Paul Moorshead says motor rates will have to rise if the market is to avoid heavy losses
The profitability of the UK motor insurance market is on a knife-edge after a year of deteriorating underwriting performance, according to our analysis of the latest FSA returns.They show that motor insurers made a modest profit during 2005, but only because they released large amounts of reserves set aside for claims in previous years. They cannot go on doing this for ever and, with rates stagnating, there is every reason to believe that the market as a whole will dip into the red during 2006, even after allowing for investment income.As we predicted last year, the market has recorded a decline in underwriting performance with pure loss ratios moving from 77.6% in 2004 to 81.2% in 2005. Expense ratios also moved out from 27.3% to 27.6%. Premium income was flat at £8.8 billion.Once again, motor insurers' profit and loss accounts were saved only through another unexpectedly huge release on back year reserves. 2004's record release of £326m (equal to 3.6% of premium income) has been topped by 2005's total of £575m (equal to 6.5% of premium income).The outcome was an operating ratio of 102.2%, slightly worse than the 101.3% recorded during 2004. With a typical motor insurer making a return on investments equal to 5% of premiums, it appears to have been just enough to continue the trend of profitability in the market established in 2001. Look behind this veneer of steady profits however and things do not look so shiny going forward.Bodily injury awards the keyThe key to future trends lies to a large degree with the cost of bodily injury awards. These have been the fastest growing and most unpredictable element of the motor insurance arithmetic.The big release in back year reserves referred to above was possible at least partly because insurers had over-estimated their bodily injury reserves in earlier years. This may be a signal that the rate of bodily injury claims inflation has dampened recently from the double-digit levels consistently seen during the previous 10 to 15 years.Alternatively, it could be that insurers are releasing excess reserves that are no longer necessary but were held in anticipation of the Courts Act 2004, which was intended to encourage higher levels of periodic payment awards. Whatever the answer, we will know the full story next year with the publication of the fourth UK bodily injury study, which has just been commissioned by the IUA and ABI.How much fat is left?The obvious question is how much more fat do motor insurers have left in back year reserves to bail out any future current year deficiencies?One way to gauge the strength of current year reserves is to look at the ratio of claims paid in the year to ultimate claims held for the year. Assuming the speed of claim settlement is constant, a low paid to ultimate ratio would suggest that insurers are reserving strongly - which is what appears to be happening. Private car comprehensive insurers, for example, are posting a lower paid to ultimate ratio in 2005 than 2004.Insurers are right to adopt a cautious approach, because inflationary pressure on bodily injury claims is far from dead even if frequency may have stabilised. Bodily injury claims severity can be expected to increase at above the rate of inflation, so any improvement is only a matter of degree. Furthermore, there may be some nasty shocks in store.There is a very real possibility, for example, that the courts will have to award increased damages to reflect rising life expectancy. Equally, a reduction in the discount rate from 2.5% to 2.0%, or even 1.5%, would massively increase claims costs, and there is the ever-present threat of higher levels of NHS charge recoveries.Will the motor market stay profitable?As ever when discussing the motor market, it is important to acknowledge that the averages hide big differences in performance between individual insurers.Top performers this year include Direct Line, National Farmers Union and Provident - all of whom booked operating ratios below 95% last year too - and Groupama.Yet again we find no clear pattern indicating that any one model of insurer ' ' is better than another. Companies can be successful (or not) regardless of size and distribution channel. Among the small players, Brit, Sabre and Westminster all turned in impressive performances in both 2004 and 2005.The figures contain a number of positives. Since the increase in expenses is less than price or wage inflation it shows that motor insurers are working hard to control costs. The introduction of new distribution channels, selling through affinity groups and the increased use of the internet have all reduced selling costs, more than offsetting any advertised discounts to premiums and thus feeding straight through to the bottom line.Beneficial factors impacting claim costs include the natural decline of theft claims mirroring the state of the economy and significant security improvements in newer vehicles. Insurers have also kept costs down through efficiencies in claim settlement and by taking action against fraud.None of this, however, can disguise where the market is heading. Looking ahead to 2006, it appears that average premiums are still stagnant. While the latest AA premium index suggests that private car non-comprehensive rates are increasing, the much larger private car comprehensive sector is seeing rate decreases. This is worrying bearing in mind comprehensive premiums for 2005 were below 2003 levels already and that most insurers witnessed a deterioration in loss ratios for 2005 over 2004.Claims inflation is likely to be broadly 5% in 2006; higher than this for injury claims and lower for the rest. We predict, therefore, that the pure year loss ratio will deteriorate from 81.2% in 2005 to 85.0% in 2006. Estimating the level of prior year release is significantly harder. Taking credit for the arguments on strength of reserves and bodily injury inflation will justify another reasonable release. Another historically large release is entirely plausible (say 4%) although the true figure could easily be lower (or possibly higher) than this.While insurers may be putting pressure on non-claims costs, it is still likely that they will increase by close to RPI moving them from 27.6% to 28%. Put together with claims, this will produce an operating ratio of 109% for 2006 and, even allowing for investment income, the industry will post a sizeable loss.Motor insurers are doing their bit for society, keeping down premiums by raiding their reserves and controlling expenses. Next year's results are highly likely to signal an end to this magnanimous stance. Rates will have to rise. IT' Paul Moorshead is a senior consultant at non-life actuarial consultants, EMBTo download the entire article as it appears in the magazine in PDF form please click below. Page 1 (947kb)
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