1. Issue number 3
ITEM Club
Financial Services
Winter 2011/12 forecast
Outlook for Financial Services
Executive summary
The ITEM Club Outlook for Financial
Services is a companion to the Banking
main ITEM Club forecast launched ►► The sharp downgrade of the ITEM potentially encouraging a shift away
to examine in more detail the economic forecast for the UK economy from bank lending towards more bond
implications of ITEM Club’s economic presents a more challenging operating financing, as already happens in the
projections for the health of the UK environment for the banking sector, United States.
which is already struggling with the
financial sector. ►► Disintermediation of lending activity is
burden of costly regulatory changes.
also underway in consumer credit, as
The report is organised into three Bank profits will remain under pressure,
an increasing number of households
forcing additional rounds of cost cutting
chapters, which in turn examine are finding that banks will only lend to
and lay-offs. Many banks will have to
the banking, insurance and asset the most financially sound borrowers,
reappraise their core business models as
management 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. Net
of the ITEM Club, which is the ►► With economic activity weakening, lending by these consumer credit
only non-governmental economic the outlook for loan demand appears providers has increased by 42%
subdued and confidence will not since the beginning of 2007, while
forecasting group to use the HM
return until a credible solution to the unsecured lending to individuals by
Treasury model of the UK economy.
Eurozone crisis is in sight. At the same banks and building societies contracted
Its forecasts are independent of any time, we expect banks to introduce by 23% over the same period. With
political, 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 in
Contact
wholesale markets. After expanding by consumer credit from banks during
Andy Baldwin an estimated 4.3% in 2011, we expect 2012, it is likely that these new lenders
Managing Partner total loans to contract by 2.2% in 2012, will continue to expand their provision
Ernst & 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 account
abaldwin@uk.ey.com 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. 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. 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 2015
economy, 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 2.0
exchange 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. 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 more
Chart 1.1: UK and Eurozone 1.0
interbank spreads
Source: ITEM/Haver Analytics
0.8
0.6
%
0.4
0.2
0.0
10
11
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11
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11
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1
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l2
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Ju
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Eurozone 3M Euribor-3M OIS UK 3M Libor-3M OIS
4 ITEM Club Outlook for Financial Services

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. This
Chart 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
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Ja 09
ay 0
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M
other consumer credit providers banks and building societies
ITEM Club Outlook for Financial Services 5

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. Here
Table 2: Banking 2010 2011 2012 2013 2014 2015
Source: 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 0.01
1
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 the
originating 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’s
headline estimates.
6 ITEM Club Outlook for Financial Services

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 28
Note: Revenue estimates exclude non-financial sector transactions (estimated to be 15% of overall trades by the European Commission)
Source: European Commission, ITEM
Table 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: ITEM
3
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 revenue
from 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 revenues
from a Eurozone FTT.
ITEM Club Outlook for Financial Services 7

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 estimate
6
Schwabish (2004), “The Stock Transfer Tax and New York City: Potential Employment Effects”, Partnership for New York City Issue Brief
7
Total financial jobs in The City of London and Canary Wharf
8 ITEM Club Outlook for Financial Services

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 declining
Chart 2.1: Gross life premiums 250 60
Source: 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. 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 substantially
Chart 2.2: UK government 18
bond yields Forecast
16
Source: 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 2014
10 ITEM Club Outlook for Financial Services

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 insurance
Chart 2.3: Gross non-life premiums 80 25
Forecast
Source: 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