Omar Shafi discusses the prospects for Brazil's insurance and reinsurance industry in the coming years.

The Brazilian economy has been the subject of continued debate since the local currency lost 50% of its value against the dollar in January 1999. Many analysts predicted at the time that inflation would skyrocket with the devaluation, wiping out the confidence that had been built since 1994, when a new economic plan managed to stabilise the economy and finally bring inflation under control (see chart).

On the one hand, the economy has managed to make a rapid recovery since January and seems more comfortable with the new exchange rate. Inflation is at a relatively low 7% p.a. and the stockmarket is 20% higher in dollar terms than it was before the devaluation. On the other hand, however, the government is still struggling to stabilise its finances and there could be further shocks to the system.

Despite the economic uncertainty that seems to be part of Brazil's fabric, insurers are still very attracted to the country. Some 30 foreign firms already have a significant presence in Brazil, including Aetna, AIG, Cigna, Hartford, HSBC, and Prudential. Most of their investments have been made in the last four years. In 1993, only 4% of total insurance activity came from firms with foreign ownership - the equivalent figure at the end of 1998 was 25%. The preferred method of entry has been through joint ventures and acquisitions, mainly to overcome foreigners' weaknesses in the areas of brand recognition and distribution. New and prospective entrants have continued to arrive during 1999, among them Axa, ACE, and Canada Life.

Primary insurance market
As the chart indicates, the fall in inflation was a major catalyst to the insurance industry. Life, health and retirement insurance have together seen the most significant amount of growth. The foreign interest has been driven not only by the stabilisation of the economy since 1994, but also by the market's significance and growth potential. Almost 50% of the South American continent's insurance activity is accounted for by Brazil. The average rate of growth of the industry since 1993 has been almost 100% in dollar terms.

#The country has long been underinsured. Insurance represented just 1% of GDP in 1993. Today it represents 2.3% of GDP - still well below average levels of 7% in developed countries.

Low inflation has improved income distribution rapidly since 1994, and this will provide a large new customer base in the next five to 10 years. Traditionally, insurance has been aimed at the wealthiest 5% of the population; however, in the coming years, insurers will have their eye on capturing the next 30% or so, a market of some 8 million households.

It is worth considering the development of the Brazilian market in a wider context. It has been said that the development of a country's insurance market tends to follow 3 stages.

The first stage typically sees insurance playing a role supporting infrastructure development and trade. This was the position that insurance in Brazil occupied for most of this century until the early 1990s.

The second stage of development involves an increased emphasis on the protection of personal wealth, with the growth of life, health and retirement insurance. This, as the chart indicates, is the stage that Brazil has reached. We believe that any further shocks to the economy will prolong this phase, rather than reverse it, and that the life and retirement markets in Brazil will continue to grow during the next 10-15 years.

The third stage typically sees a wider distribution of income and wealth among the population, encouraging a greater level of ownership of cars and homes, and an increase in the purchase of property/casualty insurance. Auto insurance in Brazil is likely to grow significantly in the next 10 years. The number of cars on the road is forecast to double in the next 15 years to 50 million, while in the shorter term the use of insurance (mainly casualty insurance) is likely to increase well beyond the current level of 20% of vehicles.

The influx of foreign insurers is helping to change the rather complacent culture that has long existed among Brazilian insurers. The message is beginning to get through to local insurers that success will come not only from gaining scale, but also from establishing productive distribution arrangements. In the next few years, many insurers will make a conscious effort to get closer to and more responsive towards customers, by communicating well, by harnessing technology such as data mining and relationship management tools, and by trying to maximise the yield of distribution channels for multiple products.

Insurers made pre-tax profits of R$1.5 billion during 1998 (equivalent to $0.8 billion at current exchange rates). Operational profits from insurance activities were negligible, while investment profits were very healthy. This has been a familiar pattern in Brazil. Before 1994, insurers relied on inflation to provide profits; today the focus is on high investment yields. However, with increasing competition, the next few years will see a greater emphasis on improving operating results with much greater pressure on improving risk selection as well as on cutting administrative and distribution costs.

Administrative and distribution costs are higher in Brazil (equivalent to 34% of total premiums) than in the US (25%) and the UK (21%). This level has fallen from 39% in 1995 due to competition. Brokers dominate distribution in Brazil (the “agent” does not formally exist) although they now face pressures from banks and from direct marketing.

Economies of scale from consolidation, new technology and outsourcing will help firms to reduce administration costs. Training and competition will improve productivity, and employment in the sector is likely to fall. The use of outsourcing will increase, making costs more flexible and predictable, but only once more viable outsourcing suppliers make this feasible.

Life and retirement products are becoming more sophisticated as the government tries to encourage private retirement provision. Group term insurance has traditionally dominated the Brazilian life market, but 1998 saw the first permanent life insurance products (endowments and whole life) although in 1999, permanent life insurance has been hit by poor marketing and recently imposed insurance taxes.

Nevertheless, life and retirement insurance have been the fastest growing area for insurers. Retirement vehicles are beginning to use mutual funds as their underlying assets and this will lead insurance companies to compete with mutual funds offered by banks. This is likely to be accentuated with the introduction of insurance-investment products such as annuities and unit-linked life insurance.

Corporate demand for insurance will also strengthen as industrial activity from local and multinational companies continues to develop in Brazil. The influence of foreign insurers and clients will gradually lead to demand for more sophisticated and customised cover, including risk management programmes.

The country's huge privatisation programme, spanning areas from railways to telecommunications, is gradually helping to boost the property/casualty market. Privatisation has transferred many publicly-owned assets to the private sector. Many of these assets were previously either underinsured, or self-insured. Additionally, privatisation has meant that when it comes to renewing insurance contracts, competition among insurers is becoming more transparent.

Further deregulation in the market is likely. In the next two to five years, this is likely to include the opening of the workman's compensation monopoly, and the legalisation of dollar-denominated insurance contracts. Within 5 to 10 years, we believe that customers will be allowed to buy insurance from outside Brazil, probably subject to specific taxes and exchange rules.

Reinsurance market
Reinsurance is obviously the most immediate area of change in Brazil. The Brazilian constitution has been changed to end the monopoly that the state-controlled IRB Brazil Re (Brazil Reinsurance Institute) has long held on writing reinsurance in the country. The IRB Brazil Re will be auctioned in October 1999, and two years later will completely lose its monopoly position.

Several foreign reinsurers have shown a keen interest in the company and in gaining a foothold in the country. These include Munich Re (a front-runner) Allianz, American, Copenhagen, General & Cologne, Lincoln, Mapfre, St Paul, Scor, Swiss, Transatlantic, and Zurich.

The reserve price set for the IRB by the government is R$439 million (US$240 million). In addition to the large international reinsurers, the two local giants of the insurance industry, Sul América and Bradesco are obvious candidates to bid for the IRB, although the authorities have proposed excluding domestic insurers in the interests of competition.

The IRB has a mixed reputation. Through its 60-year history, it has helpfully provided subsidised capacity to smaller players, aiding their survival. However, poor underwriting in the international market dating from the 1970s has left it with some dubious long-tail insurance commitments that introduce uncertainty into the valuation of the company.

Nevertheless, the IRB's profits have risen rapidly in recent years, from R$52 million in 1997 to R$170 million in 1998. The reinsurer made an operating loss (i.e. before investment income) in 1997 of some R$7 million. However, in 1998 the firm had a better year, with operational profits of R$60 million, and investment and other profits of R$110 million. The reinsurer retroceded approximately one third of its gross premiums. The 1998 results reflected a number of changes in the way that the IRB operates.

These have included laying off large numbers of its staff, decentralising, and gaining more powers to choose risks freely. “Changes were necessary and are showing through on our bottom line” says Hugo Rocha Braga, the IRB's finance director and someone who was instrumental in pushing through the changes. “We will not have a problem competing in a more open market. We have know-how and a unique understanding of the local market, and that will stand us in good stead. Improving our efficiency can only help us, and we are not going to stop here.”

#The majority of the firm's activities related to property/casualty lines, although the most profitable line was financial reinsurance, which accounted for 7% of business, but 37% of profits.

Once the IRB has been privatised, it will retain some type of competitive advantage for an interim period, until the market is fully liberalised, probably in 2002/3. One proposal put forward by the authorities is to add a “reinsurance tax” of between 3% and 5% on premiums ceded by insurers, for an interim period. Another option is to set aside as much as 60% of the reinsurance market for the IRB, to allow it to compete with foreign reinsurers. So far, insurers have voiced their preference for a (lower) tax rather than for a mandatory reserve, because it would allow much-needed choice.

“Naturally, a deregulated reinsurance market is going to affect small and medium sized insurers,” says Mr Braga. “I do not doubt that we are going to see restructuring within the local market - it is both necessary and inevitable. We will see continued consolidation by some insurers, and specialisation by others, who will look for niches or partnerships. It is the only way that firms will remain competitive.”

#And what about the future? The IRB is likely to continue to focus on property/casualty insurance at least until life and health insurance become more geared towards buying reinsurance. “Life and health reinsurance has been low because of the fact that these sectors have only recently emerged as important in the primary market, but it will grow,” says Mr Braga.

Indeed, the government proposed in July this year that reinsurance could be made compulsory for all but the largest healthcare companies. In the US reinsurers play a significant role in supporting the three primary health insurance arenas that exist there, including indemnity cover offered by insurance companies, health coverage offered by HMOs and health benefits offered through employer sponsored self insurance plans. In the American market, the most common forms of reinsurance coverage in these areas are specific and aggregate stop-loss insurance.

We believe that the reinsurance industry in Brazil will continue to attract foreign attention, particularly in the light of the current softness in reinsurance premiums around the world. As the IRB gains access to more capital and is able to pick and choose its risks independently, the amount of risk that it retains is likely to increase. Continued restructuring and liberalisation of the financial sector will drive the growth of the reinsurance market. To that extent reinsurance is less exposed to the ups and downs of the economy than the primary insurance market.

Risk exposures to new products and complex technologies are likely to grow in the coming years. New reinsurance products that transfer risks to the capital markets will become better recognised. These will include administrative reinsurance (where reinsurers buy blocks of business from primary insurers, such as life insurers who want to focus on asset management rather than mortality risk). Reinsurers may also see a demand for longer-term financial reinsurance policies, activated by financial triggers such as interest rate or foreign exchange volatility.

The key elements to watch in the Brazilian market in the coming years will be an improvement in income distribution among the population, even in the absence of economic growth, and the continuing liberalisation of the insurance and financial market.

Omar Shafi is a partner at Interfund Research. More information on the Brazilian market is available at www.interfund-research.com