Insurers are still making bumper profits, but the end of the soft times appears to be nigh, writes Shaun Drummond
Everybody knows the so-called ‘soft cycle’ will end some time, but when it will and whether it will be a not-so-soft landing, is always difficult to predict as it depends on numerous factors, many of them unknown to insurers as they grapple with predicting a more uncertain world.
The dire predictions have been coming for some time. The soft market has seen premiums squeezed steadily downwards in the commercial insurance lines by a range of factors, including competition in a lucrative market, and the ability to draw on big reserves built up by big profits.
As has often been pointed out by personal injury lawyers, ever since the tort law reforms were introduced in Australia to put a cap on how much could be claimed, insurance company profits have been mounting fast.
The Australian Prudential Regulation Authority recorded general insurance profits of more than $5 billion for the general insurance industry earlier this year, double what they had been in 2003. In line with the intent of the tort reforms, premiums have been declining steadily. But these have been accelerated by a range of other factors, not least of which is the increased competition to take advantage of a more lucrative industry. In 2006 they were down 9 per cent across the board, and they were down another 8 per cent this year.
Shane Fitzgerald, a senior insurance analyst from JP Morgan, says the main difference in this cycle is the fact that return on investment was so high, running at around 20 per cent a year, compared to previous highs of around 8 per cent.
However, the increased numbers of players in the market attracted by the big returns is inevitably leading to draws on reserves in order to compete.
Fitzgerald says for this reason, profitability in the industry is still strong, but for the first time in the past few months we have seen commentators, including Fitzgerald, begin predicting when the commercial insurance cycle will turn, and insurers en masse begin to raise premiums again.
He says he expects the cycle to turn in the next 18 months to two years. The main measure for him that leads to that conclusion is the number of insurance lines reaching what is known as a combined ratio of 100 per cent. The combined ratio is a common measure of insurance company profitability, which is calculated by adding losses to expenses, and dividing the result by premium levels.
Overall, the combined ratio for the general insurance industry moved from 91 per cent to 94 per cent, which meant profits were going down. Not fast, but in specific sectors they are now tipping over into losses.
“When I look at the commercial classes of business – commercial automotive for example, the combined ratio is now above 100 per cent. The industry is losing money right now on commercial automotive. So there are good grounds for that return,” he says. “The commercial property market, the combined ratio is now at the level that if it goes any worse, they’ll start making returns at below target.”
Fitzgerald says he believes the cycle will turn in the next 18 months because of the levels of excess profitability being recorded are now being bolstered heavily by releases of prior year reserves. “The only caveat I put on that is that just over half the industry is still carrying surplus capital. So there’s plenty of supply for them to continue to compete with. So, for the cycle to turn he says it will require “a level of discipline from the industry not to continue to use their capital to compete”.
As he puts it, over the next two years, those reserves will be running down and then it becomes “a bit of a game of chicken. He who runs out of reserves first, will feel the pain first. If their competitor has still got reserves, and they can still drop premium rates, leaves the first guy with a difficult quandary, because he hasn’t got reserves to fund a rate reduction, so he has to start walking away”.
Liberty International Underwriters’ chief operating officer, John McCabe, says it’s not just an Australian phenomenon, but all global insurance players have “impressive levels of reserves”. But he says many are raiding these to fund the premium rate reductions now going on and ultimately this is unsustainable.
He echoed Fitzgerald’s comments that the industry is getting close to the turn in the cycle, particularly given the increase in the high-level risks, with predictions of increases in physical as well as economic disasters, now affecting many different classes of insurance.
“While it could be a hurricane or a flood, it may well be financial: for example a meltdown in the US subprime mortgage market, which spread to the equity and forex markets like a virus,” he says. “Or a catastrophe may come as a series or combination of insurance and financial events, leaving the insurers’ cupboards bare. Recent market volatility demonstrated how bad news multiplies itself, as investors follow a pack mentality. So if a significant insurance event were to spook markets, funds available to cover claims could be diminished at the same time as claims spike.”
Fitzgerald says insurance companies are notoriously bad at forecasting, in part because it is just a difficult thing to do. He also says it is human nature to take the midpoint of previous results when forecasting.
For instance, he says the reduction in premiums for 1997 was forecast to be 4 per cent, and then rise by 1 per cent a year later. “What actually happened was in 1997 instead of falling by 4 per cent, they fell by 15 per cent. Then the industry says ‘well, they’ll fall by 7 [per cent]’. This is in my opinion standard human forecasting practice.”
McCabe says it must be made clearer to investors and the public that just focusing on financial year results can give a misleading image of the health of the insurance industry.
“In order for underwriters to accurately and rationally price their products, the focus and analysis should be conducted on the underwriting year. At the same time, underwriters need to remain mindful that the adequacy of the premiums charged will not be known for certain for some years to come,” he says.
“An underwriting year almost spans a 24-month period, in terms of claims attached to those policies,” he told Risk Management. “So any time over that 24 months I could have a claim related to that underwriting year. What happens on say the longer tail liabilities, like public liability or something like that, you might not get a claim even reported for anywhere up to five, six or seven years.”
It is crucial the industry resists the urge to undercut too far and maintains underwriting discipline to ensure long-term stability, as well as leaving room for the increased chance of major shocks in the coming years, such as natural disasters or sharp economic downturns, he says.
“It’s great that the industry is showing strong financial results, but lets consider the impact on the earlier years on these results as well. Let’s not fool ourselves into thinking that this can go on forever.”
However, while it is a difficult decision to make to “walk away” from writing new business, Fitzgerald, is optimistic that underwriting discipline is now better than it has been in the past.
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