Report says South Africa's life insurers are likely to rethink product strategies in the face of operational challenges

Ali Karakuyu, Primary Credit Analyst at S&P Global Ratings.

South Africa's life insurance market is facing operational and financial challenges stemming from increased capital market volatility amid stricter regulations. This is according to an article titled Challenging Operating Conditions Could Lead South Africa's Life Insurers To Rethink Product Strategies published today on RatingsDirect.

Increasing capital market volatility, seen in equity price moves in the country and widening credit spreads, could not only affect the sector's financial profile but also the value propositions of insurance products. The

sector's creditworthiness is heavily influenced by domestic economic trends because South Africa-based life insurers do a significant portion of their business domestically, and the majority of their assets are held locally.

With the planned move to the more-stringent risk adjusted capital regime, Solvency Assessment And Management (SAM; broadly similar to Europe's Solvency 2) the sector's risk management capabilities are likely to improve. We note that the sector is yet to prove its readiness to comply with conduct-of-business regulations such as RDR.

Overall, the industry is likely to move toward a more capital-light strategy because of the regulatory developments and greater capital market volatility. Such change is likely to be positive for the sector's risk adjusted capital and consequently its financial strength.

In our base case, we assume our rated South African life insurers are generally well capitalised, with sufficient liquid assets, rendering them more resistant to possible sovereign stress scenarios compared to most other local private sector issuers, particularly local banks. The ratings are supported by strong capital levels relative to risks on balance sheet, ample liquidity, and the presence of product features with high profit and loss sharing abilities with policyholders. These features enhance balance-sheet resistance to market shocks, in our view.

We have already seen signals that the South African life insurance sector is taking mitigating steps to adapt to a more volatile environment by reducing its exposure to risky assets such as equities, mostly through hedging strategies. However, as most of the industry's assets are held locally, the sector's financial strength depends heavily on the health of domestic financial markets and the creditworthiness of local issuers.

We recognize that in-progress RDR encourages transparency in terms of payment for financial advice; a common level of training and professional standards; and transparency regarding the breadth of consideration of advice--that is, whether an advisor has considered all possible options and providers. In our
view, the critical impact of the in-progress RDR will be the removal of upfront commission payments from remuneration structures.

This may lead to reduced new business volumes over the near term as brokers (independent financial advisors), who make up a material portion of the sector's distribution, may struggle to adapt; we have seen similar in the U.K. life sector, which implemented it in 2013. Over the long-term RDR will be positive over the long term because the removal of upfront commissions from the remuneration structure will reduce the incentives to churn, and hence improve persistency.

A favorable financial market environment over several years helped the sector to build significant capital and policyholder buffers. This has prepared the industry well for SAM's higher capital requirements. While we recognize that the coverage ratios under SAM are much lower, we believe that SAM is a more realistic measure of an insurer's economic risk profile. We note that the dominant players by market share benefit from a solvency ratio of 1.5x-2.0x under SAM compared with 3x to 5x under the current Aggregate Capital
Requirement regime.

The higher cost and greater effort needed for effective hedging in a volatile environment, in addition to SAM requirements, are likely to lead the sector to move toward even more capital-light products. The shift to a more customer-friendly environment similar to the U.K. model will make the operating environment difficult for opaque products. We believe that the sector will find it more and more challenging to sell complex products (such as unit-linked with guarantees).

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