Expertise in Action: Pricing: A Perfect Storm

As we enter the results reporting season, the ongoing impact of the economic downturn will be evident. While the major economies have emerged from the subprime credit crisis and global recession of 2007 to 2010, Eurozone destabilisation continues and investment in growth is scarce. As a result, many businesses are suffering from a prolonged economic lag and, while general business optimism has improved, financial results remain weak in many instances.

Economic growth rates consistently declined throughout 2012 in most major markets, and Western Europe dipped into negative growth again in the second quarter of last year. This has led many companies to maintain or intensify expense reduction targets to help drive competitiveness in the market, with costs, such as insurance, being looked at closely.

For large corporates, procurement functions are increasingly involved in decision making, including the purchase of insurance. This presents a challenge for risk managers and brokers, which have to articulate the difference between price, value and the capability of insurers in an industry that has largely struggled to do this itself.

The tough economic environment also has an impact on insurer balance sheets, demonstrated by insurer downgrades becoming more frequent – with many placed on negative watch. However, the real game changer for insurers has been the sustained low interest rate and yield environment. For an industry with low to negative underwriting operating margins but with hundreds of billions of dollars on the balance sheet, secure investment returns are critical to insurers’ ultimate financial results – and low returns have wiped out significant sums of profit. To respond to this challenge there has been an increased focus by insurers on delivering a pure underwriting profit, reducing operating expenses and driving rate increases. This means a challenging environment for customers looking to reduce costs in their business. It is essential insurers explain rate changes and effectively communicate their value propositions.

Large losses
Large loss claims trends and claims inflation further compound the problems insurers are facing. Looking at the impact of large loss trends on insurer profits and rating environments, in certain lines there has been a continuing upwards trend. For property and business interruption, which is often a large part of a corporate insurance bill, the impact of natural catastrophes is certainly a key driver. While total insured losses peaked in 2005 at around $120bn (£78.4bn) – which, of course, included Hurricane Katrina – the underlying trend over the past 10 years has clearly been increasing, with approximately $110bn in 2011, which saw the Japanese tsunami and floods in Thailand and Australia.

In Europe it can be easy to underestimate the impacts of other regional cat losses. Tornadoes in the American Midwest, for example, have contributed to a significant increase in the claims bill over the past two years for US exposed insurers. Closer to home, the increasing frequency and severity of floods in the UK has impacted domestic carriers.

And the rising claims cost is not just a nat cat phenomenon. Zurich has been tracking large property losses from non-cat events and there is a clear increase in the number of large fire losses across the portfolio. What appears to have changed over the past 10 years is not a significant shift in the type of risks insured, or in the cause of losses, but a significant change in the quantum of large losses when split between physical damage and business interruption.

In effect, the increased focus on risk engineering, physical protection and general risk management standards has reduced the frequency of losses. But, when there is a loss, the increased use of fewer but larger facilities by insureds – and increased reliance on single-source supply and lean manufacturing processes – generates a much larger BI loss.

This highlights the interdependency of business strategy and insurable risk. Customers may assume their insurance costs will fall through investment in fewer but larger and better protected facilities – but this is not necessarily the case unless the customer has tried and tested business continuity plans and a thorough understanding of interdependency and supply chain risk. These are the real differentiators for coverage and pricing.

Interestingly, the recent horsemeat contamination scandal in the UK and Europe underlines the importance of understanding supply chain. Extended chains and subcontracted contracts have left the consumer wondering how companies can truly control the quality of their products. Ultimately, the costs of the horsemeat scandal will be borne mostly by insureds as, with no injury or damage, product recall policies may not be activated. Yet the biggest impact – reputational damage – is not really an insurable risk for most companies. Firms that have watched this scandal break would be well advised to ask some key operational questions about their own supply chains, focusing on both control and resilience.

Increasing large loss trends have also been seen in other lines of business. Recent events show the potential for industry-wide losses in financial lines. Insurance for directors and officers, in particular, has been under the spotlight due to the continuing banking crisis and now specific activities relating to London Interbank Offered Rate manipulation. The high level of interconnectivity in the global financial markets seemed like a great strength while the markets were booming, but translated into a clear crisis of contagion when they collapsed – and contagion can be a threat for insurers that fail to manage their accumulations across such exposures.

Motor fleet has also been in the headlines recently over spiralling claims costs. The scale of some recent third-party bodily injury awards in UK courts – particularly those relating to periodical payment orders where the court awards the continuing increases in cost of lifetime care and life expectancy against the defendant’s insurer – is driving high double-digit rate growth in a number of large fleet renewals.

This last example brings us back to the reason behind the push by insurers for rate increases, the impact of claims inflation. While legislation and subsequent court awards may be driving significant claims inflation in motor and employers’ liability, many other areas of large corporate claims costs are also increasing – including complex BI loss settlements and even the costs of fraud prevention relating to employers’ liability or third-party claims.

Capacity contradiction
Insurers are caught in the middle of a perfect storm, with the global macro-economic environment hitting their credit rating and balance sheets, a clear trend towards increased frequency of large losses across multiple lines of business, and claims inflation and increased regulatory pressure.

The single contradictory fact in this tale of woe for the insurance sector is that capacity seems to be constantly increasing. Many would question why, at a time of decreasing returns, this is the case. Ultimately, the sector has demonstrated its resilience through the financial crisis with consistent returns supported, in part, by reserve releases. Compared with other equities, insurance companies are still considered a good risk. While the availability of capacity further limits the industry’s ability to take corrective rate action, it does give the customers an opportunity to adjust to gradually hardening rates.

This will be the story of 2013-2014; no more soft market, but a managed and controlled increase in rates across the sector. In this environment it is for the insurers to differentiate themselves, and for insureds to select insurers that demonstrate a sustainable approach to pricing, a commitment to customer service and a holistic risk management package.

Video: Zurich Q&A with Darren McCauley
With data validation increasing in importance Post sat down with Zurich's director of personal lines, pricing and underwriting Darren McCauley to discuss the trend.

In conversation with Post editor-in-chief Jonathan Swift, he addresses whether the current data sources used by insurers are up to speed; where improvements could be made; and the importance in passing this expertise down to brokers so they can clean up their books.

The pair also cover whether data validation is more important than the direct business, broker business, or equally in both, and whether it is the sole preserve of the motor business, or if it straddles other product lines.

Watch the video