NU Online News Service, Nov. 5, 10:55 a.m. – A down equity market and demand for better corporate governance are just two factors that will shape financial services companies through 2003, experts explained during a recent industry overview by accounting firm Ernst & Young L.L.P., New York.

The next area of regulatory scrutiny, now focused on investment research, may turn to the allocation of initial public offerings and high-net-worth clients, said Robert Stein, chairman-global financial services of E&Y.

Changes in corporate governance initiated by regulators can have a positive impact on the financial services industry as long as they do not create inefficiencies and stifle the willingness to take risks, Stein said.

Efficiency will be needed by all sectors of the financial services industry to respond to market doldrums and to position for the next year, the E&Y representatives contended.

For life insurers, market declines will show up on the balance sheet, said Peter Porrino, global and Americas director of insurance industry services with E&Y.

Deferred acquisition costs will make an impact on financial results of some variable annuity and life writers as market declines are reflected in a decrease in assets backing these contracts, he explained.

As the value of those assets fall, costs are amortized more quickly so that liabilities match assets, he explained.

Porrino said that DAC costs could continue to be an issue through 2003 if equity markets do not rebound.

The markets are already hurting annuity sales, with premiums declining 20% in 2001 and likely to drop again in 2002 to a level not seen since 1997, Porrino predicted.

“It is a huge issue for life companies that have cast their lot with variable products,” he added.

Life insurers are becoming more like asset managers, Porrino said. Mortality risk, which he says has significant embedded “mortality gains,” is being reinsured. Meanwhile, the life reinsurance market will continue to experience growth.

If the equity market continues its current downturn, guaranteed benefits will also continue to present problems for some variable writers, Porrino said.

For property-casualty insurers, the “same old story of fixing the hole in the balance sheet remains,” he added.

In actuality, Porrino explained, there are two holes: an “old hole” caused by asbestos and a “new hole” that resulted from “dramatic underpricing in the late ’90s.”

On the property-casualty side of the business, surplus shortfalls, caused in part by losses in investments, will continue in 2003, according to Porrino.

If surplus shortfalls continue, so does the question of whether the property-casualty business is really experiencing a hard market.

Porrino said that it is but that the market can become even harder. To achieve double-digit return on equity, the industry’s combined ratio needs to be in the mid-90s, he said. It is moving toward that but not quite there yet, Porrino added.

According to information gathered by E&Y and Goldman Sachs, New York, since mid-1998, commercial line rates went from an 8% decline to a 20% increase in the first half of 2002. During that same time frame, flat rates in the personal lines area have increased by 10%.

Volatility in the equity markets is also accelerating consolidation in the asset-management sector, said another speaker, Steven Buller, national and international director of asset management services for E&Y.

Acquisitions will be greater among high-net-worth managers and trust companies, not only because of the size of the assets under management but also because of the greater ability to leverage sales of other products, he said.

There will also be a retrenching of global investments, and the industry is going to lose some of the smaller mutual fund complexes through 2003, Buller predicted.

Fund size has also shrunk with the current market drop. Buller noted the average asset size for funds has declined to $561 million from $775 million.

Typically, a fund needs $100 million in net assets to break even, he said. Currently, 2,300 funds, or 28% of all funds, have less than $50 million in assets, and 3,300 funds, or 40%, have less than $100 million in assets, Buller noted.

Going forward, asset managers will rely more on advisors to reach the public, Buller added. Currently, financial planner, insurance and broker sales make up 85% of all fund sales, he added.