Chapter 2
Causes: insurance market issues
2.1
The causes of the insurance crisis are generally
summarised as:
- international influences including the withdrawal of capacity and
the increasing cost of reinsurance following the destruction of New York’s
World Trade Centre in terrorist attacks on September 11, 2001;
- the ‘hardening’ of the insurance market as, after a period of
underpricing and poor profitability in the mid 1990s, insurers now focus on
improving profitability rather than merely increasing market share; and
- the increasing cost of claims.
2.2
This chapter considers the international and
domestic market influences, and some related matters: APRA’s new prudential
requirements and the effects of taxes on premiums. Chapters 3 and 4 consider
the increasing number and cost of claims.
Global influences
2.3
Many submissions mentioned global influences as
contributing to the present crisis—particularly the terrorist attacks on New York’s World Trade Centre on September 11, 2001. The global insurance cycle
was already hardening, but September 11 compounded the effect. Trowbridge
Consulting observed:
The direct insurance losses
(likely to be over $A100 billion), the recognition of a major new risk factor,
and greater caution throughout the business world have combined to further
reduce the willingness to write business and further increase premium rates.[1]
2.4
The effects in Australia arise largely from the impact on the cost of reinsurance. Overseas
reinsurers dominate the Australian reinsurance industry.[2] According to the Insurance
Council of Australia:
...the terrorist attack on
September 11 was the biggest insurance loss in history and, of course, it
resulted in reinsurers substantially increasing their rates to the insurance
market. The average increase on liability classes or the long tail classes was
probably somewhere between 30 and 50 per cent, which meant at least 10 to 15
per cent on top of premiums being charged to businesses and the public for
insurance cover.[3]
2.5
APRA’s summary was:
...it is increasingly
difficult post 11 September for direct insurers to obtain affordable
reinsurance in the contracting international market. Reinsurance rates
available to local insurers have recently risen on average by around 25%. Even before September 11, APRA statistics
showed reinsurance expenses increased by 59% over the three year period to June
2001. While capital inflow into
international reinsurance will over time moderate the rising costs, this will
likely take years rather than months.[4]
2.6
A qualitative survey of insurers by JPMorgan in
August 2001 found that insurers then predicted average public liability premium
increases of 18 per cent in the year to June 2002. An update to February 2002
found predictions of 32 per cent, suggesting that 14 percentage points of
increase could be attributed to the effects of September 11 and any other
market changes in the interim.[5]
2.7
On the other hand, Trowbridge suggests that
reinsurance costs are a relatively minor driver of public liability premiums:
During the upward cycle,
reinsurers have increased their rates by in the order of 25% although one
insurer has reported a significantly greater increase. However, reinsurance
programs for public liability are typically “excess of loss programs” and only
pick up the top end of large claims (say over $2 million–$5 million depending
upon insurers’ capital levels). As such, they account for less than 10% of the
direct insurers’ premium in this class and hence the reinsurance rate increase
has a marginal effect (25% of 10% or say 2–3%) on price for most insurers.[6]
2.8
JPMorgan’s assessment is:
...in the face of the large
pay-outs from September 11, insurers had the resolve to reprice premium rates
to an appropriate level. In our view, the industry’s resolve to improve its
risk/reward position has been the greatest driver of the increase in premium
rates.[7]
2.9
The global and domestic investment cycle is also
sometimes mentioned as contributing to the crisis. Insurers supplement their
income by investing premiums. Investment returns are lower now than they were
in the early 1990s. However Trowbridge suggests that this is not a significant
factor:
Most such funds obtained
from premiums are invested by insurers in low risk fixed income securities. The
average returns available on such investments have been between 5% and 5.5%
since mid-1997, having been in the range 6.5% to 8.5% in the first half of the
1990’s. This evidence indicates that changes in the rate of investment return
should not have been a factor in premium rate changes in the last three years.[8]
2.10
Australia makes up less than two per cent of the
world’s insurance market and cannot expect to be quarantined from global
changes.[9]
However, in the Committee’s view Australia can moderate their effects by
developing a stable domestic insurance market. The Committee now turns to the
domestic insurance market.
The hardening insurance market
2.11
The insurance business is by nature cyclical.[10]
During a ‘soft’ market capital flows into the market. Insurers compete on price
to gain market share, even at the expense of profitability. The competitive
pressure is more intense where customers can and do move quickly from one
insurer to another depending on price. This is the case with the commercial
classes of insurance, including public liability and professional indemnity.
2.12
In this highly competitive market, falling
prices may lead to an unsustainable level of unprofitability—which happened in
the case of public liability and professional indemnity insurance during the
mid to late 1990s.[11]
According to the Insurance Council of Australia, ‘Public liability insurance losses across the industry have been very
large...’
The APRA statistics show
that for the period 1998–2000 gross premiums were approximately $2.5 billion,
whilst claims, also gross incurred, were $3.5 billion. In addition, if you add
the expenses to the industry for public liability insurance, which was another
$600 million, it results in an underwriting loss of $1.6 billion for public
liability insurance over that three-year period...The professional indemnity side
has also been very unprofitable for a number of years.[12]
2.13
When the industry’s profits decline to such a
level of unsustainable unprofitability, capital is withdrawn from the market
and prices rise again.
2.14
Globally most classes of insurance have been
hardening over the last two years, but in Australia the position was
exacerbated by the collapse of HIH in March 2001. HIH, a major player in public
liability and professional indemnity insurance, had been a driver of price
competition, and removal of HIH allows remaining insurers more easily to
increase prices. However the market was hardening even before the collapse of
HIH.
2.15
The ‘long tail’ nature of liability insurance
exacerbates the cycle because it increases the risk of insurers under- or
over-estimating the premiums needed to reach a target profit level. The long
tail refers to the fact that (by contrast with most other types of insurance)
claims on liability insurance can be made many years after the premium is paid.
This is particularly so for personal injury claims. Insurers, in effect, must
sell their product some years before they know how much the product will
ultimately cost them. Today’s prices must make provision for future costs.
2.16
The problem is not new: predicting future costs
is a large part of the business of insurers. In large part, the accuracy of the
prediction depends on:
- the volume of similar business: a greater volume allows
more reliable prediction;[13]
and
- the trend in claim costs: a more stable trend allows more
reliable prediction.
2.17
Liability insurance, compared with other
classes, suffers on both counts. The pools of similar risks are often small
(enlarging the database to enable better calculation of risk is a major purpose
of the proposed industry-wide data sharing discussed in chapter 5). As well,
claim costs have increased in recent years faster than expected. According to
Insurance Australia Group, ‘with the benefit of hindsight, it is now clear that
a number of insurers seriously under-estimated the growth rate in claims costs
for much of the 1990s...’
...a policy written today is not priced on the basis of the
current cost of claims but on an estimate of claims costs when claims under
that policy will, on average, be paid out...Under-pricing (and potentially
over-pricing) occurs when these estimates prove to be seriously inaccurate.
With the benefit of hindsight, it is now clear that a number of
insurers seriously under-estimated the growth rate in claims costs for much of
the 1990s. The impact on profitability for some was masked, for a time, by
buoyant but unsustainable investment profits...Today’s premiums reflect the
market’s adjustment to that reality and some expectation that this trend will
continue to impact on claims going forward. [14]
2.18
The longer the tail, the harder it is to predict
future claim costs. The problem is worse where the size of claims, as well as
the number of claims, is less predictable. This is particularly the case for
personal injury claims, which vary enormously. For example, the Insurance
Council of Australia cited the following example:
One of our member companies
collected £300 for an insurance policy for workers compensation back in the
sixties. Asbestos is now a very real problem, and they have reserved 20 $1
million claims against that £300 premium. So long tail classes have some sting.[15]
2.19
To compensate for this extra risk, JPMorgan
suggests that to achieve a reasonable rate of return on capital the profit
margin on premiums would need to be 2–3% for short-tail classes and 5–8% on
long-tail classes.[16]
2.20
Mr P. McCarthy, in a paper quoted in
Trowbridge’s March 2002 report, suggested that the causes of underprovisioning
for future claims have been poor data and inadequate access to levels of
detail; limitations of actuarial models and
science; management pressure on actuaries; inadequate understanding of the
business by actuaries; an underlying environment that leads to increases in
personal injury claims; manipulation of case estimates by insurers; poor
corporate governance; and characteristics of public liability business,
especially the variety and the types of risks.[17]
2.21
Where supply of capital is tight and insurers
have become more risk-averse, as at present, the more unpredictable classes
will have most difficulty finding affordable insurance or, sometimes, any
insurance.
Today’s premiums....also reflect a
shortage of global capital, particularly since the events of 11 September 2001,
and a preference to allocate the available capital to under-write less
volatile, and therefore less risky, products.[18]
At
a time when your attitude to risk is maybe more averse, you tend to avoid those
areas where, 99 times out of 100 or 999 times of 1,000, you do not have a
problem, but the one problem you have will cost you $X million. You tend to go
for those where you have maybe a few more incidents but each one will cost you
less because you can predict them more.[19]
Unless there is
predictability in pricing and claims development then companies are not
particularly keen to play.[20]
2.22
As suggested from paragraph 1.58, the relative
unpredictability of claims in the public liability and professional indemnity
lines is probably a significant cause of the enormous variation in premium
increases which submissions reported.
2.23
The Insurance Australia Group suggested that ‘a
sustainable solution therefore requires a concerted effort by all stakeholders
to embed much greater certainty and stability to the underlying cost drivers of
long tail insurance classes.’[21]
Other issues
New
prudential standards
2.24
The new prudential standards for general
insurers are sometimes mentioned as a possible contributor to increased
premiums. The standards came into force on 1 July 2002. The minimum capital
requirement is increased from $2 million to $5 million. Above the $5m floor,
the capital requirement is risk based. Insurers writing liability lines need
more capital to meet the greater uncertainty they face—due to the potential
time lag between premium and claim—than insurers writing property business.[22]
2.25
The Insurance Council of Australia claimed that
the more rigorous standards ‘will increase the costs for insurers and that
increased cost could be reflected in premiums’.[23] The Law Council of Australia
suggested that ‘if the federal government
wanted to do something to attract insurers into the market then they could
relax the capital prudential requirements that have been imposed by APRA from 1
July...’
We are told that they are a
disincentive to new insurers coming into or back to the market and to insurers
writing more business.[24]
2.26
Trowbridge commented: ‘These changes are not a primary driver of the increase in public
liability rates, although they reinforce the more conservative attitude to risk
of insurers and a greater focus on profitability.’[25]
2.27
In general, though, the new standards were not a
major concern in evidence, and others who mentioned them approved them for
their primary purpose of improving the stability of the industry.[26]
2.28
APRA does not believe that the new prudential
requirements are a significant element in the insurance crisis:
It is true that companies
writing long-tail liability insurance are facing relatively higher regulatory
capital requirements (because of the greater uncertainty involved in this
business) than are companies writing predominantly short-tail property
insurance, and that some smaller companies are facing a risk-adjusted
capital requirement beyond their current resources. By and large, however, the
industry overall has sufficient capital to meet the new requirements. And in
particular, the major providers of these liability business classes are among
the largest (eight or so) insurance groups in the Australian market, and are
well placed to meet the new standards.[27]
2.29
The Committee expects that the new prudential
standards will affect premiums to some degree. However, it accepts the new
standards as a necessary precaution in strengthening the solvency of insurance
companies.
Taxes
and stamp duty
2.30
State stamp duty on public liability and
professional indemnity premiums varies among the states from 8 per cent to 11.5
per cent. Stamp duty is levied on the GST-inclusive premium.[28]
2.31
A number of submissions complained that the
increasing premiums have caused a windfall in stamp duty receipts for the
states and territories. Others complained about the ‘tax on tax’ effect of
levying stamp duty on the GST-inclusive premium.[29] Some suggested that the states
and territories should remit or discount stamp duty for a period as a
contribution to ameliorating the crisis.[30]
New South, Wales, Queensland, Tasmania and the Australian Capital Territory
have made concessions or plan to do so.[31]
Comment
2.32
Some submitters who wished to talk down the
extent of the present crisis have analysed the insurance cycle in this way:
‘Insurance buyers have had bargain prices for several years—they cannot expect
it to last forever.’ For example, APRA said:
Australian policyholders have been getting a free ride in the
form of unduly cheap premiums for a number of years and they now need to accept
that this was an aberration that may never recur.[32]
2.33
The Committee agrees that insurance companies
cannot be expected to continue offering unprofitable prices. However in the
Committee’s view such comments miss the point. The essence of the present
crisis is the way so many people have been harmed by the extreme volatility of
the insurance cycle. The community groups and small businesses who are the
chief victims are not sophisticated insurance buyers. It is unrealistic to
expect them to set aside funds during the good years to pay for the bad ones.
It is probably unrealistic to expect that they would even notice that the good
years were good. They are now being hit by huge increases which they are
ill-placed to cope with. Their problems rebound in the form of bad press for
insurers. The volatility of the cycle is bad for insurance buyers and bad for
the public credit of insurers. It should be in everyone’s interest to moderate
the effects of the cycle. Governments should take an active responsibility in
helping to do this.
Part II
High Premiums—causes and solutions
The recent increases in both public liability and professional
indemnity insurance have had and will continue to have a dramatic impact on
small business, community and sporting organisations, individuals and local
councils. While the increases in public liability and professional indemnity
insurance have affected the profitability of small business, they have also
resulted in many community and sporting organisations being forced to reduce
the level of services they provide or, in many cases, to cease operations
altogether, due to their inability to obtain any affordable, or sometimes any,
insurance cover.
This section of the report builds on the analysis contained
in Part I where the report looked at the global insurance industry and the
cyclical nature of the domestic market. Part II narrows the focus to analyse the
more specific and immediate causes of premium rises.
The two following chapters deal with;
- the rise in the number of claims and
- the increase in the amount of awards or settlements.
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