Running on empty

The party is over. Having spent the past couple of years tapping their reserves to boost profits, non-life insurers have to come to terms with the fact that the pot is now close to empty.

Continuing falls in investment returns, fierce competition, low interest rates and the recession have left insurers unable to rely on bumper prior-year reserve releases to bolster their bottom line in the manner to which they have become accustomed. Although reserve releases are still likely to support profits again this year, it’s extremely unlikely that the substantial releases witnessed in recent years – estimated to be at around £1bn annually since 2005 – will be seen again.

“It varies by insurer, of course,” remarks PricewaterhouseCoopers insurance partner Paul Delbridge. “Some have a bit more in the larder than others, but by and large there isn’t as much left to draw on as there was three years ago. The cupboard is pretty much bare now.”

AXA finance director Jean Drouffe is even more forthright in his assessment of the state of prior-year reserves. “Reserve strength among insurers is eroding rapidly,” he says. “I think there will still be a fair amount of reserve release this year, but it will be much less in 2010. I anticipate in the next couple of years that we will reach a point where reserves will not be adequate, and that situation will add to the problems already facing the industry.”

The large draw on reserves over the past four years was driven initially by the sharp increase in claims in the wake of the flash floods that hit the UK, followed during the last two years by the impact of the credit crunch-inspired recession.

Profits at insurers have been hard hit by the downturn, but earnings would have been worse if companies hadn’t released billions of pounds from their reserves.

No more good news

There is currently no legal minimum requirement on the amount of prior-year reserves that non-life insurers must retain or release. Reporting this money as income, essentially a management judgment based on estimates of future claims, has allowed the industry to paper over the alarming cracks that have appeared over the past four years, caused by cut-throat competition and increased claims.

Deloitte associate partner James Rakow says: “Reserve releases have always been a feature of the market, but there has been a huge surge over the past five years and I don’t think the level of releases we’ve seen over that period are sustainable. There’s less room for manoeuvre now, and less room to balance bad news in the current year with cash from better news from previous years.”

Essentially, the industry has run out of good news. The boom years of growth and high prices have been replaced by stagnation and falling rates. And while both Rakow and Delbridge agree that prior-year reserve releases will remain a feature of this year’s financial results, they too warn that the amounts released to buoy sagging profits will be substantially less than previous years.

Smaller reserve releases will bite hard into company earnings, and many firms are likely to post sharply reduced profits for this year, or in some cases, increased losses.

“In the motor industry, reserve releases mitigated losses in recent years,” Rakow says. “This year, releases won’t be as large, and so I expect losses in the motor industry to be worse. We think the headline operating ratio for the motor market will be 107.4% this year, against last year’s figure of 105.3%.” It’s also worth bearing in mind that, in 2007, the operating ratio for the sector was 102%.

Smaller earnings will also increase the industry’s vulnerability to other threats and not just large one-off catastrophes, such as floods or a Katrina-like disaster. There are also significant inflationary pressures on claims costs, in particular on bodily injury claims. Commitments on long-term liability policies agreed in the current low inflation market may prove far more costly later on and return to haunt company balance sheets.

The price isn’t right

The industry isn’t facing a perfect storm, but it is clear that the impact of smaller reserve releases will need to be offset by an improvement in underwriting performance. Drouffe points to recent improvements in investment returns on the back of improved returns on equities and corporate bonds, which are also bolstering earnings. But the bottom line is that insurers need to increase premiums to a level where they can make a profit.

This is already starting to happen in the personal motor insurance industry. The closely watched AA Insurance Premium Index revealed a 5.6% jump in the cost of premiums for personal comprehensive car insurance during the third quarter, the biggest single quarterly jump in 15 years, and one that pushes the annualised rate of increase to 14%.

“Motor industry premiums have risen this year at their fastest rate in six years,” Rakow says. “In the absence of large reserve releases and lower investment returns, companies are clearly seeking to ensure premiums are adequate to cover claims.”

The motor industry is perhaps a special case. Reserve releases totalling more than £3bn in recent years have concealed the true impact of increased competition, inadequate premiums and claims inflation on sector profits for some time. A correction in the £9bn-a-year sector is long overdue.

But Groupama managing director Laurent Matras believes the jury is still out on whether such increases will be enough. “Yes, premiums are going up,” he says. “But motor insurance is still a highly competitive market, and it remains to be seen whether premium increases are capable of offsetting all the issues facing the industry.”

Prices have increased in other sectors too this year, particularly in the £6.5bn household insurance market, albeit at a much slower annual rate of up to 5% at best. With that in mind, Matras’s concerns remain pertinent, particularly against the backdrop of the recession and the increasing use of price comparison websites that provide consumers with easy access to bargain-basement premiums.

Cutting back

The recession has also been the catalyst for a sharp increase in claims over the past two years, piling further pressure on under-siege insurers’ shaky profits. “Yes, there has been an increase in claims, particularly theft claims on household insurance,” AXA’s Drouffe says. “We’ve also found a 30% increase in fraudulent claims in the past year.”

His views are echoed by Matras. “Along with the increase in claims, there is more tension in terms of fraudulent claims on both the domestic and commercial side. But insurers are much more efficient at detecting and combating fraud today.”

The recession has affected the industry in other ways too. Along with cancelled gym memberships and ‘staycations’, people are also taking out less insurance in a bid to reduce their outgoings.

Even compulsory insurance, such as motor cover, has been affected. “Some people are downgrading their insurance,” Matras says. “What we’re seeing is customers are choosing to increase their voluntary excess [the amount a customer agrees to cover themselves in the event of a claim] in order to pay a smaller premium. That’s fine until they find themselves in difficulty when they have to make a claim.”

How companies cope with depleted prior-year reserves depends principally on the future strength of both the insurance market and wider economic recovery. If the industry is to remain profitable, however, underwriting performance must improve, which will mean increased premiums for consumers.

Drouffe says: “Companies will have to replenish their reserves in the coming years, and ultimately we will be looking at increasing premiums to do this. It is either that or we will be watching the overall sector shrink.”

But while premium levels are clearly increasing, it is worth pointing out that in the highly competitive insurance market, and against the backdrop of a prolonged economic downturn, many insurers may find it impossible to raise prices to a level that reduces their reliance on prior-year reserves without losing a large chunk of market share in the process.

But there may be something of an upside for the industry, in the short term at least, in the form of help from an unusual source: HM Revenue & Customs. Upcoming changes to the tax regime for non-life insurers are likely to encourage some companies to keep their prior-year reserves at as low a level as possible to avoid additional taxation. This will effectively allow them to continue to support their year-end profits, even on dwindling prior-year reserves.

“It’s not quite a silver lining,” Rakow says. “But the tax changes may lead some insurers to decide to hold lower prudential margins and reduce their prior-year reserve to comply with new tax rules. The new rules mean there will be more overt downward pressure on reserves, but the changes also mean that companies will lose some of the flexibility to top up reserves in better markets.”