1 The big picture: 2014 and beyond Property & casualty insurance industry Focus on the customer for growth kpmg.com
3 Contents An open letter to our readers 5 Put the customer first 9 More regulation; More uncertainty 15 Seize the momentum for growth 17 Climate risk 21 Investment in predictive analytics and modeling 25 Underwriting discipline 29 Sources of investment income 31 Cyber security 35 M&A: A combination of options 37 Demand a culture that accepts change 39 Getting going 41
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5 The big picture: 2014 and beyond 5 An open letter to our readers It s all about the customer. As obvious a statement as that is, few can deny that the customer didn t always make it to the top of the agenda during the past five or six years. And, just as obvious, it s the customer who, for a host of reasons, is now driving the business in a new direction. Granted, focus on the customer sometimes got short shrift in the early days of the postcrisis period because the property and casualty (P&C) industry was confronted with enormous and unexpected challenges. There was gross domestic product (GDP) retrenchment in the world s major economies. Historic monetary-policy decisions negatively affecting investment income and liquidity. A torrent of new regulation creating confusion and making costs balloon. So, now that we ve launched into 2014, we expect the months ahead to bring stability and growth to many in the industry due, in part, to rebounding economies in the United States and beyond, and the positive impact of rising interest rates on investment income. Looking back, it was the agile and resilient organizations that used the postcrisis period to step back and take stock that now are geared up to take advantage of the brightening fundamentals for growth. Those that dallied are playing catch-up. As many insurers are moving forward, they nevertheless recognize that complex work on a multitude of fronts lay ahead. Consequently, many questions remain for 2014 and beyond. Among the primary questions for all insurers are those dealing with how to manage the uncertainty that still surrounds numerous regulatory issues. The regulations bring added complexity to operations, while demanding new levels of transparency, better governance processes, and increased accountability. As a result, not only will insurers risk management processes and risk governance capabilities be put to the test, so too will their data quality and data accessibility capabilities. Pending regulations range from those affecting risk management processes, to federal oversight relating to certain policies, to solvency calculations, and many more. Outside of the regulatory realm, P&C organizations will be tested at a time of rising climate risk, an especially daunting issue given that one in four people in the United States lives in a county directly on U.S. shorelines, 1 where the value of the property has crossed the $10 trillion mark. 2 That data is especially compelling when it is positioned against the spike during the past decade of catastrophic natural disasters and the resulting loss of life and insured losses. With those facts in mind, next consider that the phase-out of federal subsidies for certain premiums under the National Flood Insurance Program (NFIP) already is underway, and that millions of private-home and business-property owners are facing a steep hike in premiums as lawmakers seek to bring premiums in line with true risk. Will property owners be able to afford the premiums without federal subsidies? If not, what will the impact be on local property values and regional economies? 1 National Coastal Population Report: Population Trends from 1970 to 2020, National Oceanic and Atmospheric Administration, U.S. Department of Commerce, March Insured Values of Coastal Properties Up to $10T, But Growing at Slower Pace, PropertyCasualty360.com, June 3, 2013.
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7 The big picture: 2014 and beyond 7 On a related front, when will more P&C insurers invest in predictive analytics and modeling tools, and where will insurers find the skilled people to build the tools and understand the implications produced by the information? While many of the largest P&C insurers are beginning to more widely use predictive analytics and modeling, there are many more insurers that have not yet made the investment. The work on these and other issues is just beginning: We take the view that the majority of insurers are in mile one in a marathon race rather than headed to the finish line. Those who are gaining ground realize that the work on key issues must be done with the customer in mind at all times. That job demands adoption of a new frame of mind regarding a commitment to change that is shared across the C-suite and throughout the organization. In offering this document, with our point of view on challenges and actions, we expect debate. After all, consensus is elusive when considering the industry s current key topics. Our team of professionals welcomes this opportunity to engage with you, and we hope you take the time to reach out to us with your feedback. We look forward to hearing from you. Laura Hay National Sector Leader Insurance
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9 The big picture: 2014 and beyond 9 Like so many buzzwords, when put the customer first is uttered in a discussion about sustainable growth and competitive advantage in the P&C business, it can be interpreted in a number of ways. Put the customer first We believe best-in-class insurers adopt a customer orientation that leverages four key attributes 3 : Constant focus on a strategy that keeps the long-term needs of their customers at the forefront Embracing a culture of efficiency that relies on the investment in scalable systems, processes, and delivery channels that resolves the legacy inefficiencies that have hamstrung growth efforts for the past decade or longer An agility that relies on a top-to-bottom organizational culture that embraces the idea of adapting swiftly to the rapidly changing environment surrounding the industry Emphasizing the importance of regaining trust among customers and regulators. If nothing else has been learned in the past several years, it is that customers are not shy about voicing expectations about how they want to learn about and purchase products and services. The expectations regarding insurance are being shaped in large measure by how these very same customers are interacting with other industries. The list of industries and businesses that have transformed just in the past few years through the creation and deployment of customized, consumer-friendly, easy-to-use technologies is long and getting longer. Think about how we rent movies, buy books, read newspapers, and buy music. Are we heading to big-box retailers to shop for TVs and computers, or are we only stopping by to pick up the merchandise after we shopped and compared prices online? Isn t the only question left unanswered: What s next? These same changes that reshaped so many other industries may be creating chaos inside the walls of some of our insurers, but we believe that from chaos comes opportunity. Making matters challenging for insurers, however, is that, although the industry has long-enjoyed a reputation for being very successful, it also has been characterized as being slow at embracing change. Now, with the industry having gone through some of the toughest tests in decades, we are seeing a real movement among leaders in the industry toward adopting a customer-first mentality. We would agree with those who say that this customer-first mentality is the only source of competitive advantage remaining 4 in the current business environment. We have no doubt that a strategy that has at its heart the belief that great customer experience will ultimately lead to greater efficiency and profitable business is the sensible path forward. 3 The Valued Insurer: Leading the Pursuit of Sustainable Growth, KPMG LLP, Customer Advocacy 2013: How U.S. Consumers Rate Their Financial Firms, Forrester, November 8, 2013.
10 10 The big picture: 2014 and beyond Mega-trends Two years ago, when KPMG International published The Intelligent Insurer, it described how powerful global mega-trends would shape the industry for the next 20 years. 5 In just the past two years those mega-trends demographics, the environment, technology, and social values and ethics are being understood and felt across the industry in a huge way. As more study is conducted about the mega-trends current and future impact, there is a growing realization about how insurers can understand them and harness their power in the quest to connect with consumers and grow the business. Demographics Several major U.S. demographic changes in the next several decades population size, length of life, as well as ethnic diversity of the U.S. population are having significant consequences for P&C carriers. Understanding the implications of this shift, and planning now to meet the needs of a new America in the next generation, is critical. While U.S. population growth currently is at its lowest rate in almost a century, a higher birthrate among an expanding immigrant population in the United States is expected to be a major driver of population growth in the years ahead. 6 The U.S. population is expected to grow by about 25 percent by 2060, compared to the population of about 317 million as of January 1, In that same period, the number of U.S. citizens age 65 and older is expected to more than double to about 92 million, 8 compared to the current number. Staying abreast of the population, age, and ethic trends in the United States will allow P&C insurers to align strategies and provide risk-management products that may not now be among the products offered. U.S. Census Bureau studies predict that the number of U.S. citizens of Hispanic or Latino descent will grow rapidly in the United States by the end of the current decade, and will account for about a third of the overall U.S. population midway through this century. Between 2000 and 2010, the growth rate of the Hispanic population in the United States was four times the growth rate of the overall population. 9 5 The Intelligent Insurer: Creating Value from Opportunities in a Changing World, KPMG International, Personal Lines Consumer Markets Annual, Conning, Inc., June 5, U.S. Census Bureau, U.S. and World Population Clock, January 1, U.S. Census Bureau news release, December 12, Personal Lines Consumer Markets Annual, Conning, Inc., June 5, Top 10 Trends in Insurance, 2013, Aite Group, January Insurers that create brand-awareness campaigns among expanding population segments, and build paths and products to serve them, will gain a strong position in the marketplace of the future. Environment With higher insured losses caused by the increasing incidence of natural catastrophes, the trend toward growing urbanization, and more use of natural resources that accompanies economic expansion, the issues of climate science and climate risk have taken center stage. Most of the costliest weather-related events from an insurance perspective have occurred in the past 20 years, and 7 of the 10 largest have occurred in the past nine years. 10 Regardless of where an insurer stands on the issue of man-made climate change, the bottom-line fact is that major storms, coupled with the growth of population centers, present a growing risk to P&C carriers and their policyholders.
11 The big picture: 2014 and beyond 11 With populations increasing in low coastal zones especially in densely populated cities the increased risk of higher personal and business losses has heightened the appetite among consumers and the business community to understand how environmental and climate change policies will affect them. 11 Insurance companies, which for generations have played an integral role in the development of safety policies related to other issues, are in a position to help shape measures being developed by lawmakers and policymakers with regard to climate policies. Technology It is difficult to understate the roles that technology and the digital revolution continue to play in terms of greater connectivity between consumer and insurer, the use of social media to understand and meet consumer needs, and in gaining access to an unparalleled wealth of information. The industry s Achilles heel in terms of technology, however, is its continued reliance on too many legacy systems. Much work already has begun to address the issue, although much more work is ahead. The patchwork of hardware and software created through bolt-on additions to existing systems and through the attempt at systems integration after a merger or acquisition continues to cause major problems in the industry. Disparate systems and processes are a key cause of mistakes, they exacerbate the problems associated with duplication of efforts (which aggravate customers), and they add significant costs and time. Until the legacy issue is fixed, there will be a continued drag on productivity and profitability. From an industry competitive standpoint, we believe the slow uptake of the deployment of digital technologies to connect with consumers presents one of the greatest threats to established insurers. Already we have seen new entrants, not encumbered by the legacy systems of their more-established competitors, steadily grabbing more pieces of the market by meeting customers new connection and distribution demands. Social values and ethics In survey after survey with consumers in recent years, financial services organizations rank extremely low with regard to trust. Rebuilding a reputation that has been damaged takes more than time. The reverberations due to the financial crisis of 2008 are still being felt, and insurers as well as other organizations in the financial services industry still have not fully recovered. Rebuilding a reputation requires unstinting focus on the consumer, top-of-class governance, and a strong culture throughout the organization to do things right at all times. 11 Yvo do Boer, Special Global Advisor on Climate Change and Sustainability, KPMG International, The Intelligent Insurer: Creating Value from Opportunities in a Changing World, KPMG International, 2012.
12 12 The big picture: 2014 and beyond P&C insurers have earned higher marks in recent years in response to major natural disasters, and social media will continue to play an important role in connecting with customers and in attempting to create a positive public opinion of the industry. Social media, however, is a dual-edged sword. Done well, social media programs can help build strong alliances; the penalty for breaching trust, however, almost always is immediate and severe. Successfully building trust creates value, an intangible that increasingly is being recognized on corporate balance sheets. 12 Shift in the balance of power There literally are tens of millions of people who, without hesitation and at any time of day or night, use their mobile phones, tablets, laptops, gaming devices, and desktop personal computers to search online for products, comparison shop, and hold conversations with friends and total strangers about the utility and value of the product or services. These same people make instant and important decisions and recommendations about whether to buy or disparage products and services. Insurance executives, for many reasons, still are playing catch-up, while other industries are on pace. Anyone who doubts that the balance of power is in the hands of the consumer hasn t been paying attention. 12 The Intelligent Insurer: Creating Value from Opportunities in a Changing World, KPMG International, Valued Insurer Pulse Survey, KPMG International, conducted at industry events, June The Valued Insurer: Leading the Pursuit of Sustainable Growth, KPMG LLP, The P&C industry is showing signs of reacting quicker to customer demands for better and speedier customer service, better multichannel options to settle claims, buy and receive products, and social media needs. We believe, however, many insurers still are grappling with getting a handle on the scale of the transformation required. And fewer still are successfully achieving it. Midway through 2013, when KPMG conducted numerous industry events with leading global insurance companies, we learned that only about one third believed they have an agile business structure adaptable to changing customer and market needs. 13 It is important to understand what is meant by customer orientation, since it is frequently touted by major organizations including the insurance industry, without giving it a tangible, lasting strategic focus. In order to establish a customer orientation, firms must overcome the frequent conflicts in corporate mind-set that emphasize short-term priorities and next-quarter shareholder value. Customer centricity takes significant time and investment to embed in an organization and reap a meaningful competitive advantage and return on investment. Here, we identify four strategic building blocks, supported by a number of tactical enablers, which define the components of a customer-centric business model. 14
13 The big picture: 2014 and beyond 13 Components of a customer-centric business model Better knowledge of customers Do you understand the needs of customers and develop propositions to match? Do you use predictive analytics and propensity modeling to target and cross-sell? Customercentric business model Relevant propositions at the right time Optimal distribution for each customer segment Are your propositions based on customer needs and do your customers reward you through greater loyalty, referrals, and retention? Can you comply with more consumer-focused regulation? Do you understand how customers want to buy and have you aligned your distribution strategy? Have you optimized the cost of acquiring your customers based on the value created by your propositions? Governance and People Optimal servicing for each customer segment In an environment where competition is becoming ever more intense, it will become increasingly important for personal and commercial line insurers to: Develop differentiated products targeted at particular market segments Focus on building loyalty to reduce customer churn and pressure on business volumes Enablers Do you understand how your customers want to be serviced and through which channels? Do you promote a positive customer experience at every touch point? Regulation and Capital Management Differentiate brands through enhanced customer service, and thus Deliver maximum value for customers.
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15 The big picture: 2014 and beyond 15 Although the P&C industry may be facing fewer regulatory pressures than other sectors in the financial services industry, such as banking, the numerous new and pending insurance regulations will demand even more of the industry s attention this year than in years past in order to remain in compliance in a cost-effective way. More regulation; More uncertainty The scope of regulation continues to broaden. Consider that insurers this year will, among many other regulations, need to focus on such diverse regulations as: Risk management and solvency initiatives, such as the Own Risk and Solvency Assessment and Solvency II for companies with European ties. The possible designation of being a U.S., or a global, systemically important financial institution (or a globally important systemic insurer) Automobile policy underwriting practices Reporting on investment activities Mortgage insurance practices Through it all, the bottom line is that, collectively, these regulatory imperatives that are on 2014 s agenda add complexity and cost to operations, and they add even more compliance and reporting risk to the industry. At the end of 2013, the U.S. Department of the Treasury s Federal Insurance Office (FIO) released its long-awaited report on ways to modernize and improve the current system of insurance regulation. The FIO, created by mandate of The Dodd-Frank Wall Street Reform and Consumer Protection Act, was to have issued its report on January 21, Twenty-three months late, the FIO report does not challenge the legitimacy of the state-based insurance system. It did, however, offer a roadmap for improvement of the current state-based system and concluded that a hybrid model of state and federal authorities would help create uniformity and efficiency, improve solvency, and address certain market-conduct issues. If nothing else, the FIO report adds to the environment of regulatory uncertainty that has enveloped the industry for the past several years. In response to the report, the Property Casualty Insurers Association of America issued a statement that there is no objective proof that there are critical gaps in state regulation or that it has failed to produce a beneficial market, adding that federal regulation is not necessarily a panacea modernization solution, particularly if it will be multilayered and duplicative. 15 Also remaining on the horizon are potential changes in accounting for insurance contracts. In February 2014, the Financial Accounting Standards Board (FASB) decided to change the direction of the insurance contracts project. For short duration contracts, the board specifically decided to focus its efforts on disclosures, without changing the current U.S. GAAP model for recognition and measurement. P&C insurers should continue to expect much higher demands from consumers, lawmakers, regulators, and other stakeholders around transparency and accountability, which puts a premium on enhancing existing governance processes and risk-management capabilities while requiring a redoubling of efforts related to bolstering data quality and data accessibility capabilities. Gaining an unambiguous understanding of the implication of these regulations has been a challenge for the industry, primarily because many have been subject to debate and modification virtually from the day they were proposed. Nevertheless, insurers must devote more attention to the implications of the pending regulations in preparation for when they finally are adopted. 15 PCI Reacts to FIO Report on Insurance Modernization and Regulation, InsuranceNewsNet.com. December 13, 2103.
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17 The big picture: 2014 and beyond 17 Seize the momentum for growth Earnings and premiums A glimpse ahead At the end of 2013, with the P&C industry in the United States having gone through a period of relative calm in terms of storm-related insured losses, and an improving combined ratio, a number of recognized P&C industry analysts were confident enough to (modestly) raise earnings-per-share (EPS) estimates into 2014 in some P&C lines. The recovery in net premiums written both in the select commercial and personal lines during 2013 was due primarily to an uptick in rates and a hardening of the market and some successes in operational efficiencies. At the same time, though, net investment income has been relatively flat for the past five years, and net yield on invested assets has been on a downward path since 2005, 16 which we expect will continue to present an ongoing challenge to the industry in the medium term. While the slight rise in long-term bond yields in the final quarter 2013 helped boost P&C insurers investment income, the uncertainty surrounding action by the U.S. Federal Reserve (Fed) remains a wild card. As 2014 gets underway, the Fed has provided little solid indications about the pace it expects to employ in tapering its bond-buying program of the past several years, which is designed to provide more liquidity to the credit markets and stimulate economic growth. Some economists have theorized that the Fed will reduce the buy-back program significantly in 2014, barring unforeseen circumstances. 17 Aside from worries about the ability to boost investment income, there continues to be concerns raised about the ability of some P&C insurers to withstand significant insured losses resulting from the increasing frequency of natural catastrophes. Some analysts in 2013 predicted that catastrophic losses could double every 10 years and outpace some insurers capacity buildup SNL Financial LC 17 Rosengren Says Fed Needs to be Patient in Removing Stimulus, Bloomberg.com, January 4, Insurance Industry Outlook, Zacks.com, September 17, 2013.
18 18 The big picture: 2014 and beyond Nevertheless, the resulting favorable underwriting results in some areas have produced predictions of continued improvement in return on equity (ROE) for the overall P&C now hovering at the 6.8 percent range up from 0.74 percent in 2008, but still below the P&C sector average of 9 percent since Generally, the positive rate momentum in commercial lines experienced through 2013 is expected to continue at least into the first half of 2014, although increases in rates in property lines may moderate in the medium term. Casualty lines also are generally expected to remain healthy into Direct auto writers, with lower expense structures, should continue to experience positive momentum, and the homeowner sector depending on geography may also remain on an 20, 21 upward tack. While the improvement in 2013 is impressive, and the prospects going into 2014 are moderately encouraging, now is not the time for taking a rest. Instead, the gradually strengthening position dictates that industry executives seize the momentum and accelerate investments in people, technologies, and processes that may have been given less-than-adequate attention earlier in the postcrisis period. U.S. unemployment rate U.S. Unemployment Rate U.S. Bureau of Labor Statistics Coupled with a moderately improving jobs picture in the United States, a relatively improving U.S. economy, a slow but steady increase in home building, increasing auto sales, and rising consumer sentiment, we expect opportunities for growth in insurance coverage in areas such as auto, workers compensation, cyber security, terrorism, excess and surplus, and homeowners. These industry improvements should encourage the industry focus on the soft skills and hard investments that can help put the consumer first and drive increases in market share and create new ways to deliver the critical messages that consumers need to understand if they are going to buy new products and services being developed by industry leaders. New residential construction 2,500 2,000 1,500 1, ,097 2,170 1,570 1, , New Residential Construction (October 30) in thousands (U.S. Census Bureau) 19 Annual Report on the Insurance Industry, Federal Insurance Office, U.S. Department of the Treasury, June 2013; SNL Financial LC. 20 US P&C Insurers Generated Strong Earnings in Q on Lower Cats and Expanded Underwriting Margins, Moody s Investors Service, November 15, Outlook: Prepare for a Soft Insurance Rate Landing, Keefe, Bruyette & Woods, December 10, 2013.
19 The big picture: 2014 and beyond 19 New car/light truck sales F 14F Sources: U.S. Department of Commerce; Blue Chip Economic Indicators (11/13 and 3/13); Insurance Information Institute U.S. GDP (seasonally adjusted/annual rate) Source: Bureau of Economic Analysis U.S. Department of Commerce, Jan. 13,
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21 The big picture: 2014 and beyond 21 At the moment, about 40 percent of the U.S. population lives in a county directly on a U.S. shoreline, and the value of property in those counties is estimated at $10 trillion. 22 Considering that some are predicting more population growth in coastal regions and that sea levels will rise in the decades ahead along with predictions of more intense storms in the future the issue of climate risk is a front-and-center topic in the P&C industry. About 4 million people live within just a few feet of high tide marks, 23 with more expected in the years ahead. Climate risk These facts demand tougher decisions by P&C insurers regarding underwriting policies and processes in high-risk areas. In addition, more study is needed on new ways of pricing insurable exposures, management of claims made as a result of the climate-change era, and the role that the industry should play in disaster-preparedness of carriers and policyholders in the high-risk regions. 24 Those same facts also are at the center of the current effort to radically alter the National Flood Insurance Program (NFIP), run by the Federal Emergency Management Agency (FEMA). The Flood Insurance Reform Act of 2012 (also known as the Biggert-Waters Flood Insurance Reform Act) was passed by Congress to keep NFIP afloat after the program was forced to borrow $18 billion from the U.S. Treasury in the wake of Hurricane Katrina. The NFIP was swamped again following Super Storm Sandy, and needed to borrow another $7 billion to cover losses due to that storm. Since the 1970s, the federal government has acted as the insurer of last resort for many property owners in flood-prone areas through NFIP. Premiums charged for flood insurance in many cases are about 40 percent of the full market cost of insurance, with taxpayers subsidizing the rest. 25 The reform efforts center on eliminating the subsidies and forcing property owners in the high-risk areas to pay premiums that reflect the actuarial value of the risk involved. The phase-out of the subsidies is underway, and premiums for many affected property owners are rising, in some cases more than tripling in a very short period of time. Not surprisingly, there are now efforts in Congress and on the states level to delay the phasing out of the subsidies until an affordable alternative can be created. Critics, however, charge that the subsidies provide incentives for homeowners to continue to live in areas that are likely to be hit by storms and floods, knowing that the cost of rebuilding will be effectively 26 paid by taxpayers. The insured value of all coastal property in the United States has grown significantly during the past decade up almost 50 percent since Indications are that, as the growth of the U.S. economies increases, the annual growth rate in the insured value (and the associated replacement costs of the properties) will increase as well. By committing to participate in the debate to adopt comprehensive, long-term climate-risk strategy, insurers can make better decisions on pricing and how to write policies where the demand will be needed. In forum after forum, whether they are before government officials or at industry meetings, the debate about climate change often gets short shrift, primarily because some in the industry see other issues as posing moreimmediate concerns and that the climate issue is something that can be addressed in the distant future. 22 National Coastal Population Report: Population Trends from 1970 to 2020, National Oceanic and Atmospheric Administration, U.S. Department of Commerce, March Outsmarting the Surge, Time, Nov. 12, Aite Impact Note, January Aite Impact Note, January Congress Recesses Without Acting on Flood Insurance, Asbury Park Press, December 23, The Costs of Climate Change and Extreme Weather Are Passing the High-Water Mark, Time magazine, July, 17, The Coastline at Risk: 2013 Update to the Estimated Insured Value of U.S. Coastal Properties, AIR Worldwide Corp., 2013.
22 22 The big picture: 2014 and beyond Twelve of the most expensive cat events in U.S. history have occurred during the past decade $ $45 $40 $35 $30 $25 $20 $15 $10 $5 $ Irene (2011) Jeanne (2004) Frances (2004) Rita (2005) Tornadoes- Storms (2011) Tornadoes- Storms (2011) Hugo (1989) Ivan (2004) Charley (2004) Wilma (2005) Source: PCS; Insurance Information Institute inflation adjustments to 2012 dollars using the CPI By working collectively as an industry, and together with government, insurers might be able to avoid the very real possibility that climate change could make some risks uninsurable because addressing them was put off for too long. The idea of bankruptcy of some insurers is not far-fetched. With sensible planning and effective lobbying by the insurance industry, preventative measures can be put in place to protect the communities while taking the burden off of taxpayers. But, the industry must act in a concerted effort to initiate the change. Ike (2008) Sandy (2012) Northridge (1994) 9/11 Attack (2001) Andrew (1992) Katrina (2005)
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25 The big picture: 2014 and beyond 25 P&C business lines, including personal auto, homeowners, commercial auto, and commercial property, are stepping up their leverage of predictive analytics and modeling tools to help drive profitability, reduce risk, grow revenue, and improve efficiency, a recent survey indicates. 28 While predictive analytics and modeling are used by nearly all companies that write $1 billion or more in gross written premiums, many other insurers are not. Predictive modeling primarily is used for loss-cost modeling and underwriting, and analytics is being used in fraud investigating, claims forecasting, marketing, and reserving. 29 Investment in predictive analytics and modeling Use of predictive analytics by line of business 50% 49% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 37% 32% Source: Earnix/ISO September 2013 Survey 30% 25% 9% 5% Personal Auto Home Owners Commercial Auto Commercial Property Business Owners Workers Compensation General Liability The volume, velocity, and variety of data pouring into insurance organizations place enormous emphasis on the assurance that the data is reliable. Further, insurers must make certain that the organization has an outstanding data management environment to ensure quality and security. Sophisticated judgment and effective investment can deliver fundamental and lasting benefits to the most advanced companies. In fact, we believe that without strong technical and human capital capabilities to collate and synthesize the massive amounts of data available, insurers will find themselves, at a minimum, potentially missing an opportunity and, at worst, at a serious competitive disadvantage in the very near future. Sustainability and profitability depend on identifying the specific characteristics of policyholders that contribute to differential loss potentials as well as developing lasting and deep relationships with clients. Modeling and analysis of customer data are, therefore, fundamental to a successful business model. 28 Majority of North American Insurance Companies use Predictive Analytics to Enhance Business Performance, New Earnix/ ISO Survey Shows, Business Wire, November 4, Use of Predictive Models Widespread in P/C Insurance: Survey, Insurance Journal, November 7, 2013.
26 26 The big picture: 2014 and beyond Data and analysis Deployed hand-in-hand with more powerful computer hardware, new software applications allow companies to routinely undertake analyses that would have been prohibitively time-consuming or expensive only a few years ago. Hard figures costs, claims, dates, times, and other customer details can be trawled automatically to extract significant correlations that can yield valuable insights into core business parameters. In addition, dramatic developments in the analysis of unstructured data, or text mining, can allow large volumes of text-based material held in-house to be scanned to extract potentially significant information. Furthermore, publicly available material can complement existing consumer behavior data. Internet technology and social media now allow customers and potential customers to chronicle their lifestyles and consumer experiences online. Many people also use social media networks to evaluate products, services, and providers. It is well known that certain key life events, such as buying a house, having a baby, or retiring, are associated with insurance purchases. Increasing numbers of analysts and modelers are experienced in the necessary actuarial and statistical analysis. Identifying these key life events can make targeted marketing much more effective. Benefit to customers The benefits of advanced data analysis and prediction do not all flow one way. Many aspects that create advantages for the company also improve the customer experience: Streamlined, automated settlement processes for uncontroversial claims with fewer queries, interventions, and delays, leading to faster, hassle-free settlement Policies (terms, exceptions, excesses) tailored to individual circumstances Premiums more closely related to actual risk, resulting in benefits to lower-risk customers Faster, more personalized service at every stage of customer interaction. Investment Developing these new analytical capabilities should not be undertaken lightly. Typically, significant investment is needed in hardware, software, collecting, collating and verifying data, in data cleansing, and the development of data warehouses. Embedding data analytics in the heart of the operating model as a routine and continuing dimension of management decision making can require major change. However, many companies will already have a number of key components in terms of hardware and capacity to host the infrastructure and existing analytical tools. As is often the case, when the topic turns to investment, it almost invariably is centered on hardware, software, and data capabilities. While vital, we believe that the industry also is facing a talent shortage, and investment in human capital must rise higher on the agenda. Finding the right people with the right skills, especially high-grade talent with background in investment and risk, is one of the industry s more important unmet challenges. With investment returns a major worry, insurance industry boards and senior management will need to target individuals with specific expertise in asset management in a variety of asset classes. And with increased regulatory scrutiny now part of business as usual in every insurance organization, professionals with deep quantitative and analytical skills are needed. Investments made in people, processes, and technology can have high returns. However, all insurance businesses are different in terms of their business model, risk appetite, target customer segments, and product profile. The challenge is to relate the investment to the return in a transparent way in order to evaluate the relevance and significance of modeling outputs. This is especially challenging in view of the very long lead times in the insurance business model. Securing corporate support at the senior executive level for business investments based on data analysis depends on getting buy-in to its relevance and significance in this way.
27 The big picture: 2014 and beyond 27
28 28 The big picture: 2014 and beyond
29 The big picture: 2014 and beyond 29 As inviting as it is in a well-capitalized P&C market to chase volume through lower prices, underwriting discipline the anchor of profitability remains one of the most important pillars to support the nascent rebound in the P&C marketplace. Underwriting discipline Forward-thinking insurers will focus on underwriting discipline and avoid the lure of chasing volume through underpricing because of the long-term risk that strategy creates. They are taking into account better information produced from much more sophisticated predictive models relating to possible impact of climate changes, the potential for a prolonged period of reduced yields due to low interest rates, and the demands placed on them by regulators and ratings agencies. At a KPMG insurance conference, Eric Smith, chief executive officer and president of Swiss Re, offered this viewpoint on underwriting discipline: The seduction of volume entices us all: sell anything, underwrite everything, he said. But like man on bread, underwriters cannot live on volume alone. Quantity without regard to quality will lead to crisis. Smith issued a strong warning of the consequences of undisciplined underwriting: Like most temptations, giving in to this one is ultimately an act of laziness, not resilience. Recklessness is not an adaptation, Smith said. It s a dodge. This is a moment for old-fashioned underwriting discipline, not in spite of the environment but because of it 30 In one of his annual letters to shareholders (2011), Warren Buffett underscored the notion, saying the prudent operation of an insurance business requires four disciplines: (1) An understanding of all exposures that might cause a policy to incur losses; (2) A conservative evaluation of the likelihood of any exposure actually causing a loss and the probable cost if it does; (3) The setting of a premium that will deliver a profit, on average, after both prospective loss costs and operating expenses are covered; and (4) The willingness to walk away if the appropriate premium can t be obtained. He noted that while many insurers pass the first three tests and flunk the fourth. The urgings of Wall Street, pressures from the agency force and brokers, or simply a refusal by (some CEOs) to accept shrinking volumes has led too many insurers to write business at inadequate prices. The other guy is doing it so we must as well spells trouble in any business, but none more so than insurance. A study that evaluated the connection of ROE over 15 years with underwriting performance, investment margins, and premium surplus found a high correlation of underwriting discipline with ROE, while there was little correction of ROE with investment margins and surplus. 31 It is widely accepted in today s volatile marketplace with a new breed of consumer demands that a P&C insurer cannot earn its cost of capital over the long term through investment performance alone. Return on equity (P&C) Eric Smith, CEO/President, Swiss Re Americas, 2012 KPMG Annual Insurance Industry Conference. 31 Managing Through the P&C Cycle, McKinsey & Co., Return on Equity/P&C Source: SNL Financial, December, 2013
30 30 The big picture: 2014 and beyond
31 The big picture: 2014 and beyond 31 Concurrent with efforts to boost income through new sources of premiums, and with yields on many traditional investments to be at relatively low levels, we look for P&C insurers in 2014 to consider seeking creative yet prudent strategies to boost yield by investing more heavily in some alternative investment classes. Sources of investment income While the accompanying chart graphically illustrates the reality confronting the P&C industry, it also underscores the idea that the industry must maintain rigorous focus on investment risk-management practices. P&C sector annual net investment income/net yield on invested assets Source: SNL Financial Net Investment Income ($B) Net Yield % Despite the slight uptick in late 2013 in long-term bond yields and the accompanying boost in investment income, recent announcements from the Fed indicate that relatively low interest rates are likely at least through P&C insurers therefore cannot rely as heavily as in the past on investing primarily in the traditional array of highly rated bonds. P&C insurers are now or are actively considering diversifying their investment portfolio allocation with a higher percentage of such alternatives as hedge funds, emergingmarket bonds, real estate funds, and hard real estate assets among other investments that might have been deemed too risky in another era. Such alternatives are especially tempting as older bonds mature and the industry is leery of replacing them with bonds offering lower yields. As straightforward as it is to suggest such alternatives, there are legitimate questions about the challenges they present. Because the movement from more traditional fixed income investments to alternative investments will increase risk-based capital (RBC) requirements, boards and senior management should consider a variety of questions in making the decision. For example: Will the return on RBC requirements be greater? If the company measures capital performance using metrics other than RBC for example, economic capital will the return on economic capital be greater? Is the alternative investment within market risk tolerances, including allowable asset class, concentration risk to asset class, industry, or geography? If not, should tolerances be adjusted to accommodate the change? is through the 3rdQ
32 32 The big picture: 2014 and beyond In a 2013 report issued by State Street Corporation, in conjunction with The Economist Intelligence Unit, one in four insurers admitted their business had trouble hiring knowledgeable, qualified staff in the field of asset allocation. 32 For some, outsourcing the investment management function will be an answer, although with increasing demands by regulators for transparency, moving the investment function outside the organization could elevate risk. Expect regulators to heighten their scrutiny of alternative investment strategies in order to protect policyholders. While hedge funds can offer higher returns than U.S. Treasuries, many insurers other than the largest have avoided investing in them. However, with the specter of prolonged low rates and the steady decline in the P&C industry s net yield on invested assets, hedge funds may become attractive in 2014 for a broader swath of insurers. The risks raised by investing in alternative classes of assets also point to the need to leverage data analytics to manage the associated risks. As it is with many aspects of the P&C insurance industry, the difficult investment environment demands detailed focus on innovation. Questions remain, however, about the level of preparedness among the majority of P&C insurers to meet this challenge. 32 Facing the Future: Blueprint for Growth, State Street Corporation, 2013.
33 The big picture: 2014 and beyond 33
34 34 The big picture: 2014 and beyond
35 The big picture: 2014 and beyond 35 The risks and opportunities associated with cyber security at insurers are significant. The average operational cost of a data breach in the United States is approximately $5 million. 33 But, the monetary impact is one element of the fallout. There are issues associated with lost productivity, damage to the organization s reputation, and the very real possibility that the customer will walk away from the company. 34 Cyber security In a customer-sensitive business such as insurance, the potential impact is significant, especially in light of the increasing number of recent incidents where insurers have experienced data breaches. With the ubiquity of electronic content inside insurers computer systems and the incidence of hacking increasing, there is considerable pressure to review protection protocols against data breaches. In New York State, for example, Gov. Andrew Cuomo in 2013 issued so-called 308 letters to 31 of the state s largest insurance companies asking what steps they are taking to keep data safe from cyber threats as part of the governor s effort to protect critical infrastructure and information systems. The letters, so named after a section of the New York Insurance Law, sought information on: The cyber safeguards in place at the insurance companies The companies IT management policies The amount of funds and other resources the companies dedicate to cyber-security The companies governance and internal control policies related to cyber-security. Since these same questions surely apply to more than 31 insurers, we would suggest boards and senior management use this set of questions in examining their own operations. Further, we expect such emphasis on controls to increase in the future, and we advocate that insurers routinely test protection protocols. Conversely, with the number of cyber breaches at businesses around the world skyrocketing, and the costs associated with them growing larger, the double-digit pace of growth in sales of cyber insurance policies is expected to continue. Percent increase in purchase of cyber insurance % 70% 60% 50% 40% 30% 20% 10% 0% 27.70% All Other 20.20% 21.60% 22.90% Health Care Communications,... Retail/Wholesale 32.20% Financial Institutions Source: Marsh Global Analytics, Marsh Risk Management Research Briefing, Insurance Information Institute, March 2013 Findings from a study by Ponemon Institute, a data privacy and cybersecurity research firm, among corporate risk-management professionals released in late 2013 indicate that only about a third of the respondents said their business had cyber risk insurance coverage. But, nearly 4 in 10 indicated their business planned to purchase a policy in the future. Though final statistics for 2013 are not yet tabulated, the expectation is that the final tally will show nearly 600 computer network breaches at U.S. companies, government agencies, and other institutions, according to the Identity Theft Resource Center Cyberinsurance Picks Up Steam, Study Finds, The Wall Street Journal, August 7, Customers Take Their Business Elsewhere After a Data Breach, Infosecurity Magazine.com, October 22, Data Breaches on the Rise, Wall Street Journal CFO Journal, August 13, % Education 75.50% Services 33.30% All Industries