Insurers bank on better times

Australia’s 141 insurance companies provide financial protection to individuals and businesses against damage resulting from events ranging from car accidents to medical malpractice. They 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.

The general insurance industry will generate revenue of $42.1 billion during 2010-11, which represents a 2.9% fall on the previous year. This will comprise net premium income of $35.6 billion and net investment income of $6.5 billion. Net premium revenue and investment revenue are expected to decline, however the net profit margin is expected to remain at the 13% mark as the industry continues to rebuild its capital reserves. Industry revenue is estimated to experience an average annual decline of 3% for the five years to  2010-11.

The financial crisis deeply set back the industry in terms of profitability and its ability to generate revenue from investments, and the case for premium price rises quickly materialised. Further adding to the need for price rises was the increase in catastrophic losses incurred. However, the future looks more promising for general insurance companies. Over the next five years, industry revenue is forecast to grow by 2.4% to reach $46.92 billion in 2015-16. 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.

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 Reserve Bank to lift interest rates, which will boost bond yields and fuel sharemarket 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 $46.92 billion in the next five years. The best performing-year, 2011-12, is expected to yield 7.7% revenue growth.

IBISWorld expects rate hardening to persist until 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 a 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 14.1%, which will be 1.9% higher than average for the last five years. This will largely be attributed to better underwriting practices following a rethink 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 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.

Mixed economic news

Like all insurance industries, the general insurance industry is subject to external factors inherently difficult to forecast. One is the state of global and domestic financial markets and their effect on the industry’s investment performance. Debilitated global financial markets still have some way to go before returning to normal. During the past five years, investment income experienced extremely high volatility and this is likely to persist for some time.

The industry is also exposed to catastrophes unpredictable in their frequency and severity. Financial market conditions and catastrophic losses are particularly difficult to forecast, but both will have a considerable effect on the industry during the next five years. Do not expect total recovery of the global financial markets for quite some time. Financial market recovery will be slow due to the scope for further debt-driven turmoil in the United States arising from the siblings of subprime loans. Defaults on these assets will delay a US housing market recovery and undermine a broader improvement in its economy.

With the US economy to remain fragile, Australia’s growth prospects are mixed. Weak US consumption will have flow-on effects with Australia’s key export destinations in Asia. However, growth in this region will still be robust as foreign governments focus on developing domestic consumption. A surging population owing to immigration will also be good for Australia. However, like the United States, Australia also has its own debt problems. Rapid growth post-2000 was largely debt-driven, which means the country ultimately stole future economic growth to realise it today. The Federal Government assisted the private debt binge through its economic stimulus payments, but by helping households pay off debt through taking on debt itself, the government only shifted the problem. To return the budget to surplus, the Federal Government will ask for the money back through taxes, thus undermining future growth. Again: buying tomorrow’s growth and realising it today.

Fundamentally, the effects of deleveraging are inescapable: a period of high savings and low debt expansion has to yield weaker economic growth.

The economic news for general insurers is mixed. Indeed higher savings will mean lower gains in consumption, particularly expenditure on items such as boats, cars, appliances and housing (a new house or renovation). This means demand from the personal market is not expected to expand as rapidly as in the lead up to the financial crisis. Relatively weak consumption growth will mean unemployment will not return to the low pre-crisis levels for some time. This will be because business investment and new economic activity will be constrained not only by weak household consumption, but more subdued conditions offshore. Therefore, demand for workers’ compensation insurance and other commercial lines is not projected to grow as quickly as in the past five years.

Price rises will aid premium growth over the first two years of the five-year period. However, demand headwinds will limit the premium gains to 4.8% and 2.5%, respectively. Meanwhile, general insurers’ investment performance will also improve as economic conditions strengthen. Higher insurance prices and investment revenue will see the industry produce NPAT margins of 17.9% and 16.5%, respectively. If such strong results do eventuate, the industry will see its balance sheets shored up, with insurers in a strong financial position. With cash to burn, insurers will return to price competition in an effort to grab business and instigate industry-wide price softening. Price declines will then hamper the industry’s profitability over the following years. During 2012-13, price competition starts are likely to occur, intensifying over the years that follow.

Hidden dangers

In the previous five-year period, apart from the Queensland floods of 2010-11, the most significant natural disasters, according to the Insurance Council of Australia, were the Newcastle storms in June 2007, which caused about $1.5 billion in damages and resulted in about 100,000 claims being lodged. As highlighted with the hurricanes in the United States in 2005, which caused about US$70 billion in damage, the severity of future natural disasters may test actuarial estimates. Previously, damage of US$70 billion in one year was never considered possible, and the industry wore substantial losses, particularly reinsurers. With climate change affecting weather patterns, the possibility of a natural disaster dwarfing the $4.3 billion in damages caused by the Newcastle earthquake in 1989 remains pertinent.

Should one or more occur in a given year, the dynamics of the industry would change significantly and industry forecasts would need to be reassessed. Both general insurers and reinsurers would wear the burden, with some reinsurance risk likely to be borne by global reinsurers as well.

In recent years, the cessation ratio has dropped from about 30% to about 20% of premiums. This means general insurers are not passing on as much risk to reinsurers. By bearing more risk they are increasing their upside profit potential but also exposing themselves to large-scale disasters, such as Hurricane Katrina.

This trend has helped to improve industry profitability but serves to materially weaken profits and reserves in the event of substantial losses as experienced in 2007-08 and 2008-09. Despite these developments, awareness following the US hurricanes has improved and ratings agencies have demanded a reassessment of modelling techniques, so a falling cession ratio can be viewed as a deliberate method of improving profit by general insurers. It should also be noted that stronger prudential standards have put the industry in a much stronger position than previously.

Competition shifts focus

Strong distribution channels are important in competing in the industry. Major financial institutions will display a growing interest in the industry. Getting involved in general insurance will enable them to capitalise on existing and expanding client bases, distribution networks, processing capabilities and funds under management. Operators are expanding underwriting capacities and entering into strategic alliances with existing underwriters to reduce unit costs. There has been a trend toward the commoditisation of general insurance products. Innovative product development will be critical in creating a competitive advantage. It is predicted that products will increasingly enable the customer to select cover as required from a number of classes.

The importance of service to enhance differentiation will also increase. Underwriters are packaging standard products for the small business sector, a market that has been dominated by brokers, in order to distribute products directly.

The most successful insurers will be those who have access to capital, and strong skills in underwriting, information collection and analysis, structuring, risk assessment, pricing and negotiation. The industry is forecast to be subject to further pressure to rationalise, particularly when lower investment returns expose industry losses. This is likely to affect participant numbers, employment levels, product mixes and distribution methods. Continued rationalisation may take the form of mergers or strategic alliances (for example, combining back offices). The increasing drive to lower expense ratios will be assisted in the personal lines of business through the internet, telecommunications and changing consumer patterns. The electronic distribution channels created by these technological advances are expected to lead to cost savings over the medium term, and put pressure on brokers and agents.

The small- to medium-sized insurers, which already face increased pressure due to the absence of economies of scale benefits and increased prudential and regulatory requirements, are likely to emerge as targets for mergers and acquisitions during the next five years. In addition to Suncorp-Metway acquiring Promina in 2007, further acquisitions are likely as the major players attempt to build even greater scale and presence in a mature market.

The reasoning behind further mergers and acquisitions will be a quest to increase market share and reduce operating expenses by removing duplicated costs. Direct and online distribution channels are expected to represent a growing portion of distribution. Personal general insurance is perceived as being ideally suited to internet delivery. Some industry analysts have suggested that the industry in Australia is falling behind and vulnerable to other finance-based industries in developing e-commerce solutions, especially in an environment that is becoming increasingly competitive and globalised. Furthermore, banks continue to increase their market share in the general insurance industry. As a result, it is expected that industry participants will become more customer-focused rather than product-focused, as companies pursue ways to secure relationships with their customers. Multiple item discounts and loyalty programs are ways some companies may establish a multiple product relationship with their customers.

Key success factors

IBISWorld’s most important factors for success for the industry are:

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.