Drawing on the recent publication of Pendulum, an annual review of the general insurance industry co-authored by Finity and Deutsche Bank, Andy Cohen explores recent industry performance and the outlook for the years ahead.

Like good actuaries, let’s start with looking backward before we use these observations to inform our thoughts about the future. How did 2014/15 pan out? In short, not nearly as well as the excellent years of 2012/13 and 2013/14.

## Insurance margins below long-term average

To put some numbers to the recent performance, we estimate the insurance industry will report insurance margins for 2014/15 (broadly defined as premiums less claims less expenses plus investment returns on assets backing technical reserves) in the low double digits – perhaps around 12%.

This is well below the average margins reported over the 14 year period since the HIH collapse (around 17%) and even further below insurance margins reported in 2012/13 and 2013/14 which were not far off 20%.

Andy Cohen is speaking at the upcoming GI Glimpse event on 8 September in Sydney. To hear more on how individual classes of business are travelling, including Motor, Home, Liability and CTP, and the outlook for industry profit and growth over the next three years, view the exciting program and register to attend.

## Sluggish growth and bad weather

So what were the key drivers of the recent fall in margins? In short, sluggish premium growth and a spate of weather events.

Taking premium growth first, APRA statistics to March 2015 show gross premium growth of around 3%. Even though economic growth and inflation are at relatively low levels, 3% nominal premium growth still suggests little or no premium growth in real terms. In turn, this suggests rate reductions in many classes which, all else equal, will have put pressure on profit margins.

The APRA statistics show that Motor, Employers Liability and Fire/ISR – between them just under 40% of industry GWP – are suffering the most, with real premium growth clearly negative.

The other driver of the lower margins in 2014/15 is a series of weather events which began in November 2014 with the Brisbane hailstorm (the largest of the events at over $1 billion) and included Tropical Cyclone Marcia, the East Coast Low storms, a Sydney hailstorm and the SE Queensland/Northern NSW storms. ICA estimates for the gross cost of these events are over$3 billion. So has reinsurance come to the rescue and protected the net position? Unfortunately not – the relatively modest size of these events means that reinsurance has had limited impact on insurers’ net position. With yield curve pressures also impacting incurred claims over 2014/15, we estimate the loss ratio will be a little under 10 points worse than the preceding two years.

## Breaks on growth

Is 2014/15 a one off? We don’t think so – we feel the industry is likely to be in a low growth environment for a few years to come and negative real premium rate growth will be the norm for a while in many classes. This will put downward pressure on insurance margins.

In Personal Lines, there are a number of factors putting the brakes on growth. First and foremost is the strong profitability and above target returns on capital that are currently available. This creates a very strong competitive environment in which insurers can win market share off other players by reducing price (while still meeting return on capital targets).

Combine the competition dynamic with an increasing propensity for consumers to shop around at renewal (our analysis shows consumers’ propensity to shop for Motor insurance is up by 50% nationally, and a massive 80% in NSW), and the scene is set for significant business to change hands on the basis of cheaper pricing. Good for consumers, but not for insurers’ profits.

## Reducing car ownership and apartment living

However, there are potentially other factors at play which may put even more pressure on premium growth in Personal Lines over the next years. These include a reducing level of car ownership and a trend towards living in units rather than houses, both of which drive a lower demand for insurance. Also worthy of a mention is the prospect of technological advances increasing vehicle safety and the rise of telematics – these will de-risk Motor and lead to a reduction in the premium needed to cover the claims cost.

And then there is the “elephant” in the room” – driverless cars. This is many years way, indeed perhaps it will never happen. However, there is the long run potential for driverless cars to take a lot of the personal risk out of driving (albeit transferring it as a liability risk to car manufacturers/technology providers). Some market commentators have suggested driverless cars have the potential to decimate the Motor premium pool – indeed, Celent, have coined the memorable word “Carmageddon” to describe this.

## Surplus capacity

In the Commercial Lines space, we also see limited potential for growth. With surplus capacity available, competition remains strong and the soft cycle we have seen in recent years seems set to continue. We see particular challenges to profitability in Commercial Property and D&O, but other commercial lines are also facing headwinds.

On the investment side, the outlook remains weak and the low yield environment now feels like a familiar piece of furniture that is hard to get rid of – so no significant additional upsides from this source are expected.

## Lower reinsurance and expense costs

However, there are a couple of upsides that might prop up insurers’ margins –potentially lower reinsurance costs and savings from expense management programs. With excess global capacity in the reinsurance market, and current reinsurance pricing still higher than it was five years ago, further price reductions seem possible. On the expense side, a number of insurers are yet to see the full benefits of ongoing expense containment/management programs and these will be of some assistance going forward.

However, we do not see expense and reinsurance upsides as enough to soften the blow of limited top line growth and the continuing low yield environment. With these pressures set to be with us for some time to come, we feel we are at the beginning of a cyclical downturn that will see a period of lower margins. Expressed in terms of returns on equity (ROEs), we anticipate these will settle around 12%, quite a few points below the average 15% ROE achieved over the last decade.

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