Standard & Poor's provides an analytical overview of the Japanese non-life insurance industry, now facing all sorts of changes.

Standard & Poor's believes that the Japanese non-life insurance industry remains quite healthy with a very strong balance sheet and, following rating reductions earlier this year, a near term outlook should be reasonably stable. However, the industry has entered a three-five year period of significant change and the current sluggish Japanese economy will hurt their operating performance this fiscal year and next. Having enjoyed the fruits of a highly protected market, deregulation of the non-life sector presents these companies with the opportunity for success and the risk of failure, an environment that the industry never knew before and needs to adjust to now. The traditional companies are, however, armed with significant weapons to weather the onslaught of foreign players and start up subsidiaries of life insurers. The major companies all have strong distribution networks, established relationships with auto manufacturers, very strong balance sheets and significant hidden values to enhance their financial flexibility.

Why the concern?

Most companies would love to have the characteristics described above. But what we do have is an industry undergoing dramatic change at a dramatic pace. The removal of the Ministry of Finance's protective umbrella will expose this sector's warts, high expense structure, need for better systems for client and intermediary service, and the absence of product initiatives as competitive tools. Since most local companies have followed a similar business and product strategy, historically the biggest difference is size, giving Tokio Marine a distinct advantage. New entrants bring to the market a more effective cost structure and willingness to pass some of the savings along to their customers. Thus the personal lines, especially voluntary auto will feel some margin pressure, although prices will not be totally unregulated. On the other hand, the commercial lines, which are only around 15% of the market and well below the percentage in other developed markets, have effectively been totally deregulated. Premium rates, as would be expected, have declined. While some of the major players benefit from their group relationships, the Japanese commercial market is likely to migrate to a more complex product structure giving foreign insurers an advantage with their underwriting skills. The recent entry of foreign insurance brokers has accelerated this pace of change and reduction in margins. The asset accumulation business has remained primarily a medium term market with only 10%-15% of savings assets from the longer term annuity products. The typical life of these products is five years. This shorter duration relative to the problems of the life sector, has allowed for reasonable asset/liability management and not undue asset risk. Still there is little if any profit.

The evolution of this industry from one where insurers have survived in spite of themselves to an environment of strategic choices will come out at a cost. The larger firms will continue to increase their market share. Others will have to scramble for a niche and will need to accept the fact that they cannot be all things to all people, unless they align with a strong partner. Consolidations and/or insolvencies seem inevitable but there are no missiles to cause an immediate disaster. Even an acceleration in the pace of deregulation of the personal lines sector will only cause slow profit bleeding. The sluggish economy is hurting short term demand, but the pricing is expected to be weak anyway. And any collapse of the stock market will cause a material crisis for the banks and life insurers before any damage would be seen in this sector.

Keys to success

Standard & Poor's has identified seven factors believed to be vital to the success of Japanese non-life insurance companies.

* Satisfactory capital and solvency levels, together with reinsurance: Overall capital strength has diminished a little in the past two years, but it remains a critical strength.

* Competitive cost structures: A problem relative to the new companies in the market. The Japanese employment system does not allow for quick fixes. Longer term, the reduction of employees and investment in computer systems will be key competitive factors.

* Solid investment performance in line with prudent asset liability management: The growth in pension assets has led to greater negative spread from poor asset/liability management.

* Improved risk management skill to prepare for the liberalisation of premiums and products - the quick fix has been to obtain expertise from outsiders; internally the industry appears to remain inadequately prepared.

* Sound asset quality - the poor economic climate will further deteriorate quality over the short term, but overall credit quality compares well with other Japanese financial sectors. Compared to the banks, there is little exposure to the "Asian" crisis occurring in the developing markets.

* Sound business profile - coming under greater scrutiny is the broad business focus of the medium size companies and the uncertain long term viability of the smaller firms.

* Management - we are seeing the convergence of the insurance/asset accumulation sectors. Companies have and will have even greater choices. Management's risk tolerance is being redefined for a new environment they may not be fully prepared for.

A mature market

The Japanese non-life insurance industry is a mature market, with total premium income base of over 8 trillion yen and total asset base at 30 trillion yen. Premium growth is slow: the industry's average premium growth rate between fiscal years 1990 and 1996 was 2.7% per annum, and the premium level is expected to decline over the near term. Despite the sluggish market, the number of market players is growing, as deregulation brings in new entrants from the life insurance sector as well as from overseas markets. In 1997, there were 33 non-life insurance companies registered in Japan, including six life insurers' non-life subsidiaries, which were newly established in 1996, and five subsidiaries of foreign companies. In addition, an increasing number of foreign non-life insurers are operating through branches in Japan.

The industry has been tightly regulated by the Ministry of Finance, although the ministry, as noted above, has taken steps toward deregulation since 1996. Until recently, there has been little price and product differentiation among Japanese non-life insurers.

Risks written in the Japanese non-life market are generally short-tail and low risk. Because the industry is geographically vulnerable to earthquake and typhoon risks, Japanese non-life insurers protect themselves against these catastrophe risks through reinsurance arrangements with foreign and domestic reinsurers. Earthquake risks on residential property are reinsured through a government-subsidised scheme.

Most Japanese non-life insurers offer insurance products with savings features, such as savings-type fire insurance and savings-type personal accident insurance. These products are mainly three to five year products, and insurers invest the savings portion of premiums ("savings premiums") for the future maturity payment to policyholders. Long-term assets, which are the sum of maturity refund reserves and policyholder dividend reserves, account for approximately 50% of the industry's total assets. (see in chart 1)

Accelerated deregulation

Deregulation has opened the door to new market entrants, such as non-life subsidiaries of life insurance companies and provided better opportunities for foreign insurers, as they can more effectively seek differentiation on product, pricing and distribution. In the near term, this increased capacity will be competing in a market experiencing modest premium growth, at best. In the medium term, some contraction in capacity is expected as less well placed insurers (most likely featuring both new entrants and traditional participants) fail to attain an economically viable business franchise.

Leveraging off a policyholder base, non-life subsidiaries of life companies are expected to attain a 5% share of the market over the medium to long term. Advantages represent a natural client base, distribution sales force, challenges will be underwriting and claims handling. For some life companies acting as a distributor for a non-life underwriter may be a better option.

In the voluntary auto insurance segment, some foreign insurers have already started direct marketing, offering discount for low-risk drivers. While Standard & Poor's does not expect direct marketing to be as successful in Japan as it has been in the UK (capturing approximately 40% of the personal market), direct marketing may reasonably account for 10% to 15% of the motor market over the next 10 years.

Economic slowdown

Slow recovery of the Japanese economy will hamper growth of non-life insurance premiums, which are already under pressure resulting from increasing competition. In FY1997, the industry's aggregate direct net premiums indeed declined by 2.9% over FY1996. Prolonged low-interest rate environment has also negatively affected the insurers' investment income - the industry's aggregate investment yield fell from 6.05% in FY1991 to 3.34% in FY1996, and further decline is expected for the FY1997. As the Japanese economy struggles for recovery for the next few years, the non-life insurance market will continue to ail from slow premium growth and low investment income.

Depressed earnings

Standard & Poor's expects that underwriting profits of Japanese non-life insurers be squeezed over the next three years, as premium growth stagnates and operating expenses remain high. The net business balance ratio (a standard measure of Japanese non-life insurers' underwriting profitability, calculated as 1-loss ratio-expense ratio) may decline by at least half over the period, possibly falling to 2-3%. Because investment income will continue to be depressed and will not grow fast enough to offset falling underwriting income, overall earnings are also likely to deteriorate. (see chart 2)

Poor performance of savings and annuity products

In today's depressed investment environment, savings and annuity policies with guaranteed yield to policyholders are a heavy burden on insurers' earnings. In particular, the non-life companies are experiencing negative interest spread on annuity products, which account for as much as 15% of some companies' savings assets (which are approximately 50% of total assets). However, while the savings and annuity products will remain a drag on Japanese non-life insurers' earnings in the short term, relatively short-tail nature of these products (compared to savings products offered in the life industry) will enable non-life insurers to eliminate high guaranteed yield policies quickly, and subsequently regain profitability on these products.

Asset quality/liquidity

Japanese non-life insurers maintain high quality asset portfolios. The industry enjoys very large unrealised gains on its equity holdings - with the average "break-even" level of the Nikkei Average at about half of those of the Japanese banking and life insurance sectors. Even though the non-life insurers continue to hold some problem loans, the overall level of problem loans remains relatively low compared to the level in other Japanese financial institutions' asset portfolios. (see chart 3)

Capital adequacy

Standard & Poor's has developed a capital model that assesses the stated and the hidden capital, the latter primarily represents the unrealised gains on equities. Charges are assessed against asset and liability risk, including the significant savings and annuity liabilities. The overall industry capital adequacy has diminished some in recent years, not surprising, given the poor economy and overall decline in Japanese credit quality. However, this sector remains very well capitalised relative to other Japanese financial sectors as well as other non-life sectors throughout the world.

Robert J. Mebus is S&P's managing director-global practice leader, New York, Ian Thompson is director-regional practice leader, Melbourne, and Ayako Nakajima is associate director, Tokyo.