UK: Too Close to Call - The Future of the UK Motor Insurance Market

Weighing the evidence

Consolidation and a more predictable economic environment should mean a more stable market, but what will 2005 produce?

Our recent personal lines executive survey showed there is plenty to worry businesses as we head towards 2005. Concerns were expressed that companies are going for growth rather than profit and the industry thinks the so called UK compensation culture is a reality rather than a media myth. The impact of other factors such as reinsurance or the Courts Act could prove telling.

The market is certainly not giving clear signals about where it is going next – and our efforts to tease some clues from the figures merely proved how poised the market is: while gross operating ratios were in profit this year, net results showed a loss.

So don’t expect any bold predictions about next year – but not because we’re playing safe. The market is simply too close to call. It is possible, of course, that the cycle is not so much about to turn as coming to an end – and after analysing the industry data we ask whether the market has finally shaken out the factors that gave it such instability in the first place.

The jury is still out on that one too – but it’s not all ifs and buts. In 2005, one thing will be certain: if you want your business to outperform the market, the smallest decisions will make the difference.

2003 proved a good year for the motor market – with the Net Operating Ratio (NOR) being the third best year in the last 20. Total gross written premiums rose to over £13 billion, one year earlier than we had forecast.

The best performing businesses are those with a large market share and a NOR above the market average of 100.7%. For the 16th successive year Direct Line managed to achieve a better than market average performance with a claims ratio of 68% against the market average of 74% and a much lower expense ratio of 12% against the market’s 27%. Zurich’s 93.5% NOR was a 5 point improvement on 2002, while Royal & Sun Alliance (RSA) entered this quadrant with a 11% improvement in its NOR, over half of which was due to the reserve strengthening in 2002 not being repeated in 2003.

Only two of the big firms had a below average NOR. Norwich Union, which had the largest market share of any company, had a NOR 1% worse than average, while UK Insurance, which has grown significantly in the last year on the back of the Tesco’s business, had a NOR 6 points worse than average.

The best of the smaller companies are a mixed bag. There are the consistent performers such as Fortis, Provident and, in particular, MMA whose 14 years’ outperforming the market is beaten only by Direct Line. Then there are the ‘former pupils’ of Lloyd’s, Highway and Corinthian, making its home here after its brief relocation to Dublin; next the ‘prodigal sons’, Budget, Westminster and Sabre, making a welcome return to this sector. If nothing else, these companies show that you do not have to grow to survive in this market.

The Gross Operating Ratio (GOR) for the market in 2003 is estimated at 97.2% indicating it ceded just under four points of profitability by reinsurance. The biggest players use reinsurance extensively with Norwich Union ceding 50% of premium income, Direct Line 40% and RSA 20%. Interestingly, Norwich Union has a significantly better than average operating ratio on a gross basis.

The Lloyd’s market, analysed on the basis of the results for pure motor syndicates for the 2001 underwriting year, is dominated by Equity Red Star with around a third of that market and a better than average NOR. The other interesting development in the insurance market, Gibraltar, continues to attract business. Since being opened up to the UK in 1997, the number of companies authorised to write UK business has risen to 32, of which 13 are entitled to carry on motor business.

The biggest change in performance over the last year came from Churchill whose 37 point loss in profitability was down to a combination of reserve strengthening, expense increase and reinsurance. Axa lost volume and profitability while Zurich and RSA both gained profitability at the expense of market share. Norwich Union managed that difficult achievement of improving both profitability and market share.

On adding together the constituent parts of the various insurance groups, RBS Insurance proved to be the largest. 4 groups, RBS, Aviva, RSA and Zurich now control 64% of the company market. Of these 4 groups, RBS had a significant decrease in profitability over the last year while the other 3 improved their profitability.

Deciding which way the market is going is unusually hard this year. For example, our calculations show that, measuring GOR, the market made an underwriting profit – net results show a loss. 2003 may have been the third best year in 20 years but, as the varying fortunes of individual companies show, not everyone was making money.

Our industry benchmarks illustrate how finely balanced the market is. Our company market profitability benchmark shows a clear cycle over the past 20 years – this is paralleled by the performance of the Lloyd’s market. The company market 2003 result is so close to that of 2002, that the direction of the market is far from clear.

There has been close to a five point reduction in the amount of credit for investment return in the profitability benchmark, from 13% in 1997 to nearly 8% in 2003, and we think this could slip towards 6% over the next couple of years – unless interest rates rise.

Our reserve release benchmark (the amount of release or strengthening from FSA returns expressed as a percentage of the net earned premium of that year) has shown a cycle over the last 5 years; releasing in 2003, 2001 and 1999, and strengthening in 2002 and 2000. All movements, however, have only been plus or minus a single percentage point.

The amount of capital disclosed in the FSA returns has risen from just under £8 billion in 2002 to above £11 billion in 2003 – but the big question is: will this be needed to weather difficult times ahead?

We have based our call on profitability assuming premium inflation of 2% in 2004 and again in 2005, which is slightly higher that the 1.4% suggested by our market survey.

We have assumed that parts and labour cost inflation will remain a steady 3.5% and 3% respectively for this year and next with bodily injury at 7% – although this figure could be affected by a wide variety of issues including the Courts Act, the Ogden Tables and the Judicial Studies Board Guidelines. The impact of the government taskforce looking into the real or perceived UK compensation culture is also another obvious unknown.

The general opinion of the market seems to be that 2004 will be less profitable than 2003, but, as we have seen, it is a hard call. Deciding this, and the future direction of the cycle will therefore depend on the subtle impact of a number of influences, such as next year’s premium rate changes and the impact of reinsurance.

However, our prediction for the 2004 NOR made last year was 104% and, given our current assumptions, we are still sticking to this for 2004, and calling 106% for 2005.

In a position of such uncertainty it’s no wonder many in the motor insurance industry have been thinking to the longer term state of the cycle. Not just which way it will turn, but whether we are seeing its natural demise. There have been a lot of changes to the market, particularly as consolidation has seen the emergence of four dominant groups. The question many are asking is: are we now playing to different rules?

The economic landscape is certainly different – the Retail Price Index (RPI) inflation rate, that was high throughout the 1970s and which rose again towards the end of the 1980s, is now much lower and more stable. The level of risk free investment return is also much lower than in the 1970s and 1980s. Both influences should make for a much more stable and predictable market.

Many of the traditional causes for the cyclical nature of the motor insurance market, also seem to belong to the history of the industry rather than its current state. In the 1960s, for example, most rates were set according to a central tariff which, in those pre-computer days, depended on far fewer ratings factors. Although some companies did operate outside the tariff, most worked within it, so, while there was still a cycle, it was smaller and more predictable.

All that changed, however, in 1968, when one major player, Vehicle & General, broke the tariff significantly, precipitating a price war that led to major losses throughout the market. In the ensuing turbulence, Vehicle & General went out of business and while the market did not remain as volatile, its traditional stability was gone.

Increasing competition, and the difficulties of pricing against a background of high price inflation and investment returns, led to a long period of declining profitability from the mid-1970s to the mid-1980s. Then two additional issues put the market under even greater pressure: the introduction of broker quotation systems increased rate competition in the market, driving down profits; while major pricing errors in the late1980s and early 1990s led to big losses throughout the industry.

Then, when businesses tried to recover by raising rates and building their balance sheets, Direct Line came in and took market share on the back of a new distribution model. Another price war therefore broke out as many businesses sought to compete on the same terms, leading to the worst decline in operating ratios in the last 40 years. The situation was then compounded by legal decisions such as the Ogden judgement.

When looking at the past pressures on the market, and past errors of individual players, it is therefore possible to ask if they are still relevant today. Consolidation and a more predictable economic environment should mean a more stable market. Pricing has become more robust and risk controls have improved. This is not going to stop wild card behaviour, of course, but companies cutting rates are going to be more aware of the risks and better able to manage the possible consequences. Also the impact of the internet has not been fully exploited and that offers a lot of potential for cost savings or price cuts.

The market consolidation that we predicted some ten years ago has clearly arrived – and one of its effects could be the emergence of a market-level "tariff". With regulation and improving corporate governance we are not predicting great volatility in the near future – which is why we’re standing by our 104% call for 2004 with a slow decline to 106% in 2005.

There is, therefore, plenty of room for businesses to hone their performance over the coming year. And the main market players appear to agree – the executives in our survey said that the three biggest critical success factors were going to be pricing, distribution and cost-control.

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