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Ernst&Young on FTT

  1. 1. Issue number 3 ITEM Club Financial Services Winter 2011/12 forecast Outlook for Financial Services Executive summaryThe ITEM Club Outlook for FinancialServices is a companion to the Bankingmain ITEM Club forecast launched ►► The sharp downgrade of the ITEM potentially encouraging a shift awayto examine in more detail the economic forecast for the UK economy from bank lending towards more bondimplications of ITEM Club’s economic presents a more challenging operating financing, as already happens in theprojections for the health of the UK environment for the banking sector, United States. which is already struggling with thefinancial sector. ►► Disintermediation of lending activity is burden of costly regulatory changes. also underway in consumer credit, asThe report is organised into three Bank profits will remain under pressure, an increasing number of households forcing additional rounds of cost cuttingchapters, which in turn examine are finding that banks will only lend to and lay-offs. Many banks will have tothe banking, insurance and asset the most financially sound borrowers, reappraise their core business models asmanagement sectors. forcing them to turn to alternative they continue to restructure, stripping high-cost consumer credit providers, away less profitable units.Ernst & Young is the sole sponsor such as payday loan companies. Netof the ITEM Club, which is the ►► With economic activity weakening, lending by these consumer creditonly non-governmental economic the outlook for loan demand appears providers has increased by 42% subdued and confidence will not since the beginning of 2007, whileforecasting group to use the HM return until a credible solution to the unsecured lending to individuals byTreasury model of the UK economy. Eurozone crisis is in sight. At the same banks and building societies contractedIts forecasts are independent of any time, we expect banks to introduce by 23% over the same period. Withpolitical, economic or business bias. stricter lending policies in response to banks expected to further tighten the worsened outlook for loan quality lending conditions, contributing to as well as high costs of funding on our forecast of a 5.4% contraction inContact wholesale markets. After expanding by consumer credit from banks duringAndy Baldwin an estimated 4.3% in 2011, we expect 2012, it is likely that these new lendersManaging Partner total loans to contract by 2.2% in 2012, will continue to expand their provisionErnst & Young EMEIA Financial Services with only very modest growth of 0.9% of credit to poorer borrowers.+44 (0)20 7951 4626 envisaged in 2013. Shortages of credit ►► We estimate that the UK would could therefore pose more problems for three-quarters of potential revenues this year for businesses and households. from an EU-wide financial transactions ►► Banks’ funding costs (as measured by tax (FTT). Even if the UK opts out of yields on their bonds) have been higher the FTT, it could still account for more than those of their large corporate than half of the expected revenues clients since the 2007 crisis and our from the introduction of an FTT in expectation is that regulatory and the Eurozone. Taking account of the financial market developments will spillover effects outside the financial ensure that this disparity is maintained sector, associated job losses in the UK for some time. This creates incentives from an FTT in the Eurozone would for these corporate customers to raise likely amount to around 4,500. funds outside the banking system,
  2. 2. Insurance Asset management ►► Although the insurance industry has so ►► Although UK net sales of retail funds far remained fairly healthy compared went negative in H2 2011, institutional to other financial services sectors, fund management remained relatively this strength will be tested in coming buoyant, helped by defensive inflows months. Our forecasts point to subdued from the Eurozone and contrarian demand for insurance products in the buying of equities, from which retail near term, reflecting the constraints buyers continued to retreat. The outlook on households’ disposable income and for retail and institutional markets is prioritisation of debt repayment. We subdued in 2012 by Eurozone sovereign expect gross life premiums to grow debt and bank problems, with recovery by just 0.1% in 2012, while non-life in funds under management dependent premiums grow by 1.1%. This implies on an equity market upturn. intensified competition for declining ►► Against this background, we forecast business volumes in the domestic total assets under management to market, leading to consolidation expand only marginally, by 0.4%, over through exit or acquisition of smaller the course of this year. But prospects players. In this environment, insurers look more positive from 2013, when with a focus on emerging markets will financial market conditions should benefit from a potential source of much improve, prompting renewed inflows of faster-growing demand. funds. We expect growth in assets under ►► The market for life products is set for management to average around 8% per gradual recovery, but will not match the annum during 2013-15. rapid growth achieved before 2008, ►► Absolute-return funds suffered from whose subsequent reversal highlighted high correlation in 2011 but are set the sensitivity of demand to income. to recover in 2012 despite continued Higher capital requirements will raise volatility, and will remain a growth the cost and limit the appeal of some area fuelled by clients requiring higher previously popular savings-related returns. With demand for lower cost products. Moreover, higher contribution pushing more retail demand towards requirements (along with rising annuity tracker funds, managed funds still costs) are a threat to participation in pursuing benchmark or peer-group pension schemes which the National strategies will have to roll out lower-cost Employment Savings Trust (NEST) versions to retain a mass market under auto-enrolment will not start to tackle UCITS IV. significantly before 2014. ►► Non-life insurers experienced a sharp rise in claims in 2011, within the UK and globally, which will require a further rise in premiums. But with spare reinsurance capacity still reported, this is unlikely to signal an end to the down-phase of the underwriting cycle. Premium rises to date have mainly been concentrated in motor policies, where they have not yet matched rising costs. And Solvency II rules are likely to impede the capital adjustment that normally precedes a general hardening of premiums.2 ITEM Club Outlook for Financial Services
  3. 3. Introduction The risks to this forecast are skewed to the downside — the Eurozone crisis remains a The Eurozone crisis has already put UK key source of uncertainty and a series of business spending on hold, while the disorderly defaults would have significant consumer is still struggling with the effects negative repercussions for the UK economy. of fiscal austerity and rising unemployment. Against this background, the Ernst & Young Against this background, we present the ITEM Club Winter forecast concluded that latest ITEM Club Outlook for Financial the UK economy appears almost certain Services as a companion to the main ITEM to enter a technical recession in Q1 2012; Club forecast to examine in more detail the the key question is over how severe it will implications of our economic projections be. Even assuming an orderly resolution to for the health of the UK financial sector. the problems in the Eurozone, the UK will The report is organised into three chapters, struggle to post positive growth this year, which in turn examine the banking, with the economy expanding by just 1.8% in insurance and asset management sectors. 2013. But the current resilience of the US and many other overseas markets, together Banking with an expected fall in inflation, should help the UK to avoid a serious double dip. Difficult conditions will force a The forecast sees business investment reappraisal of business models flat in the first quarter of this year, before The ITEM Club forecast for Winter 2012 starting to pick up again in the second half concluded that the UK economy has of the year as some of the uncertainties probably already slipped back into technical dissipate. Business investment is forecast recession (defined as two consecutive to rise by 3.9% for the year as a whole; quarters of negative GDP growth), albeit however, this still means that at the end of a short and shallow one. GDP growth is 2012 the level of business investment will now seen at just 0.2% for 2012 and 1.8% be 13.6% below its pre-crisis peak. With in 2013, representing a sharp downgrade investment in dwellings flat or falling and to previous forecasts of 1.5% and 2.5% government investment being cut back respectively. The forecast still assumes by 12% a year or more, total investment that problems facing policymakers in the expenditure is expected to be broadly flat in Eurozone are successfully negotiated, but 2012, after a 2.6% fall in 2011. with the chances of a less orderly outcome for the Eurozone having increased in recent Weak economic activity will contribute months, this implies significant downside to a further rise in unemployment from risks to the outlook. already elevated levels. The forecast shows unemployment just under three million next The renewed deterioration in economic spring, equivalent to 9.3% of the workforce. conditions will present a more challenging That will dampen consumer spending just operating environment for the banking as the pressure of inflation on disposable sector, which is already struggling with incomes begins to abate. the burden of costly regulatory changes.Table 1: Forecast for the UK 2010 2011 2012 2013 2014 2015economy, Autumn 2011 GDP 2.1 0.9 0.2 1.8 2.8 2.6% changes on previous year except interest and Consumer prices 3.3 4.5 2.3 1.9 2.0 2.0exchange rates Average earnings 3.8 1.8 1.9 2.9 3.3 3.9 Unemployment rate (% of workforce) 7.9 8.1 9.0 9.2 8.8 8.2 Government net borrowing (% of GDP) 10.1 8.5 7.8 6.4 4.7 3.1 3-month interest rate 0.7 0.9 1.0 1.8 2.8 3.7 Effective exchange rate 80.5 80.0 81.5 80.4 79.1 77.5 Source: ITEM, Bank of England ITEM Club Outlook for Financial Services 3
  4. 4. The difficult domestic backdrop implies a Arrears on unsecured lending are also likely worsening of credit quality, as well as lower to pick up in light of the expected weakness demand for credit, which will hit associated in household incomes and further rises earnings. Market volatility will also dampen in unemployment. Data from the Labour investment banking fee income from M&A Force Survey (LFS) suggests that the labour activity and other advisory work, while market has already deteriorated sharply, trading conditions are likely to also prove with the International Labour Organisation difficult. Against this background, bank (ILO) data for the three months to October profits will remain under pressure, forcing showing the unemployment rate increased additional rounds of cost cutting and lay- to 8.3%. This is above the level it had offs. Many banks will have to reappraise reached during the recession and the their core business models as they highest level in 18 years. We expect the continue to restructure, stripping away less ILO unemployment rate to peak at 9.3% in profitable units. the first half of 2013 and to then drop back only very gradually. Write-offs of bank loans are forecast The housing market has been moving to rise this year… sideways in recent months and we expect The weaker outlook for the economy this trend to continue during the first half implies increased upward pressure on of 2012, with prices mounting a gradual write-offs, which will have a direct adverse recovery thereafter. Losses on residential effect on bank profitability. Data from mortgages have so far remained very low The Insolvency Service shows numbers of due to the exceptionally low level of short- corporate insolvencies were already on a term interest rates, although there is also rising trend during the first three quarters evidence that underlying distress has been of 2011 and we expect a further significant masked by forbearance. Research by the rise in coming quarters. Consumer-facing FSA and Bank of England indicates that, in industries are likely to face a particularly the absence of forbearance, the mortgage difficult period, given our forecast for arrears rate might have been 0.5% points consumer spending to grow by just 0.2% higher in Q3 2011 at 1.7%. Data collected this year and by 1.4% in 2013. Sectors by the FSA suggests that provision coverage ranging from retailers to hotels and on mortgages in forbearance is around restaurants are likely to suffer a rise in three times higher than coverage on other bankruptcies due to slumping sales. mortgages, so if more losses are realised The outlook for commercial real estate they should still be manageable. With rates also appears difficult and capital values forecast to remain at their current level of could come under renewed pressure, 0.5% until the first half of 2013, this should especially in secondary markets where help to keep a lid on upward pressure on occupation prospects are weakest. While default rates on secured lending. loan repayment forbearance by banks has so far helped to keep default rates low, …and loan growth is forecast to turn impairments could clearly rise very rapidly negative in the event that conditions in the sector High levels of uncertainty linked to the suffer a renewed deterioration. Negative ongoing problems in the Eurozone mean equity would also expose banks to higher that many businesses are putting their losses following default. investment plans on hold, while the moreChart 1.1: UK and Eurozone 1.0interbank spreadsSource: ITEM/Haver Analytics 0.8 0.6 % 0.4 0.2 0.0 10 11 10 11 10 11 12 10 11 10 11 0 1 01 01 20 20 20 20 20 20 20 20 20 20 20 l2 l2 ay ay v v ar ar p p n n n No No Ju Ju Se Se Ja Ja Ja M M M M Eurozone 3M Euribor-3M OIS UK 3M Libor-3M OIS4 ITEM Club Outlook for Financial Services
  5. 5. difficult financial situation for households spreads have continued to widen, for means they are likely to focus on improving example, they are still well below Eurozone their balance sheets over the coming year. levels, suggesting markets are less worried As a result, the outlook for loan demand about counterparty risks posed by UK appears subdued. At the same time, we banks. But the interconnectedness of the expect banks to introduce stricter lending European banking system means that the policies in response to the worsened UK money market could still freeze up again outlook for loan quality as well as high costs if the Eurozone crisis escalates. Although of funding on wholesale markets. After the Bank of England has made contingency expanding by an estimated 4.3% in 2011, plans for this outcome, banks would still be we expect total loans to contract by 2.2% likely to rein in lending if this occurred. in 2012, with only very modest growth of 0.9% envisaged in 2013. Shortages of Regulatory changes are likely to push credit could therefore pose more problems up funding costs… this year for businesses and households. The Treasury plans to push ahead with The Bank of England reported in its the Independent Commission on Banking Q4 Credit Conditions Survey that the (ICB) report proposals, entailing the ring- availability of credit for businesses and fencing of retail savings in banks that secured credit to households had remained have wholesale and investment banking broadly unchanged in the three months to operations. Banks will face higher capital mid-December 2011, while the availability requirements and higher funding costs, of unsecured credit to households had which will represent a significant drag increased. But other data from the Bank of on return on equity and force banks to England illustrates how smaller companies carefully review the optimum mix and are being affected by credit restrictions — location of their business. Although the the average interest rate on new advances implementation timetable stretches of £1mn or less was 3.81%, more than out to 2019, the ICB has urged the UK two percentage points higher than the Government to complete the ring-fence average 1.72% charged on loans larger sooner. Despite the current lack of detail than £20mn. This spread averaged just regarding the design of the ring-fence, 0.5 percentage points during 2004-08, lenders have therefore started to engage in but it has since been on an upward trend. early strategic planning ahead of an official Although the Credit Conditions Survey announcement on the rules. reported that lenders are expecting a small The ICB report recommendations may increase in overall credit availability in the accelerate a shift toward funding on a coming three months, lenders commented secured basis that is already underway. This that developments in the Eurozone and is because the explicit preference for retail their impact on banks’ funding conditions depositors contained within the proposal would be a key determinant of domestic will push unsecured bondholders further credit conditions. down the repayment hierarchy. While Financial conditions for UK banks are not banks will attempt to pass on the higher currently as difficult as for those in the cost of capital to customers in the form of Eurozone, despite longer-term financing higher prices, this may not be feasible in having dried up. Although interbank practice due to competitive pressures. ThisChart 1.2: UK consumer credit January 2007 = 100*Source: ITEM/Bank of England 150 140 130 120 110 100 90 80 70 60 07 07 07 08 08 08 09 09 Ja 09 ay 0 10 Ja 10 11 11 11 1 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 n ay p n ay p n ay p n p n ay p Se Se Se Se Se Ja Ja Ja M M M M M other consumer credit providers banks and building societies ITEM Club Outlook for Financial Services 5
  6. 6. is especially true for large non-financial It is not just the corporate sector where corporates that could most easily shift their disintermediation of lending activity business to non-UK banks and/or obtain is underway. An increasing number of financing in the bond markets. households are finding that banks will only lend to the most financially sound One important detail that the Treasury has borrowers, forcing them to turn to announced is that the overseas arms of alternative high-cost consumer credit multinational banks will be exempt from providers, such as payday loan companies. the new rules. This will put internationally According to Bank of England data1, net focused banks at less of a disadvantage lending by these consumer credit providers relative to their non-diversified rivals has increased by 42% since the beginning — those with significant operations in of 2007, while unsecured lending to emerging markets are likely to outperform individuals by banks and building societies as they will also benefit from stronger contracted by 23% over the same period growth in these economies. (see chart 1.2). With banks expected to further tighten lending conditions — …encouraging more borrowers to contributing to our forecast of a 5.4% access the ‘shadow’ banking system contraction in consumer credit from Banks’ funding costs (as measured by banks during 2012 — it is likely that these yields on their bonds) have been higher new lenders will continue to expand their than those of their large corporate clients provision of credit to poorer borrowers, since the 2007 crisis and our expectation thereby capturing a growing share of the is that regulatory and financial market lending market. developments will ensure that this disparity is maintained for some time. This creates The UK accounts for three-quarters incentives for these corporate customers of potential revenue from an EU-wide to raise funds outside the banking system, FTT… potentially encouraging a shift away Proposals for a European tax on financial from bank lending and toward more transactions (FTT) present another bond financing, as is already happening potential threat to the health of the UK in the United States. Investment funds banking sector. The European Commission and investment companies could also published an economic impact study in play a more significant role in corporate September 2011 that presented estimates credit provision. Nonetheless, banks still of the potential tax revenue that could have a comparative advantage in terms be generated by a European-wide FTT. of their expertise in managing the risks The study concluded that the FTT has associated with lending activities, so it the potential to raise around €37bn each may become more common for banks year (2010 prices), with the potential for and institutional investors to collaborate an additional €16bn of revenue if a spot in corporate financing activities. While foreign currency transaction tax (CTT) is the disintermediation of bank lending also imposed2. will reduce bank income from lending, investment banks might therefore offset For an analysis of the net impact of the the impact on earnings by generating more FTT on the EU public finances, please refer fee-based revenue. to the Ernst & Young Eurozone Financial Services Outlook Winter 2011/12. HereTable 2: Banking 2010 2011 2012 2013 2014 2015Source: ITEM/Bank of England Total assets (£mn) 7,071 7,294 7,383 7,555 7,802 8,085 Total loans (£mn) 5,489 5,727 5,600 5,648 5,871 6,083 Consumer credit (£mn) 127 119 112 115 120 126 Write-offs (% loans) 6.8 5.7 6.4 5.6 5.1 4.9 Business/corporate loans (£mn) 479 455 429 445 489 553 Write-offs (% loans) 1.3 1.7 1.9 1.2 0.7 0.4 Residential mortgage loans (£mn) 1,044 1,056 1,068 1,091 1,133 1,182 Write-offs (% loans) 0.06 0.05 0.06 0.05 0.03 0.011 We have adjusted the original Bank of England series to account for the break in January 2010, when securitised loans were reclassified from ‘other credit providers’ to the balance sheets of theoriginating MFIs.2 As the taxation of spot currency transactions could pose considerable legal issues as well as having the potential to disrupt the free movement of capital, this option was excluded from the study’sheadline estimates.6 ITEM Club Outlook for Financial Services
  7. 7. we consider the FTT in isolation, modelling …and may still account for over half what proportion of revenues would be of revenues even if the UK opts out generated by the City of London in two Although the UK Prime Minister, David scenarios. The first scenario considers Cameron, has pledged to veto the the introduction of the FTT across the introduction of an FTT at the EU level, a EU including the UK; the second scenario number of individual member states have assumes that the UK opts out but is still voiced their commitment to push ahead affected by the introduction of the FTT in with the tax at the national level, with the the Eurozone due to the use of a reverse aim of applying the FTT throughout the charge mechanism. Eurozone. In this event, the impact on How the revenues of the FTT would the UK would depend very much on the be distributed at the national level design of the tax. For example, there has was not calculated by the European been some discussion of the application of Commission’s impact study, but the authors a reverse charge mechanism for the FTT, acknowledged that revenues would be such that all trades denominated in euros distributed unevenly, in line with trading would be subject to the tax, irrespective of volumes at EU exchanges. In order to where the trade takes place. As many euro- calculate the proportion of revenue that denominated trades take place in London, the European Commission expects would this could effectively impose an FTT on the be generated in London by an EU-wide FTT, UK through the ‘back door’. we have estimated the share of UK trading We can make a rough calculation of volumes in overall turnover at the EU level the proportion of total revenues that a for each of the market segments affected Eurozone FTT could potentially generate by the FTT3. As shown in table 3, our data from the UK by estimating the share of confirms that the City of London dominates euro-denominated trades in each market EU trading in almost every market apart segment, as set out in table 44. The implied from equities. Taking the European UK revenues from a Eurozone FTT are then Commission’s estimates at face value, this calculated by applying these shares to the data implies that the UK would account UK revenue estimates in row 3 of table for 77% (€41bn) of the total potential 3. They show that the UK financial sector revenue that could be generated by an could be expected to contribute 64% of FTT. Excluding the CTT, UK revenues would total revenues from an FTT imposed at the amount to a share of 75% (€28bn) of the Eurozone level5. Excluding the CTT, the UK total projected EU revenues (€37bn). financial sector would account for 58% of total revenues. Moreover, these revenues would flow directly to governments in the Eurozone rather than to the UK Exchequer.Table 3: EU-wide FTT revenue estimates Exchange- OTC Currency Total Foreign Currency Equities Bonds traded interest rate outright Total (without currency swaps derivatives derivatives forwards CTT)(1) Estimated EU revenues (€bn) 4.7 8.8 11.3 7.8 16.0 3.7 0.8 53 37(2) Share of UK in EU trading (%) 30 84 89 74 81 65 80 77 75(3)=(1)*(2) Implied UK revenues (€bn) 1.4 7.4 10.1 5.8 12.9 2.4 0.7 41 28Note: Revenue estimates exclude non-financial sector transactions (estimated to be 15% of overall trades by the European Commission)Source: European Commission, ITEMTable 4: Eurozone FTT revenue estimates Exchange- OTC Currency Total Foreign Currency Equities Bonds traded interest rate outright Total (without currency swaps derivatives derivatives forwards CTT) (4) Euro-share of UK trading (%) 5 30 50 54 70 70 70 n/a n/a (5)=(3)*(4) Implied UK revenues (€bn) 0.1 2.2 5.5 3.1 9.1 1.7 0.5 22 13 (6)=(1)-(3) Implied Eurozone revenues 3.3 1.4 1.2 2.0 3.0 1.3 0.2 12 9 (€bn) (7)=(5)+(6) Total revenues (€bn) 3.4 3.6 6.7 5.1 12.1 3.0 0.6 35 22 Note: Revenue estimates exclude non-financial sector transactions (estimated to be 15% of overall trades by the European Commission) Source: ITEM3 Our estimates draw upon a variety of sources, including the Federation of European Securities Exchanges, the World Federation of Exchanges, the BIS and TheCityUK.4 Again, we have drawn upon a range of available data, but we have also had to estimate these shares in some cases.5 The revenue that would be generated by the FTT on Eurozone trades is calculated as the difference between rows (1) and (3) in Table 3. The calculations in row (6) of Table 4 show that total revenuefrom the Eurozone itself would likely amount to around €12bn, or €9bn if the CTT was excluded. Row 7 adds the implied revenues from the UK and Eurozone to produce an estimate of total revenuesfrom a Eurozone FTT. ITEM Club Outlook for Financial Services 7
  8. 8. The Eurozone FTT could result in that total job losses in the capital would around 4,500 job losses in the UK amount to 3,150, while job losses in the The European Commission study concludes UK as a whole would be 4,500. However, that the FTT would have only a small over time it is likely that the employment direct impact on overall employment, as impact would dissipate, as financial activity job losses would mainly be concentrated in London was redirected away from euro- within investment banks where employment denominated business and toward more intensity is very low. However, the UK is profitable trading activities. likely to bear the brunt of these losses, given that the majority of the affected Insurance financial activities take place there. The insurance industry faces a difficult Potential spillover effects to other forms outlook in the near term, characterised by of employment may also be substantial, as a weak recovery of demand and increases workers in the securities industry consume in cost due to tighter regulation and heavy a range of goods and services, thereby natural disaster claim costs in 2010- supporting other business sectors. 11. These factors are likely to delay the In order to estimate the potential impact cyclical upturn in underwriting profits that on employment in London, we rely on would normally be expected at this stage, academic studies of the relationship on the basis of industry consolidation and between stock market volumes and reduced capacity. securities industry employment based on data from New York. A stock transfer tax Consolidation likely among life (STT) was imposed at the state level in New insurers as competition intensifies York in 1909, but the tax was repealed in Premium subscriptions to life and pensions 1981. Using this experience, a number of have continued to decline from their 2007 studies have attempted to model the impact peak. Although there has been some on the city’s economy of reviving the STT. increase in personal pension contributions For example, a 2004 report produced by the since 2010 – linked to households’ general Partnership for New York City6 estimates move to raise retirement saving – the a stock market volume-securities industry decline in group pension contributions employment elasticity of 0.61 to 0.64, has so far outweighed this. Our forecasts meaning that a 10% decrease in traded point to subdued demand in the near term, volume lowers employment in the securities reflecting the constraints on households’ industry by between 6.1% and 6.4%. These disposable income and prioritisation of results appear broadly in line with a number debt repayment, resulting in gross life of earlier studies. premiums expanding by just 0.1% in 2012, According to TheCityUK, employment before picking up to 2.8% in 2013. Demand in the securities industry amounted to for single-premium policies, the main around 200,000 jobs in 20107 of which product, will start to pick up in 2013 in line we estimate around a third, or 60,000, are with household income growth; however, it involved in euro-denominated business. will not repeat the rapid growth achieved We make the conservative assumption that in 2006 and 2007, which was followed the Eurozone FTT results in a reduction by an equally sharp decline in 2008-10. of 5% in trading activity in London, The higher cost of long-term products due to reduced volumes of business in with income guarantees, because of the euro-denominated trades. Combining higher capital provisions they require this with the midpoint of the above under new regulation, will further limit the elasticity estimate and the 2010 level of re-expansion of investment plans linked to employment, this suggests that the FTT life insurance. would result in the direct loss of around The near-term outlook is for intensified 2,100 jobs in the securities industry in competition for declining business volumes, the year following the introduction of the leading to consolidation through exit or tax. Moreover, there would be spillover acquisition of smaller players. It is largely effects to other businesses in London as this (with the consequent scope to release well as outside the capital. Using multiplier reserves) that has driven the recovery in estimates for the financial services profit for some leading life providers in the industry from Oxford Economics’ UK Inter- past two years. Regional Input-Output Model, we estimate6 Schwabish (2004), “The Stock Transfer Tax and New York City: Potential Employment Effects”, Partnership for New York City Issue Brief7 Total financial jobs in The City of London and Canary Wharf8 ITEM Club Outlook for Financial Services
  9. 9. Auto-enrolment unlikely to provide a EU proposals for bringing defined significant boost in the near term… contribution schemes into the Solvency II New pension subscriptions will be boosted framework, currently being coordinated from October 2012 by the launch of by the European Insurance and automatic enrolment into occupational Occupational Pensions Authority (EIOPA), pension schemes for employees aged over could also significantly increase the cost 22, to be administered by the National of UK schemes, including NEST. As the UK Employment Savings Trust (NEST) where life market is substantially larger than EU there is no employer plan available. Auto- counterparts’ — mainly because of annuity enrolment is intended to produce a much sales — the Government has already had higher participation rate than previous to negotiate over the details of Solvency II opt-in schemes, and ensure provision for to avoid a rise in capital requirements and employees of the estimated 750,000 reduction of flexibility. Progress towards firms that currently offer no occupational this stalled in early-2012 talks, and there pension. However, the scheme will remains a risk that life providers will initially apply only to larger businesses have to tie up significant extra capital (employing 50,000 or above), for many especially where they have made bonus of which changes will be minimal because guarantees to long-term policyholders occupational schemes already exist. It based on earlier, over-optimistic will be extended gradually to smaller predictions of investment growth. firms, set to be heavier users of NEST, with those employing up to 50 workers … and low interest rates could not required to join until May 2015. This discourage pension saving staged introduction may prove beneficial Sustained low interest rates and rising for the retention of enrolments, since it longevity have combined to raise the cost gives more time for new members’ real of annuities (in terms of the pension saving incomes to recover, so that they consider needed to buy a pound of guaranteed the required contributions affordable and income) to the point where the annuity remain opted-in. is losing popularity as a way to convert pensions on retirement. This reflects the The advantage to scheme members (and recent decline in gilt yields to near-record to pension fund managers) over personal lows, reflecting the ‘safe haven’ status of pensions is that employers and government the UK amidst the Eurozone crisis, as well will supplement employee contributions, as the Bank of England’s money-printing substantially increasing the overall flow programme. Although the ITEM Club of pension saving. NEST will, however, envisages only a gradual rise in yields, if our add to the existing pressure to make fund expectation for them to hit 5% by late 2013 management charges more transparent and plays out, this would still help to relieve a bring them down. Competition with other significant amount of the current pressure forms of pension provision will intensify on annuity costs. if, as widely expected, new rules permit employees to transfer past contributions A widely expected rule change that would to other schemes into NEST, to consolidate allow retirees to take small pension pots their pension pots from different as cash could further encourage the move employments before retirement. away from annuities. While the industry can adapt to this shift, the long phase of low pension-fund returns and decliningChart 2.1: Gross life premiums 250 60Source: ITEM/OECD Forecast 50 200 40 30 150 20 % year 10 £bn 100 0 –10 50 –20 –30 0 –40 2000 2003 2006 2009 2012 2015 Gross life premiums (lhs) Annual growth (rhs) ITEM Club Outlook for Financial Services 9
  10. 10. annuity rates raises the danger that Emerging markets provide pension saving will be deterred altogether, opportunities for growth ... with more households choosing to rely Emerging markets, especially in Asia, on an only marginally improved state remain a potential source of much faster- pension. The rapid and ongoing shift growing demand due to rapid income of existing occupational schemes to growth and limited state provision of defined contribution (money purchase) pensions and welfare. Regulation, as well as from defined benefit (now mostly the need for local market knowledge, often closed to new members) has reduced requires UK-based insurers to enter new the appeal of employer-linked pension non-European markets via local providers; schemes in general, while generally poor however, the need for more private performance of personal pensions (linked provision is pressuring governments to to high charges) has limited their take- make foreign entry easier, and slow growth up even by workers with no possibility in existing high-income markets (especially of an occupational scheme. Higher in Europe) will increase sales and marketing contributions to public-sector pensions, investments further afield. Local providers, enforced by the Government following especially those that link to EU or US the Hutton Report, are expected to cause partners, will achieve a knowledge transfer some dropping-out of these schemes even that eventually enables them to capture though this means a sacrifice of employer business from multinationals, however, contributions. The same choice may be from their small base life-product sales in made by some lower-income employees emerging markets will outpace those to enrolled into NEST, and the long-term rise established markets throughout 2012-15. in pension saving due to the new scheme remains very hard to predict. Heavy natural disaster claims still The UK life sector’s main distribution being felt by non-life insurers… channel, independent financial advisers, is Globally, 2011 is set to have been the also undergoing consolidation as a result biggest ever year for insurance payouts, of the FSA’s Retail Distribution Review with US$380bn of losses and US$105bn (RDR), with its higher prudential capital of claims (on Munich Re estimates) for requirements and minimum qualifications natural disasters. The biggest arose from for advisers taking effect in 2013. Advisers the Japanese tsunami and New Zealand and brokers have boosted their market earthquakes, but floods in Thailand and a share since 2008, mainly at the expense sharp rise in US weather-related damage of direct sales, and these intermediaries also contributed to a bill which is set to accounted for around half of investment- go above premium income, having stayed linked insurance sales (by value) in the close to it in 2010 (when claims were second half of 2011. But customers’ boosted by the Chilean earthquake and ongoing concern to avoid visible charges Mexican Gulf oil spill). The previous record will also sustain the growth of sales via was for claims of US$101bn, set in 2005. platforms (around 40% of the total in the Extreme weather events have been rising second half of 2011). in scale and expense, but their total cost and insurance cost varies substantiallyChart 2.2: UK government 18bond yields Forecast 16Source: ITEM/Haver Analytics yield on 10-year benchmark bond (%) 14 12 10 8 6 4 2 0 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 201410 ITEM Club Outlook for Financial Services
  11. 11. with location. The suspected but unclear …but premium rises will be difficult link with global warming compounds the with the UK entering recession problem of predicting future expense. Large Within the UK, wind and flood damage in man-made disaster risks are also increasing December 2011 triggered a sharp upturn as commercial pressures lead to the in claims extending into 2012, of sufficient adoption of more complex technologies, as scale to require a rise in premiums. Some exemplified by the Mexican Gulf deep-water weather-related risks, especially related drilling accident in 2010. The January to flooding, appear to have been subject 2012 Costa Concordia ferry accident may to previous under-estimation, which is have wider repercussions for shipping becoming easier to correct as more local insurance costs if it leads to a reappraisal of information becomes available. Premium large cruise-liner design, although maritime rises will be restrained, however, by fear accident rates remain extremely low. of customers switching to lower-cost The increase in payouts (expected to push competition, or reducing their level of cover the 2011 combined ratio above 100%) because of its expense, especially in 2012- and new evidence on risk will trigger a 13 as household incomes remain squeezed. rise in premiums for large-risk cover. This As a result, growth in gross non-life will extend to household policies – with premiums is forecast at just 1.1% in 2012, premiums for buildings and contents set to rising to 2.1% in 2013. rise by as much as 10% on average – even The end-year upturn in weather-related though milder weather led to fewer claims claims exacerbated a longer-running last year than in 2010. But there is no firm problem arising from escalating claim costs evidence of an upturn in the underwriting for motor insurance, the largest non-life cycle, even though premium rises follow segment but one that has been unprofitable on from an erosion of capital since 2008. for a number of years. An Office of Fair Despite taking their largest underwriting Trading (OFT) enquiry has confirmed the loss since 2001 as a result of record extent to which additional claim costs have natural disaster liabilities, reinsurers say raised payouts on motor insurance despite there is still sufficient capacity to absorb a falling accident rate. Part of the increase additional risks without raising new capital. arises from the pursuit of legitimate Independent estimates put spare capacity claims, promoted by claims management at upwards of £20bn. In contrast to the US, companies’ willingness to pay referral fees. where steady growth of premiums through There is also evidence of more exaggerated the second half of 2011 has raised hope or invented claims, which present anti-fraud of an end to the down-cycle that began in measures have not been able to filter out. 2004, UK insurers may have to prepare for an extension of the current cycle beyond Average premiums have risen as insurers the characteristic eight years. The unusually aim to write motor insurance profitably, deep recession and slow recovery has and this helped to reduce motor insurers’ limited the capacity of customers (especially underlying net combined ratios below 120% smaller businesses) to absorb premium in 2010. Although premium increases have increases, raising the risk that some will been constrained by strong competition respond to these by economising on cover (reflecting ease of entry) in this segment, to contain their overall spending. the consequent rise in insurance costs —, which has arguably led to motor insuranceChart 2.3: Gross non-life premiums 80 25 ForecastSource: ITEM/Haver Analytics 70 20 60 15 50 10 40 £bn % 5 30 0 20 10 –5 0 –10 2000 2003 2006 2009 2012 2015 Gross non-life premiums (lhs) Annual growth (rhs) ITEM Club Outlook for Financial Services 11