financial investors looking for deals. Instability in Indonesia and the political uncertainty in Malaysia have further reduced the business potential for investors. With the poor-performing Japanese economy and an uncertain US economy, Southeast Asia's two largest export markets, and the attractiveness of investment opportunities in China, the region is losing the attention of foreign investors, who are going to northern Asia. There they can achieve better economies of scale and risk diversification.

Southeast Asia has not addressed the need to create a unified market, instead of several small domestic markets, in order to attract large-scale foreign direct investment. Singapore is the first country to react to this challenge. For example, the Development Bank of Singapore recently acquired Dao Heng Bank, one of the largest local, quoted banking groups in Hong Kong, setting a precedent for cross-border acquisition in the financial services sector in Asia.

Like Hong Kong, Singapore is a regional centre for both shipping and financial services. They are supported by an excellent infrastructure, and a population proficient in English. However, given the state of the global economy and the economic and political difficulties in the neighbouring countries, Singapore is in a recession, the second since the Asian economic crisis of 1997.

In Singapore, already a liberal market, the government is working toward further opening of its financial markets to foreign participation, especially in reinsurance. At the same time, the Monetary Authority of Singapore is reforming sales practices and introducing RBC standards to prepare for increasing competition. Singapore continues to position itself as a centre of reinsurance in Asia.

It has moved toward allowing brokers unrestricted access to the market and foreign investors to hold major stakes in domestic insurers. With this environment, it is inevitable to see more merger and acquisition activities taking place in the market. However, market entry of international players will create pressure on domestic players to conduct their operations and deliver services on an international standard.

In comparison to the non-life insurance market, the life insurance market grew tremendously from 1990-1997 prior to the Asian crisis. In 1998, the market showed negative growth due to the crisis, but the recovery was smooth with the help of stock market upturn. These factors have attracted the public to put their money into investment-linked single premium life insurance plans. The rapid growth in the life insurers' assets, however, has raised concerns in the market regarding insurers' expertise in fund management. Thus, closer cooperation between life insurers and professional fund management firms could be imminent.

Growth in the non-life market is not as robust as in the life sector. Given the number of non-life insurers in Singapore – 45 as at year-end 2000 – the market is highly saturated. Fragmentation does not provide sound profitability to the insurers, especially if they fail to operate on a low-cost basis, and given the low volume of business. Local tie-ups among the domestic players have proved to be difficult, since the companies are mostly privately owned.

Malaysia is undergoing a restructuring process accelerated by the Financial Sector Master Plan introduced by Bank Negara Malaysia, the central bank of Malaysia, in March this year. Due to the increasingly competitive market environment, companies are pressured to achieve economies of scale to enhance their expense ratios as well as risk diversification. The Master Plan focuses on enhancing domestic capacity and capability over a three-year period. Currently, there are seven life companies, 36 general insurers, and ten composites. Over the next few years some decrease in these numbers is expected.

Malaysia has a high savings rate, which means there is growth potential in the life market, where the ratio of premiums to GDP is a still low, at 2.4%. The insurance sector, after a time lag, has recovered from the financial crisis of 1997 with a higher growth rate than the economy. The market reported a 17% growth in 2000. Most of that growth comes from the life sector, which accounts for roughly 60% of the market.

The Malaysian industry is considered the leader in online operations in Asia, as there are more than 60 insurance and reinsurance companies in Malaysia that deal electronically. The Central Administration Bureau, set up by Malaysian National Reinsurance Berhad, handles facultative reinsurance electronically. The system is expected to bring dramatic changes in the way insurance is conducted in Malaysia, and will benefit the industry with increased productivity, faster settlements, reduced operating costs and improved quality.

Indonesia has a population of roughly 210 million, which makes it the fourth most populated country in the world. However, it is not only its population that makes Indonesia one of the most attractive countries for insurers: low insurance penetration of 1.24% of GDP is also a draw.

It is expected that the Indonesian industry will show high growth in terms of volume over the next several years, but this does not mean that companies will benefit. Currently about 60% of the assets are invested in time deposits, due to traditionally high interest and inflation rates, but with inflation being curbed interest rates are coming down, hence pressuring companies to seek other high-yield investment instruments.

It remains to be seen how companies will cope with the high default rate of the corporate bonds in Indonesia.

Due to the high growth potential of the Indonesian market, companies that practice good underwriting and risk management will benefit and outgrow their competitors.

Thailand, one of the Asian tigers in the 1990s, has undergone tremendous structural reforms under the instruction of International Monetary Fund. The gradual improvement of its market standards and transparency in industry will provide a strong fundamental basis for international players to participate more actively in the insurance sector. Given the low penetration of life insurance, the potential growth for the life market is more significant than that of the non-life sector.

To improve market conditions, the regulator – the insurance department under the Ministry of Commerce – is prepared to allow insurers more leeway in investing their assets.

These measures include permitting insurers to purchase stock issued by investment-grade foreign insurance companies listed on foreign stock markets, and increasing the investment ceiling for stock issued by local investment-grade companies and low-risk state enterprises to 20% and 40%, respectively.

These measures would benefit the life insurance industry more than non-life market, given the sizable asset managed by life insurers.

Best's regional outlook
Long overdue fragmentation is transforming the Asian market. A variety of new entrants, including monoline and niche players, are introducing new products and business models as well as a focus on profitability over market share. Transactions are not leading to consolidation (unlike other regions of the world) due to uncertainty about valuations and the risks assumed. Alliances, including bancassurance partnerships, are being forged to bring down distribution costs and expand distribution channels. A brief phase of domestic market fragmentation is expected to be followed by a longer phase of regional consolidation, since many Asian domestic markets are too small to diversify risk and attain strategic growth momentum on their own.

Pressure on profits will remain for the foreseeable future, as revenue and earnings become more volatile. Lower premium growth in traditional product lines will continue, as consumer confidence deteriorates.

Many new products are in the process of being launched, and will require some time before they generate profit and demonstrate pricing adequacy. Over the long term, however, the region is expected to benefit from the diversification of revenue and earnings sources. While bancassurance and other new approaches to distribution have the potential to reduce distribution costs, it will take time for these benefits to be realised.

An important development in the measurement of financial performance in the Asian market is a growing focus on risk-adjusted returns on equity and capital. This trend is being driven to a large extent by multinationals interested in acquiring local companies, and wanting to fully understand not just the subsidiary's potential revenue and earnings contribution, but also the risk contribution.

Risks can grow faster than profits in the volatile Asian marketplace, and there is the potential for an Asian subsidiary to contribute a disproportionate level of risk to an enterprise.

Risk-adjusted performance measures, such as risk-adjusted return on capital and value-at-risk, already widely used in the global financial services industry, are becoming increasingly popular in Asia as a way of capturing most risks to the overall enterprise.

They are also used as the basis for management incentives and to help management deploy capital more efficiently and determine appropriate levels of capital for their risks

The focus on better risk management and asset-liability management is expected to benefit the larger existing insurers and new entrants who are not saddled with unprofitable blocks of business.

Many of the unprofitable smaller insurers will not survive, although reinsurers and the capital markets may find ways to transfer their risks to a broad base of investors.