The UK motor insurance industry has long been one of the most deregulated in the world. As a consequence, it has been subject to market forces that have created an ultra-competitive environment. It could be seen as a glimpse into the future for those countries, especially in the rest of Europe, that are heading towards deregulation.
The UK motor insurance market is one of the largest in Europe. Although rates have hardened recently, it has been a tough environment by any standards. The combination of plummeting prices and worsening claims experience has inevitable consequences. In 1998 (the last year for which figures were available at the time of writing), loss ratios had risen to an average of 92.2%, pushing up combined ratios to over 120%. Even allowing for investment income, the industry must have been operating at a substantial loss. The long awaited rate corrections began, for some players, as early as the second quarter of 1999.
Despite these difficult conditions there were some remarkable success stories. Indeed, the environment has shaped an industry that has become, out of necessity, leaner and better able to anticipate events. As I shall explain later, many companies have responded by becoming more efficient and acquiring a more detailed, more accurate understanding of their data and of their customers. This has led to some highly sophisticated techniques for the pricing and reserving of the primary risks.
During the downturn, the reinsurance market has also suffered and is only now beginning to harden. The analysis techniques for the reinsurance coverage have not progressed as fast as the changes seen in the primary market. It is worth highlighting the key drivers behind reinsurance premiums and claims, and discussing how they are strikingly different from the primary market.
Reinsurance premiums - a “double whammy” for reinsurers
One of the factors that sets the UK motor reinsurance market apart from many others is that the business is predominantly excess of loss, with quota share treaty rarely utilised compared with practice in the rest of Europe. This in itself is a reflection of the maturity and sophistication of the UK market.
The premium to the UK excess of loss market is largely driven by flat rated contracts. The premium to the reinsurer (for a given layer of reinsurance coverage) is charged as a flat percentage of the ceding company's (net of commissions and earned) premium income. As the premium collected by the primary companies has fallen with the insurance cycle, so the income to the reinsurer has fallen. Furthermore, in many cases the flat rate charged by the reinsurer has fallen, due to broker and client pressure, hence producing a “double whammy” effect.
Reinsurance losses - another “double whammy”
The squeeze on reinsurers' margins does not end with reduced premiums; it continues when the claims come in.
Analysis conducted by English Matthews Brockman demonstrated how a typical excess of loss treaty would suffer when subjected to an increase in claims experience in the primary market. The results were striking, with claims activity to the excess layers magnified several times compared to increases in the primary market.
There are two main reasons for this differential. Firstly, the largest claims that tend to concern reinsurers have been affected more in percentage terms by recent developments. Secondly, the whole process is geared, which ensures that relatively small changes in the primary market mushroom as the reinsurers come into play.
This “double whammy” effect was well demonstrated two years ago by a case in the House of Lords, which is the UK's highest court. Known as Wells v Wells, the judgment reduced the discount rate (the interest rates that insurers can assume claimants will earn from lump sum payments) from 4.5% to 3%. This had the immediate effect of increasing reserves for all serious outstanding (ie open) bodily injury claims. Clearly, there was also an impact on the costings for bodily injury claims that were yet to be reported. Overall, the impact on the primary market was equivalent to a 3% rise in motor premiums to the public.
Our analysis showed that, by contrast, reinsurers would require rate hikes of between 20% and potentially 100%, especially at the lower layers, to meet the additional claims. Reserving levels for reinsurers would have to increase by between 5% and 100%.
Come the reinsurance renewal season, however, premium increases of this order were impossible to achieve in what turned out to be one of the softest markets for many years. While some reinsurers were aware of the technical impact, others were less well informed, contributing to depressed rates. Although there are no definitive market-wide statistics for reinsurers in the UK motor market, it is fair to say that they would not make pretty reading.
More increases likely
Looking to the future, no one in the UK motor reinsurance industry can rely on a reduction or levelling out of claims experience; the opposite is more likely.
According to another analysis, conducted in 1999 on behalf of the International Underwriting Association of London (IUA) and Association of British Insurers (ABI)* by English Matthews Brockman, motor bodily injury claims have been escalating at 12% a year over the past decade, and probably longer. The survey involved more than 700,000 bodily injury cases and investigated the frequency of claims at differing excess points. Having established certain layers of deemed excess of loss coverage, it was also possible to investigate the severity by layer. Perhaps more importantly, we examined the trend in the frequencies and severities, which provided an insight into the raw inflationary trends.
These analyses were conducted at a macro level and did not attempt to isolate risk factors associated with a particular claimant. However, it was possible by using powerful software to understand the data with a detail and precision that would not previously have been feasible. This level of analysis is a natural step forward for reinsurers, and builds on the detailed risk profiling work that many primary companies now do as standard. In theory, it should help reinsurers differentiate between two primary companies seeking the same excess reinsurance, on the basis of the underlying insured profile.
The analysis concluded that the biggest bodily injury claims, of particular interest to reinsurers, have been going up even faster than the average. There are many reasons for this escalation: better, more expensive medical care; longer life expectancy for seriously injured people; an increased willingness to go to court, assisted by a new “no win, no fee” legal culture; a higher propensity for the public to seek accountability for accidents; and recent changes in the law, backed up by judgments such as Wells v Wells. In this 1998 judgment, the House of Lords ruled that the lump sum needed to compensate seriously injured accident victims should be calculated on the basis of the income generated by low risk government securities rather than a mixed basket of government securities and equities.
As far as anyone can tell, the upward trend is likely to continue, since these forces are not going away. Recently, for example, the Appeal Court considered eight test cases on general damages for non-financial loss, such as pain and suffering. It sanctioned retrospective increases on a sliding scale, rising to 33% for those at £150,000. This judgment was, in fact, considered by most to be quite lenient on the insurers concerned.
Another threat hanging over the industry is the possibility of a further cut in discount rates from the 3% determined by the House of Lords. Indeed, some cases have already been settled out of court at below that level. If the official rate were to drop to, say, 2%, reinsurers could expect a further increase in claims experience of anywhere between 15% and 60%.
Furthermore, the government recently decided to load a significant proportion of the costs for personal injury treatment (previously paid for by the publicly funded National Health Service) onto the insurance industry, and may be tempted to burden it with the entire cost.
A formula for profitability
Market forces will eventually dictate that reinsurers return to profitability, but the market upswing may not be dramatic or prolonged enough for many.
Premium levels in the primary market have already increased by between 10% and 20% and reinsurance rates are certain to increase too in the coming renewal season. The key to an adequate return over the reinsurance cycle, however, is to manage the performance of the reinsurance portfolio over the downturn.
There are two key ways to achieve this. The first involves getting closer to the primary insurer to fully understand the various risk and exposure analyses carried out in-house. The second involves enhancing the level of analysis carried out by the reinsurer, in order to make full use of the data supplied by the primary company, either direct or via the reinsurance broker.
Although many of the best performing primary companies are also among the largest, this is not the criterion that determines success. The most telling competitive advantage is usually a deep and detailed understanding of the data, covering the original insured and the market segments in which they are competing. UK motor players have become among the most sophisticated in the world when it comes to accurate, well-targeted underwriting and reserving.
There are insights within this data that will aid the reinsurer, such as splitting the reserve and payments for large claims into the two key components of general and special damages. Our analysis indicates that the likelihood of a large bodily injury claim emerging from the portfolio of a direct writer depends on the exposures within each of the motorcycle account, the fleet account, the commercial account and of course the private car account. Furthermore, the private car account has two key coverages (comprehensive and non-comprehensive), and these can also exhibit different trends.
Sophisticated decision support software now exists for reinsurers to carry out various types of analysis. Some products allow an extensive frequency and severity analysis on the data provided by primary companies. It is now a relatively straightforward task to allocate losses to various layers (before or after inflation), allow for the development of losses and adjust for the change in primary exposures.
A key part of the analysis is to recognise when the credibility of the data is limited and hence when to move from experience rating to exposure rating. No less key is the ability to benchmark the primary company against its peers, given the exposure profile. Although quite detailed, these models are now very user friendly and allow non-actuaries to apply actuarial techniques.
Other products, meanwhile, model the historical losses and provide a simulation based on these losses to a prospective reinsurance treaty. These tools are highly graphical and allow the reinsurer to visualise the potential loss activity to an excess contract.
Furthermore, provided the data is adequately segmented, it would be a simple task to consider various “what if” scenarios. In particular, it should be possible to investigate the impact of legal changes on (excess) reinsurances written in the past that are still subject to open claims. This information should provide a valuable insight, on renewal, into the rating of a prospective treaty.
Primary insurers have long been discussing the possible creation of a market-wide, yet confidential database of claims. The Second UK Bodily Injury Awards Study certainly highlighted the benefits of such a database. In reality, such a project is unlikely to get off the ground, partly because of the size and cost of the task. The largest insurers are, furthermore, reluctant to pool their information (and so competitive advantage) with their smaller rivals.
A reinsurance company, however, could drive this internally depending on its share of the motor reinsurance market, with the resulting competitive benefits likely to be significant. This data used with the techniques described above (along with core information on profitability of the primary market) would allow reinsurers the chance to actively manage the ferocity of the reinsurance cycle.
Surviving in the motor reinsurance jungle
In his theory of evolution, Charles Darwin stated that the survival of a species depended not on its size, but on its ability to adapt to changes in the environment. This observation is equally true of today's motor insurers and reinsurers in competitive markets such as the UK. By adopting a sophisticated and methodical technical approach, it is possible to acquire a sensitive and detailed understanding of the always-changing competitive environment in which we operate.
*The Second UK Bodily Injury Awards Study (October 1999), published by the International Underwriting Association of London (IUA).