If you believe everything you read, we live in unprofitable times. Ten years ago, all except one of Lloyd’s eight classes of business were in the black. Now they’re all unprofitable, without exception. Given that we are an industry that seeks to base its decisions on decades or even centuries of data, it could be difficult for an outsider to decipher the cause of this shift.
The drivers of industry profitability are fairly clear and mostly stable. Roughly 50% of industry premiums go towards paying smaller, attritional claims and 10% to large natural or man-made catastrophes. Acquisition costs consume around 30%, and insurers’ internal operating expenses account for about 10%. A small investment return delivers a modest industry profit, which probably doesn’t return the current cost of capital.
While insurance is unusual in that ultimate claims costs are unknown at the point of sale, only one of these five main drivers of profitability is inherently unpredictable in any single year, the amount of large losses. Attritional claim ratios are relatively stable, acquisition costs and operating expenses are under the control of the insurer, and investment returns, if not controllable, are at least known and predictable.
Rising costs are largely within insurers’ control
The claims loss ratio shows no increasing trend over time, although individual years may be heavily impacted by catastrophe losses. The deteriorating trend in industry profitability is instead arising from those drivers that are under insurers’ control or are known. Using Lloyd’s market data to compare the average of the last three years of account to a similar period ten years ago shows that acquisition costs have risen by five percentage points, internal operating costs by three points, while investment returns have reduced by three points.
Acquisition costs have traditionally been high because there are many mouths to feed in the placement process. A small firm’s property insurance may pass through a local agent, an MGA, a wholesale broker, and a reinsurance broker before it ends up on the books of a reinsurer. Each of these entities takes a chunk of commission.
Increased regulatory oversight has added to the industry’s cost base. In Europe, the cost of introducing Solvency II is estimated at 1% of industry premiums. Ongoing costs are smaller, but still sizable. A recent survey found that 90% of industry professionals believe that the introduction of IFRS17 in 2022 will cost more to implement than Solvency II.
The quest to be lean
The pace of modernisation in the market is slow. This theme is not new, but inefficient processes and the enormous task of getting all the players in a global market to face in the same direction, given their various systems, bespoke products, and different roles in the value chain, is unsurprisingly taking time. Solving the profitability problem is therefore extremely challenging. The obvious place to start is to reduce the amount of expense, particularly acquisition costs. That is easier said than done, but it is essential.
A consultant who had worked on Google’s driverless cars project told a recent conference that he was amazed to learn that the insurance industry’s expense ratio is 40%. His declared: “People are sitting in California right now who will be looking to come into the insurance industry and turn it on its head by using technology to slash costs. You won’t have heard of them, but they will be there.”
They are already here. Successful, innovative companies, with expertise in other heavily intermediated sectors, have entered the insurance broking sector with the stated aim of using technology to disrupt and transform the sector.
Our industry relies on data to make decisions, but we do not use the intelligence that data provides as well as we could. All too often, risk data which may be detailed and exhaustive at the point of initial application is passed down the chain using inefficient technology. It loses granularity at every stage. Trading in some parts of the world is still carried out face to face by brokers carrying bundles of paper around their market.
A generation ago stock markets operated in a similar way. Business was carried out face to face. Deals were written out on paper, and settlement was many days forward. Because of this inefficiency, trading costs were high. Now stock market deals are done electronically, in real-time, at a small fixed cost. The insurance industry has yet to make that leap.
Most large or sophisticated insurers have an army of actuaries, catastrophe modellers, and risk analysts to support the underwriting process, maybe ten times more today than 25 years ago. They have undoubtedly done a great job of better matching risk to price, and improving insurers’ understanding of risk exposures. While underwriters have undoubtedly become more technical over the years, the number of underwriter/actuaries is still very small.
Technology to drive down expense ratio
The intermediary’s job is to link risk with capital. That makes it likely that we will see brokers using technology to create platforms that shorten the chain between insureds and ultimate risk carriers. If brokers can efficiently transfer risk to the market, together with all the granular data and analysis that sits behind it, then several links could be removed from the cost chain. That would result in considerable savings.
Advanced capital providers such as ILS funds are already embracing this possibility and working with visionary brokers. For some standardised products, insurance companies already have online tools to sell directly to their clients. And as connectivity improves, insureds will be able to buy online, even for big risks. It will become common to trade catastrophe risk this way, and to be able to buy hurricane insurance in real time as a storm approaches.
Technology will also help drive down the industry’s expense ratio by expanding the global premium base and by reducing claims costs. New parametric products, such as flight delay, are already being sold via mobile phone apps. Artificial Intelligence is allowing products to be sold using chat-bots. Drones are providing a real-time view of damage that allows claims to be assessed and settled quickly. The Internet of Things enables industrial boilers to monitor their own performance and send performance data back to HQ, which reduces the risk of explosive claims.
Brokers need to create added value
With this change in how products are developed and sold, the role of the broker is evolving. A recent survey by PwC found that less than half of insureds now find value in the placement process. Instead, the valuable broker is likely to focus on innovation in technology, and on finding solutions for large uninsured risks. In recent U.S. catastrophe events, two thirds of economic losses were uninsured. AIRMIC, the UK risk management association, recently reported that risk managers believe 90% of their risks are not addressed. Cyber risk is potentially huge, but industry capacity is limited.
Ultimately, the brokers that manage to maximise the intelligence held data, exploit the edge that innovative technology provides, and harness the intellectual capital of their people to create innovative solutions for clients will emerge as the winners in the race to proceed, and will help to return the industry to a new era of profitability. A
Mr Jonathan Tilman is group chief actuary for Ed Broking.