Deregulation of the Japanese non-life insurance market is likely to lead to significantly reduced commercial insurance rates but there are other implications, says Miles Wixon.

Deregulation, combined with the weak economy and the sector's high exposure to Japan's financial system through equity stakes and lending, should produce pressure on underwriting margins and asset values, sapping the financial strength of most incumbent domestic players.

The full liberalisation of non-life insurance premiums in Japan began in July. Until then, non-life insurers had not generally been allowed to deviate by more than several percent from the rates calculated by a government-sanctioned premium setting body.

Several non-life companies have received permission from the Ministry of Finance to price corporate products freely. Some have already begun offering discounts on some smaller corporate lines, and we see no reason why similar competition will not spread to corporate fire insurance and other product lines. Even if companies attempt to keep competition bottled up on retail lines, the fight over high-margin corporate accounts - which already generate some 60% of pre-tax underwriting income for larger non-life companies - has already begun.

In May, premium rating agencies revamped pricing for auto, fire and personal accident lines, in a last ditch attempt to block the effects of aggressive discounts by foreign insurers and bottle up competition among incumbent players.

Profitable underwriting

Unlike Western insurers, Japanese non-life companies have relied largely on underwriting income for their profitability. The system under which premium rating agencies calculated mandatory pricing succeeded in stifling competition and keeping underwriting profitable - although shareholders never reaped large benefits. Property/casualty combined ratios were well under 100% in Japan, meaning that Tokio Marine, the largest non-life company, enjoyed double digit margins on underwriting.

With no price-based competition and fat margins on underwriting, the name of the game in Japan has been one of grabbing market share by holding large equity and lending stakes in customers and setting up as many insurance agents as possible. Both happened with little regard to efficiency.

The status quo held up fairly well until early this decade. However, premium growth rates fell as the insurance market matured, putting pressure on returns to shareholders that were never that high in the first place. Non-life companies still held on to gigantic, unmanaged equity stakes in customers as the Nikkei stock market average collapsed. The poor investment returns from these large equity stakes more than offset margin gains from underwriting.

The firewall between life and non-life insurance companies came down in October 1996 and several life insurers are now underwriting non-life products. Life insurers that have entered the non-life sector hold large equity stakes in potential corporate customers and will not be burdened by shareholders' concerns that they suffer losses while grabbing market share.

While foreign and life insurers may not soon acquire large market share, they will at minimum sap already anaemic growth and provide further pricing pressure. The recent entry into the sector of Sony and Secom provides further indication that this is not simply a battle between AIG and incumbent non-life companies, and we believe that foreign non-life companies are only one ingredient of the formula that will create true competition.

Smaller companies are also a factor. If their underwriting portfolios were significantly different to their larger competitors, they could focus on their own niche markets to blunt the effects of intensified price competition. However, all non-life companies have virtually identical product line-ups. While they seem certain to cut costs, we do not expect smaller companies to sit idly by and watch bigger competitors steal their customers. They will be forced to respond with the only weapon at their disposal; undercutting their competitors.

Fiscal 1997

With the dependence of non-life companies on underwriting profits, what lurks behind the benign headline figures for fiscal 1997, announced in May, does not bode well for an industry facing a deregulatory precipice. Premium income fell for all insurers and most relied on gains from sales of securities and reductions in reinsurance purchases to avoid net losses. Behind the numbers we find an industry whose profitability has begun to show significant deterioration and at a faster pace than we expected. However, deteriorating profitability has failed to spark dramatic restructuring.

We continue to believe agency commissions, along with passive asset management, are a critical structural issue in the non-life sector, as commissions paid to agents average 20.3% of net premiums. Most agents sell policies for several companies, meaning non-lifes have little leverage over them to cut costs. Any domestic or foreign acquirer of an incumbent non-life faces the same hurdle, leaving us to wonder what the franchise value is of a company that has little control over its customer base. Results meetings this summer left us disappointed by a lack of specific reform plans aimed at remedying inefficient distribution.

Most companies are attempting to cut non-commission costs but face an uphill battle. Because of deregulation, they can no longer grow their way into better underwriting results, and the impact of falling premiums on underwriting margins is likely to exceed that of cost cutting efforts.

We have found across the sector that management teams place a very high priority on expanding market share. To be sure, economies of scale continue to play a vital role in underwriting non-life insurance in Japan. However, in fiscal 1997 there was little movement in overall market share numbers. More importantly, as underwriting margins come under pressure, the value of expanding market share becomes close to meaningless, and we believe it only matters if it can be utilised to underwrite more profitably - such as providing leverage in forcing agencies to take a cut in commissions.


Companies were far off their original underwriting estimates last fiscal year and we suspect this will happen again in 1998. We are sceptical whether all the non-life companies will generate positive premium growth without further cuts in reinsurance. Further, with more evaluation losses on securities likely because of high exposure to financial and construction companies and with Japan's non-performing loan crisis more likely to affect the sector, recurring profit and net income targets are likely to be achieved only through gains on sales of securities.

With full deregulation underway, non-life insurers have begun experiencing significant erosion of underwriting profitability. We forecast that, even on a mild deregulatory outlook, adjusted underwriting profits (simply net premiums multiplied by underwriting margins) will be significantly affected by March 2000 if companies do not intensify restructuring or find other sources of profitability.

The maturing of the Japanese insurance market means that in the long run to achieve substantial growth Japan's non-lifes will likely need to look abroad, as their US and European counterparts have done. Today, the international underwriting operations of Japanese non-lifes is minor with Tokio Marine, perhaps the most international of the group, having only some 4% of total net premiums from underwriting outside Japan. Furthermore, instead of insuring locals, this figure is dominated by insuring overseas operations of Japanese businesses. Over the next few years, non-lifes will surely focus almost entirely on protecting domestic market share and surviving deregulation without attempting to tap into local markets outside Japan.

At this time, it is difficult to envision Japan's non-life companies acquiring the know-how and requisite risk management skills to underwrite policies profitably abroad, save for Japanese firms. Trapped by a mature market and the inefficient agency system, unable to realise investment income and with deregulation that is for the first time forcing them to compete on price and risk management, we believe that Japan's non-life insurers are unlikely to match global standards of either competitiveness or profitability.

Over the next two to three years, deregulation will slam the door on growth and drive margins further downward, forcing companies to rethink even the basics of how they have operated for decades. They will have to slash commissions to agents and dramatically strengthen asset management to generate healthy growth in earnings to keep increasingly demanding shareholders happy.

If Japan's non-life market were still experiencing high growth, domestic players would probably be satisfied with keeping cartel style pricing, even with liberalisation. However, the underwriting context in which deregulation is taking place - a slow-growth mature market with hungry challengers and no product differentiation - provides ample breeding ground for intense competition. While foreign and life insurance companies should see earnings grow from non-life operations, we believe Japanese consumers will be the winners of deregulation, most of whom will finally benefit from better prices, products and service - unless they have to foot the bill for non-lifes that fall into financial difficulty.

Miles Wixon is an analyst with Salomon Smith Barney, Tokyo. Tel: 81 3 5574 4782. Fax: 81 3 5574 5592. E-mail: