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.
Market cycles and competition are recurring themes at these gatherings. Of course, a hot topic in 2010 was the aftermath of the financial crisis.
The prevailing sentiment particularly among brokers (but also voiced by Lloyds in the course of this year) is the ‘threat of more regulation‘. Many feel that, “we’re not the bad guys; the banks are,” leading to a conclusion (in my humble opinion an erroneous one) that perhaps we should not be, “treated like the banks,” by regulators. Little do we realise that the problem was fundamentally not banking or insurance related but a credit problem. Simply because the insurance industry was not a ‘culprit’ this time round does not mean that we are immune to it. Do the terms ‘ London Spiral’ or ‘LMX’ from the early 1990s ring a bell? We can spin the story on these two events almost two decades apart whichever way we choose. But, 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. Synthesized, one can encapsulate both into a simple phrase, i.e. greed beyond reason.
Market Cycles: Cost of Capital vs. Catastrophe
The topic of the credit crisis (or its aftermath) is also not unrelated from the cyclical nature of insurance and also from what some practitioners label as competition.
I am not an economist so if there are any economists reading this who disagree with my arguments please feel free to contribute. But, as a market practitioner, it appears that what we are experiencing is not retail market competition but market aggression. There is excess insurance capacity relative to insurance demand as companies try to maximize on their RoE within a wider prolonged depressed economic scenario.
What’s the difference between aggression and competition?
The net result may be similar. But, the processes leading to the result would be different. Therefore the strategies to combat it need to be 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 (since time is money) as well as at pricing (and what one is giving within that pricing since, as the actuaries would attest, there is no such thing as a free lunch) etc. These are all effective short-run operational tactics when playing the competition game.
Figure 1 provides a snap shot of world premiums over the past 2 decades illustrating the otherwise cyclical nature of insurance markets and the prolonged soft market scenario in recent years.
Comparing the rate of global growth in gross written premium to the annual movement in premium as a percentage of GDP the revelations are stark, i.e. we can clearly etch out the three periods of relative market hardening globally during the past couple of decades namely:
1993: This is post-LMX / London Spiral debacle coupled with the turmoil in the finance / investment market at the time. 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 insurance, reinsurance and retrocession markets. Post-1992 there was a three-year cycle of a relatively harder market. It is interesting to note that the initial year is generally harder but then starts to settle at a lower level almost immediately (this is evidenced from the premium to GDP percentage).
1999: There was a slight ‘build-up’ from 1997 to 1999 mainly due to the uncertainties and perceived risks associated with the millennium change. When on 1st January 2000 people realised that no systems crashed and no Armageddon occurred as a result of technological hitches the insurance industry experienced an immediate softening.
2002: The immediate aftermath of September 11th 2001 resulted in a panic surge in some premium classes or products like marine hull, energy, aviation, terrorism etc. which however dissipated as fast as they struck.
It is interesting to note that the rate of premium growth internationally between 2003 and 2007 was relatively healthy and does not correspond to the movement in premium as a percentage of GDP for the same period. In fact the relationship between the two is negative notwithstanding that global premium and gross domestic product both independently grew during these years! This is attributable to a number of factors. What we witnessed was not a short-run (frictional) competitive scenario but a structural (long-term, sustained) deflationary scenario brought about by a combination of factors. Other than the small panic blimp immediately after September 11th effecting specific insurance classes or products and the earlier perceived millennium threat the market has had a sustained relatively soft cycle of over 15 years. Why is this? The post 9/11 petrol-dollar boom, the Bush (USA) administration spending like there is no tomorrow, irresponsible consumer lending, the unregulated mutation of derivative markets, double-digit inflation in countries showing greatest growth (such as in the BRIC economies and the GCC region) as well as other factors all contributed to a demand which, in hindsight was synthetic and/or inflated.
Notwithstanding the synthetic nature of demand, this was met with increased insurance and reinsurance supply. The post-crisis result is evident. The UK market (because of the London Market), as an international insurance melting pot suffered a 50% drop in its insurance consumption growth rate when comparing its rate of growth pre-crisis (2006 – 7) to that post-crisis. And this 2006 – 9 drop in rate of insurance consumption has not only happened in the UK or USA (13% drop) but, with a delayed effect, is also being witnessed in developing markets (Brazil -25%, Russia -32%, India -18%, China -15% and UAE -24%) as shown in Figure 2.
Sustained excess capacity means sustained lower pricing. Is this competition? No. Particularly in the retail insurance market, is it aggressive under-cutting (i.e. price-driven tactics)? Yes. Since it is a longer term structural problem, longer term strategic positioning (and not tactical warfare) is required to address this phenomenon.
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 (whether or not driven by these events) that dictates market cycles. In some markets, i.e. the GCC insurance markets, such events as Hurricane Gonu came and went but because the cost of capacity (in other words reinsurance counter-party credit or newly licensed capital) remained readily available at economic pricing such events have had negligible effect on retail pricing.
The UAE Market Pre- and Post-Crisis
Is the GCC or Middle East insurance market in synch or immune to the above trends and patterns? To what extent is it exposed to the same cycles and counter-party credit exposures? The short answer is that although as an emerging market it is relatively more volatile, it is nevertheless showing the same trends as the global picture as indicated in Figure 3:
The following interesting differences do however emerge when compared to global statistics:
As an emerging market, UAE was going through a period of unprecedented growth particularly from 2004 onwards. This is witnessed not only in the dramatic growth in GDP but also in a 66% growth in insurance as a percentage of the GDP. This reflects the growing need of contractually, project, finance or compulsory driven insurances as a result of the infrastructure, economic and demographic growth;
As would be the case with any emerging market the relationship between cost of capital and/or credit and insurance growth is more pronounced because insurance is more of a by-product to other ongoing economic or demographic activity in such markets.
Insurance as a percentage of GDP is significantly volatile (unlike global statistics which are dominated by more mature markets such as Europe and the USA) and one would, for example, expect the rate of growth in insurance penetration in UAE (represented by insurance as a percentage of GDP) to shrink in the immediate future (2010 – 2011).
There has been a delayed reaction to the economic crisis within the region in as far as insurance is concerned because of the relative availability of economical insurance capital whether in the form of new insurance licensees over the past five years or in the form of international reinsurers becoming more active in the region. But the impact of the crisis has not been averted; it has merely been delayed as illustrated in figure 2 above.
Therefore, given the above trends and characteristics, how and when will the regional insurance industry emerge from the crisis?
Although being part of the tertiary sector, capitalisation, solvency and regulatory requirements inhibit an insurance company’s elasticity of supply. Therefore since it is relatively difficult to exit the industry once a company is capitalised, it seems more plausible for several retail insurance companies in the region to continue fighting for market share notwithstanding the prevailing unfavourable market conditions. This is further aided by the availability of reinsurance support. However, the results of several companies in the region (particularly the younger ones) speak for themselves. Figure 4 shows the deteriorating results, even eating into equity, of some of the newer insurance companies in UAE:
The following factors will continue to adversely affect insurance market recovery in the region:
Insurance, particularly retail insurance, is less (or not) systemic and therefore we tend to ignore the fact that lack of market discipline can lead to structural risk with long term / chronic effect. There is too much of an ‘each to his own’ syndrome in the current market environment which, unless we address systemically will only serve to continue hurting net results. Greater market discipline and cooperation is required to counter this;
In most of the GCC insurance markets and more certainly in the UAE there is still a dearth of technical expertise often peppered with bigotry. This will continue to propagate a tactically reactive, as opposed to strategically proactive, management. It is sound knowledge (not solely experience) that drives vision. The industry as a whole, probably driven by regulators need to commit to structured license-driven qualifications as well as structured continued professional education;
Proper regulation and supervision is still elusive in number of the GCC states. This is even more the case with prudential supervision than it is with the actual drafting and enactment of regulations. Internationally, some are hoping that Solvency II will bring more discipline to the market and address these problems; however this might not necessarily be the case for our region for four main factors namely:
a) Capital in insurance can be bought and sold albeit at a price. So more stringent capital requirements under Solvency II will be addressed by higher outward reinsurance from the lower capitalised entities. Out of the top ten insurance companies in the UAE, for example, nine consistently spend proportionately much more (in percentage terms) on outward reinsurance than they recover on reinsured claims;
b) The above serves to shift competition from the primary (retail) market to the secondary (reinsurance) market. This is already the case in most of the Middle East markets and certainly in the UAE were several cedants are little more than ‘reinsurance agents’. Solvency II will not change this;
c) Solvency II, although intended to have far reaching implications will be particularly onerous on the EU market. Europe accounts for about 40% of world premium / insurance activity. Therefore, in the grander scheme of things, it will not be globally as far reaching as one would wish it to be;
d) 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. The regional market already has its own prudential and/or regulatory challenges to contend with.
In an endeavour to keep up with geometric GDP growth some of the regional insurance markets ran at a time when they probably should have been walking. The disproportionate growth in capacity both in the form of new insurance licensees as well as increased reinsurance presence during a period of economic prosperity has further heightened the hunger for top-line growth. All of this has not been matched by the necessary regulatory development which is critical (albeit unpopular) for any young market.
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 regional insurance market survive post-crisis without these factors? Yes. But why merely survive when you can prosper?
Author’s Note: A Chartered Insurance Practitioner by profession, James Portelli is also a Fellow of the Chartered Insurance Institute and of the Institute of Risk Management. James has been active in insurance in Europe and the Middle East for the past 20 years first moving to the GCC in 1998. He also coordinates Middle East Regional Group activities of the (UK) Institute of Risk Management. Views expressed are personal.