Insuring the future

Australia’s 141 insurers give peace of mind to many individuals and businesses. They provide protection against damage resulting from a variety of events, from car accidents to medical malpractice, and are able to do so at a fraction of the potential loss by spreading risk.

General insurers derive revenue from insurance premiums and the investment of premium reserves in bonds, stocks and other assets. The vast majority of general insurance premiums are derived from the renewal of policies that relate to existing risk. The remaining premiums relate to an increase in risk exposure or a change in pricing conditions. Policy pricing alternates between softening (price declines) and hardening (price increases). All things being equal, a hard market will produce growth in premium revenue without a change in coverage.

This year, the General Insurance industry will generate $42 billion in revenue; 2.1% higher year-on-year. This will comprise net premium income of $35.6 billion and net investment income of $6.5 billion. Although net premium revenue is expected to decline by 0.6%, investment revenue is expected to jump 20.3%, which will strengthen overall revenue generated by the industry.

The small price increases and higher investment returns will bolster the industry’s bottom line and this will be welcomed after the challenging years that the industry endured at the time the financial decimated the economy. This will allow the industry to regain some capital strength lost during the crisis year, which will see its NPAT push back up to double-digit figures.

Industry outlook

The short-term outlook for general insurers is positive. An accelerating economy will yield strong demand for general insurance and this will force insurers to lift prices as capacity is stretched. The outcome will be strong gains in net premium income. Meanwhile, a strengthening Australian economy will prompt the RBA to lift interest rates, boosting bond yields, and also fuel stock market gains.

This will enable the industry to generate solid investment returns. The continuing improvement in economic conditions will propel general insurance revenue growth of 2.4% per annum to $47.3 billion by the end of the next five years.

IBISWorld expects rate hardening will persist until sometime around the end of 2011-12. However, price rises will continue for longer if the industry suffers consecutive years of high catastrophic losses, or one year of record losses. Ultimately, the purpose of price rises will be to restore the industry’s capital surplus, which would take longer if losses were abnormally high. The transition to soft insurance market in 2012-13 will somewhat limit the benefits of an expanding economy thereafter. However, a growing economy will see ongoing gains in investment income.

The industry’s economic condition will exhibit strong growth, marking a reversal from the decline posted in the previous five years. The return to value added growth will reflect significant gains in industry profit that will improve through disciplined pricing and the return to normal investment gains.

IBISWorld forecasts profit margins to average 14.5%, which will be 4.9 percentage points higher than the average for the last five years. And importantly, this will be much higher than the margins achieved during the years around 2000. This will largely be attributed to better underwriting practices following a re-think of strategy post-2001, which sought to reduce reliance on investment income to prop up poor underwriting performances.

IBISWorld also expects industry establishment and enterprise numbers to contract given that further consolidation is likely to occur. The industry is expected to reduce labour intensity as consolidation brings about scale economies and investment in technology increases automation. Lower labour intensity will produce slow employment growth.

Key success factors

• Ability to effectively manage risk: A diversified risk profile should focus on business lines, and the spread of the business, reinsurers and investment assets.
• Management of a high quality assets portfolio: Adequate asset management should be effected through investment in diversified low volatility portfolios with a maturity profile that takes into account anticipated claims.
• Provision of a related range of goods/services (“one stop shop”): Companies must be able to cross-sell products from an existing customer base and develop new products.
• Well developed internal processes: Effective and low cost administration systems help to ensure streamlined operations. Cost control of underwriting expenses is critical to maintaining an acceptable combined ratio.
• Superior financial management and debt management: Insurers’ underwriting procedures must emphasise quality risks. Adequate provision must be made for future claims using in-house and external actuarial resources. Sufficient capital and solvency levels are required to accommodate adverse claim outcomes.
• Having a cost effective distribution system: Low cost and efficient product distribution channels are important in minimising costs. In many cases, insurers “outsource” distribution by using brokers and agents.
• Capacity to objectively assess new investments: Reinsurance levels must be assessed for their capacity to meet ongoing obligations.

Barriers to entry

Barriers to entry in this industry are medium and are steady. The moderate level of barriers has enabled non-traditional competitors who cross-sell financial services to customers to enter the market.

Regulatory requirements: The General Insurance industry has a high level of regulatory requirements, most of which pertain to maintaining adequate capital and remaining solvent. Insurers must also be licensed and are required to regularly report to APRA.

Capital requirements: Maintaining adequate capital is a barrier to growth as to underwrite a large book of business an insurer will need more capital. However, insurers do have the ability to cede some risk to reinsurers, which can increase their capacity to grow.

Established major players: Though the industry is moderately concentrated, the major players and their respective brands are well known in Australia and have built up many years of goodwill. Many of these brands specialise in specific markets and in certain lines, which creates opportunities for some players to service a particular market niche. Though the major players are fairly established, their collective market power has not constrained new entrants from being able to successfully enter the market.

Building a customer base: A new entrant may either acquire an existing player or commence building their own operations. There are a number of start-up expenses, which can be considered a barrier to entry and building a viable critical mass of customers can take time.

Distribution channels and networks: The nature of the distribution system in the General Insurance industry is a major factor in determining barriers to entry and the ease with which capital and capacity can enter and exit the market. In personal lines of insurance, over 70% of business is written directly through call centres or branches, effectively creating a set of higher barriers to entry. Unless the insurer has access to a distribution channel it is difficult to attract business.

Commercial lines insurance, on the other hand, does not have the same characteristics and is dominated by intermediary distribution channels. More than 90% of these classes are distributed indirectly, predominantly through brokers. . This eases the ability to transfer new capital into and out of the commercial lines market. A broker looking to place business will choose the underwriter that offers the best terms and pricing with acceptable security.

New entrants need only approach the broker market, establish a relationship and offer competitive terms. The use of intermediaries in the distribution of products acts to lower the barriers to entry into the commercial lines market, allowing the insurance cycle to operate.

Robert Bryant is the general manager of business information firm IBISWorld.