Insurance markets are relatively small (or closed) communities and news of, say, liquidity problems travels fast. Post financial crisis there were at least two significantly sized brokers within the GCC region that caused a bit of a stir in this regard.
What differentiates us from the banking sector and what arguably spared us from a similar fate during the financial crisis is that fact that banks are in the ‘asset’ business whereas insurers are in the ‘liability’ business. What does this mean? Banks create money by providing loans which in turn create debtors, i.e. an asset on the books of the banks. Although the money has not yet been ‘earned’ by the banks, the clients are debtors (or assets) on the books of account of banks. Hence, the higher exposure to the risk of credit default. Of course this is a rather simplistic overview of the crisis because there the problem lay in financial institutions supposedly creating and selling assets out of books of liability to offset these exposures from their balance sheets. But that would be a topic for another article!
In insurance on the other hand, we create liabilities. How? Every time we accept a premium we are providing a ‘promise to pay’ an amount which is potentially much higher than the premium received in the event of a claim. Therefore written premiums only become ‘earned’ at the expiry of that commitment that we give to the clients; in other words, by writing business we are creating a liability on our balance sheet.
Because of this some may think that since we are not really in the business of credit, we are not that exposed to credit risk. In reality, for retail insurers, the credit risk is significantly high particularly in the Middle East markets because of the heavy reliance on reinsurance. In effect, reinsurers become a retail insurer’s debtor in respect of claims recoveries from reinsurers (which are substantial for any retail insurer). Probably the only insurer in the GCC to go belly up just over 10 years ago in Oman did so because of an inability or inadequacy of reinsurance / retrocession protection when faced with substantial claims.
These two realities, i.e. the liability nature of written premium and the credit risk of arguably our the largest asset (reinsurance) on our books, necessitates a closer look at what constitutes a premium, what needs to be taken out to yield a technical profit and when is this profit realised. The following table provides a simple snap-shot of inflows and outflows into an insurance pool or the constituents of an office premium paid by a client:
Traditionally significant emphasis was placed on investment return to prop up profits with portfolios of, say, motor or medical insurance, generally consistently running at over 100% loss ratio. This was known as ‘cash flow’ underwriting. In other words insurers went for volumes with the objective of investing more and reaping investment returns that would, in part, offset technical losses. This practice was less prevalent (or visible) in the GCC region because in most GCC markets motor insurance consisted of a relatively proportionately lower share of the market premiums due to for example energy, petrochemical and related premium spend. Added to this, since insurers in the region have tended to live more off reinsurance commissions, overall these also served to camouflage any technical loss in a specific class of business.
As they say, old habits die hard and even post-crisis when investment returns dropped considerably the above practices generally prevailed notwithstanding drop in net technical return experienced by several insurance companies in the region. The top ten companies in the UAE, for example, suffered an overall average of 9% drop in technical returns in 2010 compared to 2009 with some companies suffering more than 15% or 20% drop in technical returns.
The ability to invest and earn investment returns is also affected by the class of insurance business. For example the claims throughput in motor and medical insurance is much higher due to a relatively larger but smaller claims coming in on a daily basis. A squeeze on returns due to the higher burning cost (i.e. claims) element and associated administrative expenses as well as the lower investment return potential necessitates a closer containment of other cost elements (such as commissions or brokerage) in order to yield a technical return. In certain life assurance classes where a fairly longer view on losses and/or profitability is taken, it is not uncommon for a company to pay a commission equivalent to 100% of the premium in the first year of insurance. In contrast, motor commissions in the retail market generally vary between 5% and 15% depending on coverage and source of distribution. Where loss patterns are more infrequent, such as in most commercial property classes, commissions would be higher. But, the important thing to bear in mind that all follows the simple rule of strict proportionality. If outflows increase (i.e. higher claims or commissions) or inflows decrease (i.e. reinsurance commissions drop) these would result in a squeeze on the balance, i.e. the technical profit.
Although on a slightly different vein, I will end on by taking a cue from the opening of the article. Whilst premium represents a liability to insurers until it is ‘earned’ (hence the reason why premiums are allotted to reserves on a reducing basis for the duration of the period of insurance) likewise they also represent a liability to brokers until they are remitted to insurers. For every premium collected by the broker, the insurer becomes a creditor of the broker for the period of credit. In the absence of appropriate regulation and / or supervision in the region, some brokers have for long assumed that they have a right over that money, offset very short term current liabilities of expiring credit terms with fresh premium coming in that is creating fresh liabilities. The crisis put the brakes on the gravy train and incoming premiums could no longer subsidize outstanding liabilities for at least two significantly sized brokers that until recently where active in the region. One hopes that legislation will follow hot on the trail to address this practice. It’s not rocket science really. It’s called, “clients’ money” and deposited in separate accounts.