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The Actuary The magazine of the Institute & Faculty of Actuaries

Inventing the future

Where is the UK retail financial services market going and where do we want to be in it? This is a question chief executive officers (CEOs) in our industry must ask themselves on a regular basis if they wish to keep ahead of the game. But how can a CEO answer this question within this ever-changing environment?
Consider a hypothetical CEO who could take a view on the long-term trends that will influence the market. The list could include:
– the introduction of the CAT (charges access transparency) standard and maximum 1% charge for stakeholder pensions;
– lower inflation and long-term interest rates leading to lower expected returns on equity investment;
– the increasing burden of defined benefit provision leading to more defined contribution schemes;
– demographic changes leading to longer than expected retirement;
– an international trend, also present in the UK, of state provision being reduced by governments;
– continued upheaval in the UK regulatory environment; and
– an increase in media and public awareness and criticism of the financial services market.
So having identified these trends or ‘forces’ which will shape the industry, our CEO must try to decide what impact they will have. This is not easy, as there are many unanswered questions to ponder:
– What effect will stakeholder have on total market volumes?
– How many companies, if any, will successfully offer stakeholder?
– What is the future for occupational pension schemes?
– When will the consolidation in the industry end?
– Will stakeholder take the place of other forms of pension provision?
– Will overseas new entrants, in particular US 401(k) providers, come into the market?
– How strong will affinity group distribution be?
– What impact will the new pooled investment regime have?
– Will the regulatory framework remain consistent?
So our CEO has plenty to mull over. Strategic and marketing directors could write reams of qualitative conjecture based on gut feeling; but we would recommend, as all good consulting actuaries would, that the need for a strategic framework is great, and a model capable of delivering that framework is the answer to the CEO’s cogitations.

The model
The model works by projecting forwards the three basic ingredients of the market: customers, distribution channels, and products, and the most important of these is customers. The CEO is now interested in the shape and future of the entire industry so the potential customer base is the entire UK population. We divide our customers into segments defined by customer need:
– employer-sponsored retirement;
– regular savings for retirement;
– lump sum investors;
– medium-term regular savers;
– rainy day savers; and
– mortgage repayers.
For each of these segments we also need to estimate:
– How many potential customers are there?
– What annual conversion rate is achievable?
– What proportion of customers will require advice?
These can be estimated from UK industry data such as statistics from the Association of British Insurers.
The second ingredient of our model is the distribution channels:
– employee benefit consultancies;
– independent financial advisers (IFAs);
– direct sales force (top end);
– direct sales force (mass market);
– bancassurance;
– industrial branch;
– direct advice channels;
– shop assurance;
– telephony;
– Internet;
– newspapers and direct mail.
The first eight provide advice, while the other four do not. Most should be self-explanatory but the term ‘direct advice channels’, probably requires some explanation. This refers to some future success in providing advice using either telephony or the Internet. By combining assumptions about market size, case size, and future growth in the market and distribution channel it is possible, given a set of customer targeting rules, to project future sale numbers split by both channel and customer segment.
Our CEO has spotted immediately that this is not a traditional model. Most actuarial models seem to concentrate on accurately modelling in-force business so that yesterday’s mistakes can be repaired. This model is much easier to run and understand, and focuses on the business issues that are important for choosing a distribution strategy. It is only now that we introduce products with a unique distribution for each customer segment, driven by customer needs. This gives a split of sales numbers by distribution channel, customer segment, and product.
Now, our CEO is quite interested in these customers buying products which meet their needs, but how much money will this generate in the industry, and how much can be attracted to the bottom line? To generate cashflows resulting from each product sale requires inputs about product structure and expected business experience, such as case size, selling costs, and persistency. By combining these elements, future industry cashflows and new business value-added can be calculated, split by segment, channel, and product.
Our CEO is now interested in seeing some results and how these results can answer some questions:
– What is the range of possible tomorrows?
– What do the CAT standards mean for the affordability of distribution and servicing costs?
– Which customer segments and channels are likely to be most (and least) profitable?
– What is the best business formula for tomorrow’s market?
– What is the likely effect on the CEO’s job security and the company’s share price?
– Does the company have enough capital?
These questions can be answered, in part, by looking at growth in new funds under management, new business added value, the cost base performance of different channels and, finally, accumulated impact on surplus.

The results
Our CEO is now positively salivating at the possibility of seeing some numbers. Wishing to be the bringer of good news, we have provided one optimistic results scenario to whet the appetite where government’s aims are met, customers are satisfied, and financial services providers are profitable. The main assumptions for this are that within five years:
– 1% per annum charge cap on all products;
– potential size of pensions segments increases by 20%;
– potential size of other segments increases by 10%;
– increase in distribution capacity in five years to:
—sales force, IFAs, advisers 25%;
—bancassurance 100%;
—direct distribution 200 times bigger;
– 20% increase in average case sizes;
– general reduction in costs by around 50%;
– real return on equity net of tax of 5% per annum;
– 20% reduction in the proportion of lapsing customers.
One assumption that our CEO doubts is the cost reduction. However, our model shows that for business to be profitable, costs had to be reduced to half their current level measured as a percentage of premium. Our results are shown in figures 1 and 2.
Our CEO can see huge increases in premium, across all channels. Much of this is penetration of the occupational scheme market, but also represents large increases in sale to the previously ‘unpensioned’. IFAs and salesforce distribution are still in the lead but direct advice channels are also winning large amounts of new business. Government and consumers seem to be happy. But the picture is a little different for the industry.
New business added value is the embedded value profit on new business, so this takes account of all the future profits expected to be earned from new business sold during the year.
Only the direct advice distribution channel is able to make a reasonable profit on new business. On average, providers manage to make a profit on products sold by IFAs, but direct sales forces are loss-making, even after allowing for the reduction in sales costs.
Figure 2 shows that only one channel the IFA is providing any significant surplus, and this is just a repayment of historic new business strain. The rapid growth of the direct advice channel means that it would still require new capital. This suggests lots of pressure to reduce costs.

What now?
Even looking at one possible scenario shows that everything points to a huge emphasis on cost control. Some companies now seem confident that they can offer stakeholder and CAT-marked products profitably, but when these are extended to all retail savings and investment products it is a different story. Business cases cannot be built on marginal cost bases; core costs across all products have to be brought down to this level. We believe that this is a very different scenario from the one we are in now. What does our CEO do now?