Running out of gas?

Motor insurance is one of the most important determinants of the profitability of the UK insurance market. Households spend £9bn a year to insure their cars, with an average annual expenditure of over £500 per household.

But insurers are not seeing the profits from such a large business sector. Based on the latest FSA returns, the operating ratio for the 2007 financial year, net of outward reinsurance, was 102%. This is only slightly worse than the result from 2006 of 101% and continues the trend of ‘cruise control’ which has been a feature of the market since 2002 (see Fig. 1).

Not since the tariff days of the 1960s has there been so little variation from year to year in the headline market results. This begs the question of whether we have seen the end of the traditional underwriting cycle – the feast and famine image entrenched in the minds of so many in the industry.

However, taking these figures at face value ignores a number of features below the surface, all of which have an effect on the operating ratio.

Reserve releases, market segmentation, reinsurance and the relative profitability for personal and commercial lines business all help to determine overall profitability of the UK market. By taking into account or neglecting any of these features, the market operating ratio can be anywhere between 98% and 114%. Even with such a wide space to play in, more than half of the companies in the market delivered results in 2007 outside this range.

The key driver behind the consistent operating ratio in recent years has been an unprecedented level of prior year reserve releases. 2006 saw market-wide reserve releases which equated to 10% of net earned premium, and the level of release in 2007 appears even greater at 12%. These releases are included in the calculation of the operating ratio, and so without them, the pure year ratio would have been well over 110%.

It is not unusual for companies to release reserves from prior years and to hold a margin within their reserves for the current accident year. If the approach is stable across the market, from year to year, then reserve releases will not distort the reported results. But for the past two years the approach has been anything but stable and the apparent flat calm of the underwriting cycle hides a worrying trend for insurers.

Once the effect of reserve releases is taken out of the calculation, the traditional underwriting cycle is still evident in the market (see Fig. 2). For the first time, the market as a whole has been able to use reserve releases to iron out the motor underwriting cycle. Of course not all insurers are releasing large amounts of money, and even among those which are, the levels of release vary greatly from company to company.

Given the amount which has been released over the past few years, it is natural to question the sustainability of such a strategy. It is unlikely that, back in 2005, many insurers planned to make quite such large reserve releases in 2006 and 2007 – the pressures from shareholders and executives for jam today would act against this.

A significant part of the reserves held for prior years are for personal injury claims. A key consideration when the reserves were first established would have been an assessment of the trends for these claims. Trends in injury claims have been less severe in the past few years and undoubtedly this will have made a significant contribution to insurers’ ability to release reserves.

A second year of reserve release of close to £1bn will have surprised many in the market and few would bet on it being sustainable. However, we still see evidence in the FSA returns that, at a market level, the pot has not yet run dry and many companies are still replenishing it by holding margins within their current year reserves. For those companies which in 2007 looked around for every last penny that could be released, this will paint a worrying picture.

Another issue is whether size matters in the profitability stakes. The 2007 results suggest that in today’s landscape it might.

With the exception of the usual market-beating niche players, 2007 saw a mass movement of smaller insurers to a significantly worse than average performance position. The volume of reserves held by the larger insurers may provide a level of cushioning against difficult market conditions that many smaller insurers may struggle to obtain. Their results in 2007 seem more closely bound to the underlying pure cycle (see Fig. 2).

Smaller insurers

In 2007 there was a clear explanation for the difference in results between the smaller insurers outperforming the market and those which are not. Quite simply the higher performers are making reserve releases that are three times the size of those made by the lower performers.

The potential for making reserve releases was not the only benefit of scale seen in 2007. The five largest companies, which together represent approximately 50% of the market, have a pure year operating ratio that is

six percentage points better than the remainder of the market.

Ten years ago, the net operating ratios for the UK motor market’s personal and commercial lines were comparable. A four year period followed where personal lines consistently outperformed the commercial lines market. Parity was reached again five years ago and this has been followed by a four-year period where commercial lines significantly outperformed personal lines.

The latest results for 2007 show that the profitability gap between the two markets has closed from 13 percentage points in 2006 to six percentage points in 2007.

So what is the current profitability of the UK motor market? There are as many answers to this as there are ways to compartmentalise the market and define current profitability.

If prior year adjustments are taken into account then the market is operating at 102%. However, for “pure year” performance this ratio deteriorates to 114%.

Splitting the market by relative size of insurer, the five largest companies have an average operating ratio of 99%, while the remaining 50% of the market have an operating ratio closer to 105%.

The personal lines result for 2007 has held steady at 104%, while the commercial lines result has deteriorated to 98% from 92% in 2006.

Clearly, when the operating ratio is in excess of 100%, investment income is critical to achieve profitability. Once investment returns are taken into account the market has enjoyed seven years of clear profit. On the face of it the current net operating ratio of 102% looks attractive, especially when compared with the results of the late 1990s when the ratio exceeded 118% for three years in a row.

If the market really was trading at a comfortable 102% net operating ratio there would not be the current pricing behaviour. The first sustained period of premium increases for private motor insurance since 2002 came in 2007 (see Fig. 3).

Moving into 2008, the momentum gained in 2007 has continued. Competition for customers is still fierce and the number of options open to consumers when they come to buy their insurance policies has proliferated. It would be unsurprising if premium rates continued to increase during the remainder of 2008, but most likely at a slower rate as the increasing level of aggregator presence in the market continues to help customers shop around.

At the other extreme, the market is not behaving as though the underlying results are as bad as the pure year ratio of 114%. At this end of the range the current level of premium increases, which are not much in excess of claims inflation, would do little to alleviate the painful losses that such a ratio would imply.