Are UK general insurance companies using capital more efficiently, asks Trevor Moss.
With low levels of inflation, sluggish growth in domestic GDP, falling exports and a UK manufacturing downturn, premium levels are unlikely to rise significantly in the near term. But rising asset values and a relatively low level of claims in the last five years have led to abundant levels of capital in the industry. This scenario may once have led to a rate cutting blood bath, but while pricing is likely to remain difficult, certain structural changes in the management of the industry leave more room for optimism than in previous downturns.
Recent mergers at the top end of the industry have consolidated market shares significantly. For example, the top 10 underwriters wrote 60% of the UK market for one year business in 1994. Pro forma of expected mergers, just the top five underwriters are writing close to the same volume of business, with the top two alone accounting for over 30%.
The three biggest underwriters (assuming mergers are completed) are CGU, Royal & SunAlliance and Zurich, all of whom have stated publicly that they intend to use positions of market leadership to help influence rates. Evidence already suggests that they mean it. Price leadership should be more significant going forward, which will help to promote rating stability.
Mergers do not normally remove capacity from the market in the same way as acquisitions or company bankruptcies, but merging companies are inevitably too busy to pursue expansion. Besides, one of the advantages of having a larger portfolio or being part of a larger group is that there is simply no further commercial reason to write for market share. Profitability is far more important. At the same time, the wider geographical and segmental scope of the new groups presents management with better opportunities to use their capital elsewhere. For example, Zurich management will simply not permit Eagle Star to write business at unprofitable rates. Why waste capital in the UK when there are so many opportunities elsewhere within the group to use it more effectively?
Price leadership should not be limited to these three insurance groups. A number of other companies with significant market shares will, no doubt, look to take advantage of a more stable market to improve the profitability of their portfolios. If they can take market share in the process (perhaps in the broker market) then, so much the better. Norwich Union, AXA Provincial and Independent Insurance are companies whose non-life returns the stock market scrutinises carefully, and their high market valuations cannot accommodate anything other than good quality underwriting returns. UK life insurers have also been rationalising their non-life businesses in recent years, and they are unlikely to wish to compete aggressively, especially given narrow margins already being earned.
Some commentators (and insurance company managements, for that matter) say that the more extensive use of technology and information systems provides better underwriting performance through more detailed portfolio and risk analysis. Modern systems are undeniably capable of providing huge volumes of information for the underwriter and manager alike, allowing more powerful analysis and interpretation of underwriting results.
Although better underwriting is not just about the amount of information but the wise use of it, these systems may be providing better underwriting performance by default. As a result of the more extensive use of such systems, major UK quoted companies are now able to access line-by-line analyses of the business being written and the results therefrom. Quite a lot of this information is now disseminated to shareholders, so that now both companies and investors alike are better able to analyse the returns from the business. With return on capital. measures increasingly used to value insurance companies, it has become crucial for management to segregate business areas and make decisions that can either add to returns or at least make them more sustainable. Companies which effectively manage their returns on capital are being well rewarded through share price appreciation.
More flexible remuneration structures mean that management bonuses and share options are increasingly derived from profitability measures, such as return on capital. The incentive for good underwriting management is clear, and while concern over profitability and ROE measures could influence management in a negative way (possible incentive to run down reserves, use higher risk investment strategies, etc), there does appear to have been an enhanced emphasis on profitability throughout organisations.
There appears to be a growing urgency among insurance company management to use capital in a constructive way. If growth opportunities are limited, at the very least capital can be more efficiently repatriated to other parts of a group (or to shareholders). If management is truly changing with the times and responding to investor concerns, perhaps the UK general insurance market might not be such a bad place to have capital invested after all.
Trevor Moss is an insurance analyst at Robert Fleming Securities. The views expressed are personal and should not be taken as reflecting the views of Robert Fleming & Co Limited.