Featured, comment

Hard Times Are Still Ahead

Whereas banks are mainly in the business of credit (ie lending) and insurers in the business of risk (not lending) this crisis has its roots in the sub-prime (a credit risk) unleashing global credit-related maladies. Credit, as a risk, is subsidiary and not core to insurance operations as illustrated on page 46:

Is it hunky dory for insurance?
The fact that the current financial crisis has its roots in banking (or to be exact largely unregulated shadow banking) activities it effects are being universally felt as lack of liquidity results in lower infrastructural, industrial and commercial investment, higher unemployment, lower spending and, consequently, a general slow down in economic activity. Several leading economies have experienced recession during 2009 and some, such as the UK, have not yet emerged from it.

Insurance is not a product in itself. It is a complement to some other commodity or medium of exchange. Households and firms consume insurance because of property they have purchased or potential liabilities they may incur, because of financing or other contractual agreements, for estate planning purposes etc. If there is a large- scale slow-down in economic activity it falls that any complement – such as insurance – is also directly and adversely effected. Current predictions on the length of the recessionary period based on past history is a 24 to 30-month period from inception (ie around October 2008). Therefore, it is reasonable to assume that increasing top-line growth in insurance until, say Q4-2010 will be a challenge. From a risk management perspective this is not necessarily worrying. What may be worrying in this scenario are the following factors:

Business retention = higher loss ratios?
It is easy to fall into the trap of thinking that hard economic times generally increase moral hazard and, consequently, claims. This is possibly the case in mainly personal lines sectors. For example a general increase in the number of private medical insurance claims has been witnessed in the market in anticipation of redundancies. Motor claims have also been on the increase. In the commercial arena arson may not necessarily be off the charts. However, increased moral hazard during a hard economic cycle is unlikely to tip the scales for insurance companies. The more worrying factor in this respect is the philosophy of business retention at all costs on the pretext that new business is scarce during a time of recession and it is, anyway, always more expensive to write new business than to renew existing business.

Since there has been no shortage of reinsurance capacity or anticipated general increase in the cost of reinsurance protection insurance companies may have been reducing rates to maintain their book of business or even under-cutting in an endeavour to supplement lost business. Since loss ratios are a factor of business written (and not of the rate at which it is written), the same book of business (or increased book of business) at lower premium rates will inevitably result in higher loss ratios for several insurance classes in the region. The effect of this will be delayed.

The uncertainty in the cost or availability of reinsurance capacity earlier in the year may have prompted insurers to “wait it out”. Clarity on reinsurance price stability from Q2-2009 onwards and positive H1-2009 results for leading reinsurers or reinsurance markets together with corporate pressure may not be too far off their targets.

With insurance contracts mainly being 12-month contracts, the full extent of higher loss ratios will unfold by Q3 and Q4 of 2010. It is expected that this will adversely affect technical loss ratios next year.

Business retention = higher default?
Clients have, to varying degrees, been affected by the credit crunch. Cynically stated, insurance may not have been at the top of insurance buyers’ credit agenda even at the best of times. Despite insurers also having their obligations mainly with claimants and reinsurers, there has been a relative increase in credit with clients asking for instalment or deferred payments. This presents a number of problems, namely:

. The longer a debt is unpaid, statistically, the higher the default probability. Some companies may be turning a chronic nuisance into an acute credit risk in an endeavour to maintain their top-line position during the period of downturn
. Increasing aggregate credit means that the cost of operations (due to, for example, bank overdrafts and other borrowing facilities) for the insurance company increases
. From an asset liability perspective, the higher the aggregate credit the lower
the amount of revenue that can be tied
in investment vehicles. Therefore, not only investment returns are low as a result of the current economic cycle, but the potential of return on assets is further impaired due to higher credit on the liability (operations) side.

Therefore, just as a higher claims ratio cannot entirely be blamed on the economic cycle or on increased moral hazard, a predicted 2010 drop in investment return will also stem from internal technical decisions. In addition to lower technical return as a result of higher loss ratios, an aggressive policy of business retention will also result in a drop in investment return.

Conclusion
The silver lining of the crisis on the industry is that, for those who learnedly ride the opportunity, it will enhance credit worthiness within the regional insurance sector because:
. The cost of reinsurance has remained relatively soft and rated capacity in general is readily available within the region
. Top-line growth, which was previously unpredictably high, often in double-digit figures, has now been curbed. This reduces both the technical as well as the credit risk;
. The reduction in top-line growth reveals the true worth of a company’s reserving policy as proportionately more premiums become earned and, also proportionately, more claims are run off in comparison to the business being written
. There is a greater emphasis on regulation and supervision of solvency and capital adequacy throughout the financial services sector.

The deciding factor as to whether a company will suffer higher loss ratios and lower investment return depends on whether crisis-spurred knee jerk reactions have caused it to shoot itself in the foot in the course of 2009. The more successful crisis management is formulated, communicated and agreed prior to (and not during) a crisis. The end of 2010 will paint us the full picture.

Pages: 1 2