As insurers look forward to the potential benefits the new year may bring, experts are tempering expectations some in light of the unsettled nature of few key areas.

In a report released today by PricewaterhouseCoopers LLP (PWC), the insurance industry may not see a return to relative stability and certainty for a few years as it reacts to the effects of regulatory reform, increased government intervention and potential tax law changes in the aftermath of the financial crisis. Within five years, PWC believes 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.

The PricewaterhouseCoopers report, "Emerging from the Storm: The Day After Tomorrow for Insurance," outlines nine key developments that 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 will likely be sweeping regulatory changes resulting from proposed legislation to reform health insurance and increase federal oversight of insurance and financial industries.

The majority of regulation of insurance firms in the U.S. occurs at the state level, the report says, but there is political pressure to expand federal oversight. 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.

"Insurers are in the business of managing risk and measuring probability," says Bill Chrnelich, partner, PricewaterhouseCoopers' insurance sector. "They don't like uncertainty, yet they are facing two massive reform initiatives, the outcomes of which are unknown but could alter their destiny. 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 PricewaterhouseCoopers, 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. In addition, they will carefully factor the following considerations into their business decisions:

• Insurance industry consolidation: The U.S. insurance market remains highly fragmented, and the strong underlying rationale for consolidation and restructuring means that merger and acquisition activity may be set to accelerate rapidly, particularly as larger, better-capitalized firms consume smaller firms. Consolidation is expected to help to 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.

• The end of innocence for retail investors: 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.  The pursuit of innovation 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. An example of this is the recent resurgence in demand for whole life insurance. The apparent desire for guarantees, however, 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.

• Mounting uncertainty over tax: As debts and fiscal deficits mount, governments are looking for ways to increase their tax revenues. They will look closely at insurance companies, as the industry is a major source of potential tax receipts and has moved significant business capacity to other jurisdictions in recent years. Accordingly, insurers can expect renewed scrutiny of their tax planning techniques, as well as more stringent requirements for transparency and information exchange relating to clients.

• Organic restructuring: As a result of the financial crisis, many insurers have been forced to raise prices, restrict the pursuit of new business or withdraw from high risk and peripheral markets. 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 are likely to be in a stronger position to capitalize on potential openings that less-informed and less-assured competitors may miss.

• Rethinking insurance financial reporting: Many insurance executives justifiably complain that their share prices fail to reflect the true level of value being created within their business. 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. With funds constrained, many portfolio investors could simply choose to put their money elsewhere, leaving the insurance industry with major challenges. According to PricewaterhouseCoopers, 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.

• Blurring the lines between the public and private sector: The relationship between the public and private sectors could change as the government exerts a stronger influence over the insurance market as a result of bailouts, regulatory reform, and greater control over pensions, healthcare, trade credit and mortgage support.

• Greater scrutiny of executive compensation: Two concerns raised by the financial crisis were the lack of understanding of risk at the board of directors' level and compensation for senior executives.  With appointment of the Special Master for TARP 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.

• Challenging prospects for reinsurers: While demand for reinsurance 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.

"There is only one certainty for the insurance industry: Change is coming and, as a result, the competitive landscape will be very different in five years from what exists today," Chrnelich says. "This will jeopardize some insurers' business, but it should also enable those who are better prepared to excel in a new environment. Success will likely depend on close monitoring of developments and the ability to quickly capitalize on opportunities as reforms and changes within the industry become clearer."

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