A true picture of the state we’re in
By Noel MacCarthy, Executive VP and Senior VP Casualty Asia Pacific and CUO Global Casualty, Liberty International Underwriters
These are difficult times in the Australian insurance market – prices are soft, and getting softer.
With fierce competition in the market, and prices being referred to as “too cheap” – and even “insane” in some quarters – the question is: do we know how far we are from the bottom?
An insurer’s profit and loss is affected by several factors, including gross written premium (GWP), claims, expenses, broker commissions and investment income.
Growing the top line is a common aim, and insurance underwriters, brokers and managing general agents (MGAs) alike are scrambling to retain and hopefully increase market share.
One of the ways GWP can rise is following a natural increase in the size of the market.
This organic increase is more likely in a growth economy, such as in China, where market penetration – reflecting the sale of insurance to new buyers – has a greater impact on GWP.
Contrast this with Australia, where the relatively small and stable population creates a smaller, stable market, with a preponderance of “mature” insurance buyers and few “first-time” buyers, so organic growth is less of a feature.
Added to this is a relatively low GDP growth environment, which, following a drop from the 2013 high, has been relatively flat for some time now.
These factors result in an insurance market in Australia characterised by relatively inelastic demand.
This means even a dramatic drop in premium prices will not be rewarded with a surge in the volume of sales.
Competition also has its impact, whether in the form of new players in the market or heightened aggression by existing entities.
New and existing markets can expect support from the current global influx of new capital in the form of new Lloyd’s syndicates, aggressive contenders such as Warren Buffett’s Berkshire Hathaway or the burgeoning MGA space (including the AUB Group and Steadfast underwriting agencies, which are estimated to write more than $1.1 billion this year).
This growing pool of capital requires servicing, but when combined with pressure on companies to grow their GWP from a stagnant premium pool, the only way forward for pricing is down.
There is no denying the cost of claims is rising. Claims inflation has been ranked a top-10 risk and challenge for insurers, both in terms of understanding its impact on the future portfolio, and then pricing for it.
Despite the impact of claims inflation, a recent study by the UK Institute of Actuaries acknowledged there is a lack of consistency in its definition and measurement.
Of the various factors inflating the cost of claims, perhaps the most obvious is the consumer price index (CPI), which is currently less than 2%. However, the cost of claims in dollar terms inflates at a rate higher than CPI.
Besides CPI, other inflationary factors may include:
- Climate change, causing an increase in the frequency or magnitude of natural catastrophes
- Cyber exposures, which are significant and on the rise (and some of these exposures are covered by existing policies)
- Class action and litigation funding, both on the increase
- Fraud, the incidence of which rises in a soft economy (about 10% of all claims in Australia are estimated to be fraudulent)
- Superimposed inflation, as a result of increased recourse to legal action, better preparation by plaintiff lawyers, legal decisions that increase the average award for a head of damage or new area of compensation etc.
There is a clear increase in broker commissions across the insurance industry, as brokers respond to the soft market by making a play for a larger share of the client’s premium dollar.
Their simplest approach is to increase commissions, but in addition a number of broker companies are acquiring underwriting agencies, risk service companies and premium funding companies as a way of vertically integrating into the supply chain, to cream off more of the premium dollar.
It is probably safe to speculate that all sectors of the insurance industry – underwriters, brokers, reinsurers, MGAs or insurance lawyers – are likely to be “feeling the pinch” and focusing on trimming their expenses to counterbalance the squeeze on profits.
Head counts, salaries and bonuses are all fair game.
Investment income is a key contributor to profit for insurers.
Even if the “cashflow underwriting” strategy – where an insurer would price a policy at a loss to access and invest the insurance funds – is a thing of the past, investment yields over the past couple of years should be enough to discourage any reliance on investment income.
Added to which, we know that if the interest rates or investment yields drop by as little as 1%, the reduction in the loss ratio needs to be something like 3% on a long-tail portfolio if the return on equity is to be maintained.
In summary: prices are soft, competition is fierce, demand for the product is inelastic, claims costs are increasing, broker commissions are rising, expenses are under pressure and investment income is unreliable.
With industry optimism at such a low ebb, why can’t we assume insurers will simply take note of their results and tighten underwriting and increase prices accordingly?
The answer lies in the way companies report their results.
In financial year (FY) figures that appear to conflict with what we know of the current market cycle, many insurers appear to be performing well.
Reporting on an FY basis, the results may be reasonable, but the same may not be true when reported on an underwriting year (UY) basis.
While it is possible to manipulate the FY results to give a distorted impression of operational profits, this is almost impossible to do with an accident year (AY) or UY.
Reporting on an FY basis may mask a dip in profits that would be immediately apparent on an AY report schedule.
What can we conclude?
Going forward into a still-softening market, insurers should consider the components of their profit and loss (rates, claims inflation, broker commissions, expenses and investment yield), and assess the impact of one year on the next. Then re-do the profit and loss, and assess it on an accident year basis. MGAs should be doing this for their portfolios as well, making sure claims are actuarially developed to their ultimate loss ratio.
In a soft market, an existing portfolio is sometimes used as a bank to fund the growth of new business. This “bleeding in” of more keenly priced new business into a stable and profitable renewal portfolio can mask a problem result until it becomes a major issue.
So it would be advisable to measure the combined operating ratio, or failing that even just the gross loss ratio, split between the existing portfolio and the new business portfolio.