Riding out a year of storms

The U.K. non-life insurance industry has been hit hard this year by three large weather events that in aggregate could add more than 30 percentage points to its property gross loss ratio for 2007 and ten percentage points to its overall gross loss ratio for the year. These events will, therefore, be the principal cause of what will be a significant loss in the industry's property line of business for 2007, and will probably leave its overall underwriting result in the red for the year.

Standard & Poor's Ratings Services continues to keep a close eye on the individual and cumulative impact of these events, but so far has not made any rating changes due to these events alone, which reflects the generally robust capital adequacy and healthy recent underwriting performance of its rated entities. Nevertheless, Standard & Poor's will continue to assess the financial strength of its rated entities in the light of further developments; moreover, with two months remaining in the year, further large weather events could yet occur that might prompt negative ratings actions.

The three large weather events that have occurred to date in 2007 in the UK are: Kyrill, a storm that hit large parts of the country in January, and was reported by the Association of British Insurers (ABI) in February to have cost insurers £350 million; and floods in June and again in July, where the cost has been estimated by the ABI at more than £3 billion. In aggregate, therefore, the insured losses currently amount to a total of at least £3.35 billion, the vast majority of which are property related, including business interruption. To put this into context, the most expensive weather losses EVER??, using today's prices, cost insurers £3.3 billion for the high winds that occurred in early 1990.

The profitability of the industry will undoubtedly be severely hit by these events. Assuming that virtually all losses are property related, Standard & Poor's estimates that a £3.35 billion aggregate loss will add approximately 31 percentage points to the gross loss ratio for the industry's property line of business. If one assumes that a normal annual loss from weather events is £1 billion, the abnormal additional gross losses from these events would add 22 percentage points. Although the amount of the gross losses that will be absorbed by the reinsurance industry is not yet publicly known with any precision, a working assumption of 33% of gross losses paid by reinsurers puts the additional net losses at about 26 percentage points. Consequently, it is almost certain that the four-year run of underwriting profitability for UK property risks will have been eliminated and turned into a significant net loss for 2007. At the overall level, the additional industry gross losses would add about ten percentage points to the gross loss ratio. This means that it is probable that the industry will record an underwriting loss for the year.

“A £3.5bn aggregate loss will add about 31 percentage points to the gross loss ratio for the industry's property line of business

Despite their cumulative size, Standard & Poor's has not lowered its ratings on any UK rated entities solely on the basis of their losses from these events. This largely reflects the businesses’ robust capital adequacy that allows them to absorb such large losses without significantly affecting their overall financial strength, as well as the recent healthy results of property underwriting. The impact of these events will be markedly different between entities, however, depending on the risk profile of their property book of business, their diversification by line of business and geographically, and the structure of their reinsurance protection, both vertically and horizontally.

Property insurance, particularly commercial property, has been under varying degrees of price pressure this year. Standard & Poor's expects this pressure overall will decrease following the latest floods, with commercial and personal property rates for flood-affected areas very likely to rise. The swing factor may well be the response of reinsurers to these losses, a significant proportion of which were thought to be remote, and that is not yet clear.

Apart from the operating and capital impact of these events, Standard & Poor's is also reviewing insurers' enterprise risk management (ERM) and, in particular, what changes, if any, insurers have determined they need to make to their ERM as a result of these events. For example, we will look at the actual exposure of insurers to these events in comparison with insurers' modelled or estimated exposures and determine if any discrepancies exist and, if so, why. This, in turn, will help us understand better the robustness of each insurer's ERM and how each will respond to the lessons that undoubtedly can be learnt from such an experience.

The U.K. non-life insurance market is very competitive, particularly with regard to pricing. It has attracted investment from a wide range of groups, both insurance and banking, foreign and domestic, including some of the best known financial services groups in Europe. Furthermore, it is a market that continues to attract new competitors, including some domiciled abroad, which are often nimble or aggressive. Nevertheless, Standard & Poor's believes that competition, and price competition in particular, will be more disciplined in the future as the market in general becomes more focused on risk-adjusted returns and preserving underwriting profitability rather than on market share.

Supervision of the UK non-life insurance industry by the Financial Services Authority (FSA) is a positive factor in Standard & Poor's assessment of the credit quality of the industry. The FSA has pre-empted the introduction of Solvency II with the introduction of a risk-based capital regime that is one of the most rigorous and advanced in the world. Although still evolving, the regime, which is calibrated to a 99.5% confidence level that a firm will survive for a one-year period, has resulted in a noticeable improvement in ERM among rated companies. Furthermore, this improvement has been achieved in spite of the volume, complexity, and cost of the regulatory changes being implemented over the past few years.

The regime has, to an extent, levelled the ERM playing field, partly because it allows best practices to be shared via FSA feedback. Although this might have reduced the competitive advantage of those insurers that previously had developed their own sophisticated ERM tools, Standard & Poor's expects the overall industry benefits to be more rational pricing and capital allocation, and therefore less volatile cycles.