Re/insurance – an industry that destroys value (or transfers it to brokers): McKinsey

According to a new report from McKinsey consultants, the global insurance and reinsurance industry has shifted from a “moderately value-creating” industry to one that is “value-destroying”.

It’s a damning assessment of the industry, which McKinsey says is strongest at the enterprise level.

Like, “Half of insurers globally are not earning their cost of capital, and half are trading below book value,” the report explains.

This is partly due to the uneven distribution of winners and losers in the insurance and reinsurance industry, with many companies playing roles in the market chain that add little real value.

There is also likely an element of “creative destruction” at play here, as the industry has tried to adapt to new technologies and new competitors, both from the insurtech side and from alternative capital.

This is the convention devised by the economist Joseph Schumpeter, who suggests that economic development can result from the destruction of a previous economic order.

So you can also think of creative destruction as innovation constantly driving change, pushing back the old guard and creating new opportunities in an industry.

We have certainly seen this happen in insurance and reinsurance over the past two decades and it aligns with the thinking of analysts at McKinsey.

“After decades of stable returns, insurance is now a value-destroying industry in which half of the players are not earning their cost of equity,” the McKinsey report asserts.

The fragmentation of market share and lack of evidence of global effects in the industry, as well as the inability to reduce costs, difficulties in significantly increasing efficiency and proving it by yields, resulted in negative economic benefits for the sector.

The fact that insurance barely generates a cost of capital makes investors skeptical, says McKinsey, even at a time when many re/insurance stocks have been relatively buoyant relative to broader stock markets.

McKinsey’s report displays the economic profit “power curve” distribution of each sector of the economy, including insurance and reinsurance.

“Not only has the global insurance industry destroyed value in recent years, but its positioning has eroded from 2005-09 to 2015-19,” concludes McKinsey.

But as you can see from the power curves, which we repeat below from McKinsey’s report, the only insurance and reinsurance market segment that created clear value, or perhaps more precisely, accumulated a greater part of the value lost by the re/insurers, is the brokerage segment.

Although we said the uneven distribution above, it’s about winners and losers, not so much about performance.

McKinsey points out that when it comes to value destruction, “it’s not a problem caused by a few underperformers. Rather, it’s the whole industry: 54% of listed insurers, accounting for 52% of global industry equity, have had an ROE below their cost of equity over the past five years, raising questions about the long-term economic viability of their business model. ”

Regarding the equality of distribution, of winners and losers and also those who generate profits, a notable change is the rise of the brokerage segment.

“Over the past five to ten years, brokers have emerged as the big winners in the industry, with public and private investors recognizing their position of strength in the insurance value chain,” says McKinsey.

This is partly due to insurers and reinsurers who lack control of the distribution channels, of which the intermediaries are now firmly in control.

McKinsey consultants point out that due to the lack of distribution control, re/insurers “could run an even greater risk of becoming pure balance sheet providers, while intermediaries retain an asset-light client relationship model. “.

The authors of the McKinsey report state that “the transition to digital may be the last chance for insurers to regain the upper hand in this ‘fight for the customer’. »

While value may have been destroyed by the insurance and reinsurance industry, in economic terms we believe it has also been displaced, or abandoned, by not capitalizing on the one thing brokers don’t handle. not directly, venture capital itself.

Rather than breaking the value chains of the market, as the disruption probably should have done, with venture capital being key to the eventual delivery of a risk transfer product, control of the chains consolidated towards the brokers, it seems.

In recent years, this has meant a steady increase in returns for brokers, while many re/insurers have seen their returns decline.

The advantage of data, along with brokers becoming venture marshals, which we discussed in this recent article, may be the main reasons for the shift in value from the underwriting community to the brokerage community in recent years.

In 2018, we questioned the ability of market participants to survive if they could not clearly demonstrate and monetize the value they bring to the chain from risk to capital.

Perhaps brokers have been much better at this in recent years, while re/insurers haven’t taken advantage of opportunities to push their own importance as a link in the chain high, for fear not wanting to do all-in in competition with the big brokerages.

This has left many reinsurers in a position where, lacking scale, reach, diversification, efficiency and technical or data advantage, they no longer have the stature to regain lost ground and could find themselves in a position where mergers and acquisitions might be their only way to avoid a slow death spiral into insignificance.

If venture capital is all you’re bringing in, then unless it’s the most effective and least expensive, your position in the chain has lost significant value now.

Especially when brokers, who currently rake in the highest economic value, are increasingly also marshals of capital for the industry.

Along with brokers, the other winners in terms of value creation at the moment seem to be those who occupy a mixed position of underwriting and distribution, such as MGAs.

Freed from large balance sheets and all the additional regulatory requirements that surround it, the MGA business model has flourished in recent years, but now relies heavily on access to capital and capacity, as well as its distribution.

The McKinsey report describes the “value shift towards intermediaries” in the insurance and reinsurance industry.

It seems carriers have let this change happen and accelerate in recent years, failing to double down on opportunities to democratize key elements of the chain linking risk and capital.

Ownership of some elements of the chain remains in the hands of intermediaries, in some cases where there may be a more optimal and efficient alternative available and where their ownership should have changed a few years ago.

The advent of capital market securitization technology and its use in reinsurance could have pushed some elements of the chain into the hands of other players and away from brokers. Technology too.

But so far, we don’t see these changes, and brokers are doing a great job of retaining pieces of the chain that can perhaps be executed better and more efficiently by others.

This is partly due to the scale and importance of brokers in the insurance and reinsurance market.

But it’s also partly because carriers have failed to advance their own efficiency as fast as they could, but more importantly because they’ve failed to push for a global reinvention of the market chain. capital insurance risk, which could have shifted some additional value in their favor.

McKinsey’s report is good reading for anyone interested in the future of insurance and reinsurance and although it discusses value shifting towards brokers and value destruction on the carrier side, we believe this is still in its infancy and the market remains on the cusp of more global change that could alter these dynamics again.

Ultimately, there is still a tremendous amount of value to be created in insurance and reinsurance, not least through the massive adoption of new technologies alongside capital market tools, to create entirely new ways of match and trade risk and capital.

Along with the creation of new product categories, as the world becomes increasingly risk averse and sees insurance and reinsurance players as the experts who can help smooth out volatility.

While McKinsey’s report may provide a bleak outlook, it’s actually a moment of significant optimism. But that’s going to require a further reorganization of the custody, as the value isn’t always properly distributed right now.

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