Australia's rated insurers are well-placed to contend with current challenges relating to high natural peril claims costs, pricing and earnings weakness in some product lines, the emergence of market disruptors, and a sustained period of low investment yields, says S&P Global Ratings.
The trend for S&P's ratings on Australian P&C insurers is stable, supported by prospective strong overall earnings and capital adequacy, the rating agency says.
S&P anticipates Australia's P&C insurers will continue to generate robust earnings and, for the rated entities, a weighted ROE of about 14% in both 2017 and 2018. It also expects an annual average growth in industry gross written premiums of about 3% for both these years, slightly stronger than prior years recognising the rate hardening for particular lines. The sector's operating performance has benefited from sound underwriting practices involving significant rate increases for select lines, and comprehensive property catastrophe cover.
In the half year to 30 June 2017, the industry's ROE was steady compared with the 2016 calendar return as underlying operating performance benefited from net earned premium (NEP) growth and improved investment income but moderated by higher peril claims. S&P expects calendar 2017 returns to strengthen reflecting further rate hardening and, to a lesser extent, continued modest reserve releases, while the impact of perils will be moderated by comprehensive reinsurance protection. In the half year to 30 June 2017, the P&C industry logged 2.4% annualised direct gross earned premium (GEP) growth, which is trending toward S&P's expectation of 3% for the year. Premium growth forecasts recognise some benefits of the turning pricing cycle during 2016, in particular commercial lines of property, compulsory third-party (CTP), and motor vehicle.
Nevertheless, S&P believes margins remain poor on the back book for CTP in New South Wales (NSW), which is yet to fully reprice, and in some commercial lines such as commercial motor vehicle and commercial property. Premium growth will also benefit from rate increases effective 30 June 2017, particularly those exposed to commercial lines. S&P expects the insurers to manage margins through additional rate increases, enhanced underwriting, and, in the case of NSW CTP, the pending legislative reform.
Over recent years, insurer earnings have materially benefited from prior year reserve releases, mainly for some long tail lines, such as CTP. Over time, as insurers adjust their pricing and reserving assumptions for improved experience, S&P expects these releases will moderate to less than 3% of NEP and trend toward about 1.0%-1.5%. There are also some other portfolio specific challenges, in terms of earnings, such as elevated claims inflation from domestic motor vehicle insurance.
Overall, S&P expects insurer capital adequacy and liquidity positions to remain strong. Capital returns to shareholders over the coming year are largely expected to be limited to current year cash earnings. S&P also anticipates insurers will continue to benefit from access to sizeable reinsurance protection that has, in some cases, been reinstated on relatively favorable terms.
Catastrophes on the rise but reinsurance remains robust
The rating agency anticipates that insurers with more conservative settings for their natural peril budgets and reinsurance programmes will continue to deliver stronger resilience of earnings. Claims arising from natural peril events have been steadily increasing year on year, given the higher frequency of medium-sized events and growing population density in affected areas. For example, results in 1Q2017 reflected significant peril events such as tropical cyclone Debbie, the impact of the Kaikoura earthquake, and a Sydney hailstorm such that the loss ratio increased to 81% for the quarter, up from 64% for the year to 31 December 2016. The benefits of robust reinsurance arrangements can be seen in the net claims outcome in the first half of 2017. During this period, GWP growth was overshadowed by a 7.9% annualised increase in claims primarily due to material peril claims, which were about A$3.5 billion (US$2.8 billion) higher than the prior corresponding period (pcp).
With the mitigating impact of catastrophe and large risk coverage being utilised, the net combined operating ratio for the half year was a respectable 92%.
Adapting to a low-yield paradigm
Australian P&C insurers' exposure to investment risk is relatively low and they typically manage credit risk and the asset and liability mismatch well. The impact of the low interest-rate environment is apparent from the steady downtrend in interest income earned while the trend in aggregate P&C investment income has been driven by the volatility of unrealised market-to-market movements over the past few years. Insurers have adapted to the low investment yield environment without being tempted to chase yield or materially increase the risk profile of their investment portfolios.
Investments remain predominantly focused on cash and high quality fixed interest securities, with only marginal shifts to higher risk assets to improve yields, and some targeting more niche asset classes. More recently, there has been an increased appetite for infrastructure securities and direct loans and advances, albeit off a low base.
Asset and liability cash flows are also relatively closely matched by duration for insurers that S&P rates, which is a reflection of their sophisticated risk management capabilities. While there remains some concentration in asset exposures to securities issued by major Australian financial institutions and the Australian government these entities maintain very strong credit ratings.
The threat of disruption looms for the industry but thus far new entrants and distribution platforms have had minimal impact. While there has been some bundling of products, typically the disparate nature of P&C products provides an easier avenue for challengers to target products offering higher returns--particularly in personal lines.
Many insurers are actively responding to the evolving competitive threats by engaging with external disruptors, building incubation labs, testing alternative distribution avenues, exploring new risk management products, amongst other activities.
Disruption could result in a shrinking pool of insurable risks and material loss of market share for the direct insurers, in our view. However, if managed well, there are some potential positive aspects to disruption, including cost savings, revenue opportunities through enhanced segmentation of risk and better customer experience; and therefore better retention outcomes.
S&P expects it will be difficult for disruptors to gain material market share from larger players, particularly where specialist product and pricing knowledge is required, there are broad and well established distribution networks and high quality policy administration and claims systems and processes.