Most social science theories, including in economics, business and finance are ‘deductive theories’ based on the modus ponens mechanism. What this basically means is that conclusions are drawn from evidence; and from these conclusions one can then infer recommendations or an action plan.
Put simply, a ‘deductive theory’ draws a conclusion from a fact. A simple example would be (a) it is raining so (b) people carry an umbrella. It is reasonable to deduce that people carry an umbrella if / when it is raining. However, the inverse is not necessarily true, i.e. If people are carrying an umbrella it is not necessarily reasonable to assume that it is raining. A simple example perhaps (but I will be tying this to GCC insurance markets further on in this article). Deductive theory contrasts with Inductive theory (such as in mathematics). In inductive theory results are absolute i.e. If (a) 3 + 1 = 4 then (a) 4 – 3 = 1.
A disconnect seems to happen when mathematical and/or actuarial absolutes are inferred forward in business and finance into ‘models’. Mathematical modeling would perhaps have undergone rigorous testing within a framework of a set of variables. The world of economics and finance is a living, breathing and constantly changing beast and a change in variables may render a model that seemed otherwise robust yesterday obsolete today. Black Sholes for example came under severe criticism during the financial crisis. But, in reality, is it the case of the model being wrong / inadequate or is it a case of ignorance on the part of people who perhaps continued to rely on it (and similar other models) without taking into account the fact that models require constant recalibration in response to a constantly changing economic reality.
A COMMON MISCONCEPTION
I mentioned above that I will give an example of a deductive theory wrongly interpreted in place of the ‘umbrella example’ above closer to home in the UAE. A reasonable conclusion inferred from a competitive market is that prices are proportionately low and that is significant competition on non-price variables as a result. However, the inverse is not necessarily true, i.e. low prices are not necessarily indicative of a competitive market.
There is a misconception that the UAE insurance market is a competitive one. An inverted modus ponens, if you like, based on the fact that pricing is relatively very aggressive. This, in turn, generates comments, such as by an AON Benfield broker (Amy Andrews Analysis in the MENA Insurance Review, December 2012) that the Emirates Insurance Association should perhaps be agreeing on the imposition of minimum premiums to combat this. Setting aside the fact that, coming from a broker, this sort of statement is tantamount to foot-in-mouth verbal diarrhea, such assertions are nothing more than wrongly inferred conclusions. In the same way that the sight of Filipinas with umbrellas in Dubai does not necessarily suggest that it is raining, so also aggressive pricing in insurance does not necessarily suggest that the market is a competitive one. The following are some live examples as to why the primary insurance market in UAE is not a competitive one.
Firstly, the profits made by the insurance companies that are in the black, are consistently more than one would term ‘normal profits’. Growth and profitability is again in double-digit percentages.
Secondly, there is a certain opacity or inconsistency with which premiums are booked or reported. For example, Oman Insurance Co did not previously declare BUPA premiums on their books on the basis that this was purely fronted business. Without going into the argument as to whether they should or should not have been doing this, there is a possibility of a ‘U’ turn in this practice in the end of year 2012 financials. If this happens it will probably not happen to right a technical wrong but to reduce top-line losses which in 2012 were in free-fall; potentially around the AED 0.5 billion mark. Similarly there are at least two regional ‘A’ rated insurance groups that are internally creating a reinsurance spiral (London LMX anyone? Does the topic still bring shivers down your spine?) because on the face of it higher overall top-line gets reported. One of these companies has also recently (December 2012) issued an internal memo with various cost cutting measures and inter-group executive merry-go-round implying that not all is hunky-dory after all! This lack of transparency is as consistent with the conduct of a company in competitive market as the constantly changing closing date for financials every December.
Thirdly, because of the nature of ownership of some of the larger insurance companies that dominate the market, there is also an element of price discrimination. This, again, is a practice that is generally conspicuous by its absence in competitive markets but is certainly present in the region. It is also generally the case that price discrimination happens more in different geographies and not in the same market as is the case in insurance within the GCC.
Whilst the primary market is not competitive, the reinsurance market is vicariously competitive through primary carriers. This explains why, for example, certain major international reinsurers have cut down on their capacity. For them capacity is capital employed on which they need to see a certain return based on their normal profits models. When this does not happen capacity generally moves to other markets or products which can generate this return for the respective reinsurer. This happens because mobility (or ease of market entry and/or exit) is generally high in competitive markets. This being said as some capacity exits the market, fresh capacity replaces it underlying the relative competitiveness that exists in the reinsurance market when compared to the primary market. The continuous availability of reinsurance capacity by providers that are mainly price takers (and not price makers) and who, on the facultative side are increasingly working on a ‘net basis’ strongly suggests a competitive market at reinsurance level. A cursory look at their annual accounts also suggests the same. However, competition stops at the door of the primary market within the region.
Educating or reversing the regional ‘herd’ mindset is essential in order to instil competition in the market. This is easier said than done in that this requires not only a change in thought but primarily a change in the old guard entrenched in their thought. Was it not Einstein who said, “Only a fool does the same thing over and over again expecting different results?”