The insurance industry will undergo increasing consolidation as part of the fallout from government intervention and potential tax law changes following the financial crisis, a consulting firm is advising.

And insurance industry stability and certainty may not return for a few years as insurers react to regulatory reform, PricewaterhouseCoopers LLP said.

PwC projects in a report that within five years the industry landscape could look markedly different and Americans may find their insurance policies underwritten by a handful of large, well-capitalized firms that can demonstrate financial strength and economies of scale.

Titled “Emerging from the Storm: The Day After Tomorrow for Insurance,” the PwC analysis outlines nine key developments the firm said are expected to reshape the insurance industry and their strategic implications during the next five years.

The most significant of these developments for U.S. insurers, PwC said, will likely be sweeping regulatory changes resulting from proposed legislation to reform health insurance and increase federal oversight of the insurance and financial industries.

Creation of a Federal Insurance Office could provide federal policymakers with the information and resources to better respond to crises, mitigate systemic risks and help ensure a well-functioning financial system, but it could also lead to dual regulation at both the state and federal levels, according to the report.

Bill Chrnelich, PwC insurance sector partner, said, “Insurers are in the business of managing risk and measuring probability. They don’t like uncertainty, yet they are facing two massive reform initiatives, the outcomes of which are unknown but could alter their destiny.”

He noted, “Some insurers are taking a cautious wait-and-see approach, while others see this period as a once-in-a-generation opportunity to shape their future.”

According to PwC, the insurers most likely to succeed once regulatory changes are enacted are those that closely monitor developments and create business strategies that anticipate the most likely possibilities for reform.

PwC said the U.S. insurance market remains highly fragmented, and there is a strong underlying rationale for consolidation and restructuring, which means merger and acquisition activity may be set to accelerate rapidly.

This could particularly occur, according to the firm, as larger, better-capitalized firms consume smaller firms.

The report said consolidation is expected to help deliver the capital stability and economies of scale that will be important in attracting customers and demonstrating financial strength, not only to ratings agencies but also to third-party distributors whose “ownership of the customer” makes them a key determinant of an insurers’ fate.

PwC found that the faith of investors, who had become accustomed to high yields but were unaware of the related risks, “appears to have given way to shock, disillusionment and caution.”

A pursuit of innovation, said PwC,  appears to have been displaced by a focus on stability, risk management and demand for simpler, more straightforward and transparent policies and investment products such as index-linked investments. 

As an example of this, the firm mentioned the recent resurgence in demand for whole life insurance.

But it cautioned that the apparent desire for guarantees could create dilemmas for insurance companies that want to scale back such products as they seek to limit risk.

Potentially higher costs of risk and guarantees, along with what may be higher commission payments to distributors, could change product economics, and insurers will need to better understand component costs, pricing and profit profiles, the report advised.

PwC predicted that governments will be looking closely at insurance companies’ tax status as the industry is a major source of potential tax receipts and has moved significant business capacity to other jurisdictions in recent years.

Insurers, PwC said, can expect renewed scrutiny of their tax planning techniques, as well as more stringent requirements for transparency and information exchange relating to clients.

As a result of the financial crisis, the consultants noted, many insurers have been forced to raise prices, restrict the pursuit of new business, or withdraw from high risk and peripheral markets. 

It forecasted that as insurers withdraw from some of their geographic markets and scale back particular lines of business, the market shares and opportunities for those that remain could sharply increase, leading to a significant reconfiguration in the list of leading players. 

Companies with a better understanding of their risks, said PwC, are likely to be in a stronger position to capitalize on potential openings that less-informed and less-assured competitors may miss.

PwC warned that without an industry consensus on a genuinely relevant, intelligible and comparable basis of accounting and disclosure, insurers may find it increasingly difficult to compete for capital. 

Further, with funds constrained, many portfolio investors could simply choose to put their money elsewhere, leaving the insurance industry with major challenges, according to the firm’s analysis. 

PwC said in a statement that “it seems imperative that the industry come together to develop a basis of relevant disclosures that reflect the nuances of their business and satisfy analyst and investor demands.”

As the government exerts a stronger influence over the insurance market as a result of bailouts, regulatory reform and greater control over pensions, health care, trade credit and mortgage support, the relationship between the public and private sectors could change, PwC suggested.

With the appointment of the Special Master for Troubled Asset Relief Program Executive Compensation in the United States, insurers are likely to base much more of their performance-related pay on risk-adjusted measures aligned to their business strategy.  They also are expected to face tougher regulation over how compensation is governed, said PwC.

The firm also found that for reinsurers, while demand is likely to increase within emerging markets, this is unlikely to offset the decline in reinsurance buying in developed markets and may force many reinsurers to rethink how they sustain profitability and growth. 

The trend toward higher retention of straightforward risks could accelerate. As companies become more risk-aware through advances in enterprise risk management, they will be better able to choose what risks to retain and which to reinsure, PwC said.

Mr. Chrnelich said the coming changes mean the competitive landscape will be very different in five years from what exists today. “This will jeopardize some insurers' business, but it should also enable those who are better prepared to excel in a new environment.” 

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