The Monte Carlo Rendezvous and the Baden Baden meetings herald the major reinsurance renewal season and, with them, a potpourri of predictions and admonitions ranging from broker soap-box sermons to subtler and more learned perspectives from leading reinsurers. Hot on the heels of the financial crisis, the prevailing sentiment particularly among brokers is the threat of more regulation. Many feel that the insurance industry is being penalised for the banks’ sins. Little do we realise that the problem was neither banking nor insurance related but a credit problem.
The “London Spiral” or “LMX” from the early 1990s attests that we are not immune to it. Irrespective of how we spin the story of these two events they are intrinsically similar i.e. credit (or counter-party credit) problems with severe governance lapses or market indiscipline or bigotry at their core; one event perpetrated by insurers and the other by bankers or pseudo-bankers.
The topic of the credit crisis is also related to the cyclical nature of insurance and to competition.
From an insurance perspective, it appears that what we are experiencing is retail market aggression in the guise of competition. There is chronic excess (re)insurance capacity relative to insurance demand leading to a prolonged depressed economic scenario.
What’s the difference between aggression and competition?
The net result may be similar. But, the processes are different. In a competitive situation, ceteris paribus, one witnesses excess supply relative to demand (or vice versa) being rectified in a series of short-run positions. Hence the reason for soft and hard market cycles.
In the grander scheme of things a short-run hard or soft cycle is more or less frictional and addressed by controlling the cost components of the “office premium”, i.e. restructuring of one’s reinsurance (layering, pricing, over-riders, reinstatements), a closer look at claims and their administration costs, a knock-down effect on retail acquisition cost reflecting changes in over-riding commissions, a closer look at one’s credit policy as well as at pricing. These are all effective short-run operational tactics when playing the competition game.
Figure 1 provides a snap shot of the cyclical nature of premiums globally and the prolonged soft market scenario in recent years.
Comparing global growth in premium to the annual movement in premium/GDP percentage one can clearly etch out the three periods of relative market hardening namely:
1993: This is post-LMX debacle coupled with the investment. As insurers we can try to pin the blame on asbestosis, pollution or hurricanes but the common lapsus was the market’s inability to assess the full extent of the counter-party credit exposure in the (re)insurance/retro markets. Three relatively harder years followed as a result.
1999: There was a slight “build-up” from 1997 to 1999 mainly due to the uncertainties associated with the millennium change. When on January 1, 2000 people realised that no Armageddon occurred as a result of technological hitches the insurance industry experienced an immediate softening.
2002: The immediate aftermath of September 11, 2001 resulted in a panic surge in some premium classes or products which however dissipated as fast as they struck.
It is interesting to note that the rate of premium growth internationally between 2003 and 2007 does not correspond to the movement in the premium / GDP percentage. The relationship between the two is negative! This is attributable to a number of factors. What we witnessed was not a short-run (frictional) competitive scenario but a structural deflationary scenario brought about by a combination of factors such as the post 9/11 petrol-dollar boom, the US spending like there is no tomorrow, irresponsible consumer lending, the unregulated mutation of derivatives, double-digit inflation in emerging countries (e.g. BRIC and GCC) etc all contributing to a synthetic and/or inflated demand.
Demand was met with increased (re)insurance supply. The post-crisis result is evident. The UK market i.e. an international insurance melting pot suffered a 50 per cent drop in its insurance consumption growth rate when comparing its rate of growth pre-crisis (2006-2007) to that post-crisis. This dip has also been witnessed in the US (13 per cent drop) and, with a delayed effect, in developing markets (Brazil -25 per cent, Russia -32 per cent, India -18 per cent, China-15 per cent and UAE -24 per cent).
The above clearly illustrates that notwithstanding the widespread devastation of such events as the BP (Gulf of Mexico) oil spill, the myriad of hurricanes and floods, terrorist attacks etc. it is not these events but the market’s adjustment to credit requirements that dictates market cycles. In some markets because certain catastrophic events did not curtail capacity at economic pricing such events have had negligible effect on retail insurance pricing.
Whether insurance markets are in synch or immune from the global trend depends on how mature they are. For example, the Maltese insurance market essentially has two markets within it, a relatively mature “domestic” market and an emerging “inward (re)insurance” market. Whereas mature markets in general saw a relative slowdown in activity, emerging markets (including inward international (re)insurance business into Malta) witnessed growth. Reinsurance markets geographically closer to emerging retail markets (such as Japan) continued to witness growth. This also explains why certain markets (such as Lloyds) are stepping up their presence in emerging markets (i.e. China, Russia and India).
GDP growth reflects the growing need for contractually, project, finance or compulsory driven insurances as a result of the infrastructure, economic and demographic growth. This market characteristic will also impinge significantly on how it will continue to react or recover post-crisis.
Another important factor, affected by regulation, is elasticity of supply. Although being part of the tertiary sector, regulatory requirements inhibit an insurance company’s elasticity of supply. Since it is relatively difficult to exit the industry, it seems more plausible for domestic retail insurance companies even in Malta to continue fighting for market share. This is further aided by the availability of economical reinsurance capacity.
Finally, the non-systemic nature of our business also effects or impedes recovery. Insurance is not systemic and therefore we tend to relate market indiscipline to structural/operational macro-problems. There is too much of an “each to his own” syndrome in several retail insurance markets. Greater market discipline and cooperation is required to bolster net technical results.
Some hope that Solvency II will bring more discipline to the industry; however this might not necessarily be the case because
Insurance capital can be leased, bought and sold. More stringent capital requirements under Solvency II may be addressed by higher outward reinsurance from the lower capitalised entities. Maltese insurance companies, for example, already spend proportionately more (in percentage terms) on outward reinsurance than they recover on reinsured claims;
The above serves to shift competition from the retail market to the reinsurance market.
The net effect is that some insurers are little more than “reinsurance agents”. Solvency II will not change this; Solvency II will be particularly onerous on the EU market. Europe accounts for about 40 per cent of world premium / insurance activity. Therefore, in the grander scheme of things, it will not leave as global a mark as one would wish;
The delays experienced in getting consensus to implement Solvency II seems to suggest a lack of political will on the part of the EU member states. This does not augur well and further suggests that once implemented it will not solve current prudential issues because these are essentially governance / operational risk related and not quantitative issues.
If the insurance market is to grow steadily and sensibly and with less volatility a firmer commitment to regulatory development, prudential supervision and to intellectual professional development is a must. Will the insurance industry survive post-crisis without these factors? Yes. But why merely survive when you can prosper?
portellijames@gmail.com
The author, a chartered insurance practitioner by profession, is also a Fellow of the Chartered Insurance Institute and of the Institute of Risk Management. He has been active in insurance in Europe and the Middle East for the past 20 years.