2014 J.P. Morgan Taylor Fry General Insurance Barometer

Transcription

1 2014 J.P. Morgan Taylor Fry General Insurance Barometer Direct Underwriters, Reinsurers and Brokers Insurance Siddharth Parameswaran AC (61-2) Alvin Liu (61-2) J.P. Morgan Securities Australia Limited Taylor Fry Kevin Gomes (61-2) Sharanjit Paddam (61-2) Joshua Jaroudy (61-2) This is the result of a joint research effort between J.P. Morgan and Taylor Fry. See page 185 for analyst certification and important disclosures, including non-us analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.

2 Table of Contents Survey Description...3 Executive Summary...4 Macro backdrop for Australian insurers...6 What history / the survey say about growth The Impact of Technology on Insurance The Political Impact of Climate Change on Insurers Alternative Capital Survey Participants

3 Survey Description This is the third edition of The Barometer, a joint effort between J.P. Morgan and Taylor Fry. The publication continues from 19 editions of the J.P. Morgan Deloitte General Insurance Survey, the last of which was published in 2012, for the year to 2011, with the first edition of the Barometer published the following year. The 2014 J.P. Morgan Taylor Fry General Insurance Barometer provides a detailed overview of the current state of the Australian general insurance industry and the industry s expectations. The report conveys analyses on the key elements of the industry from the perspective of direct underwriters, reinsurers and brokers, including: detailed product information for the current period and industry expectations for the next two years, covering issues such as premium rate trends, capacity changes, claims trends, loss and expense ratios perceptions of product profitability distribution trends practitioner views on key issues affecting the industry and particular classes brokers perceptions of underwriters. As has been our longstanding custom, we have also provided editorial comments from J.P. Morgan and Taylor Fry on key industry issues which serve as a commentary on industry developments to complement the survey results and respondent feedback. Sources of Information All information in this report is sourced from a survey of the major underwriters, reinsurers and brokers in the Australian general insurance industry, along with certain APRA data. A complete list of participating companies is contained at the end of this report. The survey is the 22 nd consecutive data collection and accordingly there is now a substantial body of trend data available, and many of the comments and observations in the report have been drawn from this information. Acknowledgments This report has been produced with the support of the Australian insurance industry. The insurance industry s support has been generous and is greatly appreciated. The J.P. Morgan and Taylor Fry teams hope you find this a valuable reference. 3

4 Executive Summary The key themes to emerge from the 2014 survey and our analysis are outlined below. Another great set of combined ratios but as good as it gets The 2014 year saw very strong combined ratios for the insurance industry, primarily due to the impact of previous rate increases, a soft period for natural peril claims and a continuation of reserve releases, though at reduced levels. Survey respondents reported overall combined ratios of 87% in 2014 same as in This was matched by a Direct Insurer APRA RoE of 18%, flat on the 2013 level. For the straight domestic lines that we cover in the survey, the combined ratio improved to 86% from 89% in This is supported by very strong results in householders, offset by some deterioration (though still good results) in motor, and tough trends again in NSW CTP. In the commercial classes, the combined ratio was 91%, a slight deterioration from 2013 (90%). Reserve release continued in both commercial and personal lines, although at a reduced rate compared to The COR trends in 2014 were better than the industry expected in the 2013 survey (92%). Premium rate pressures are strong, with outlook quite weak Participants said that domestic class rates slowed to 2% (nominal), below claims inflation of 3%. Domestic class rates were expected to slow further in Householders in particular slowed from 5 years of double digit rises from 2009 to 4% in 2014, with more softness expected going forward. This class had by far been the biggest driver of growth in premium in the last few years, so its slowdown should leave a hole in GWP growth. In commercial lines, rate trends were much weaker as well (-6% reduction overall on weighted average basis, on largely an inflation adjusted basis) significantly less than the flat result expected in the 2013 survey. We note that underwriters recorded better rate results than brokers which may reflect brokers focusing on 30 June, top end results. Fire/ISR showed very soft trends for both underwriters and brokers - averaging -12%. The industry is expecting negative commercial rate trends for both 2015 and Claims trends claim size inflation continuing at moderate levels, frequency favourable again For both domestic lines and commercial lines, inflation in 2014 was at similar levels overall to 2013 (3% and 4%, respectively). The only class showing some claim size inflation was workers compensation (both WA and in TAS/ ACT / NT). The outlook is reasonably similar. Frequency trends in most classes were favourable in 2014 (0% in domestic lines, -3.2% in commercial lines), although both NSW CTP and D&O showed some increases. Whilst inflation / frequency trends are subdued, some insurers expressed concern around the ability to maintain margins in an environment of premium pressures, and low yields on investment income. Top concerns for the insurance industry 69% of underwriters in the survey identified competition /rates / capacity as a key concern (up from 2nd spot last year where it was behind regulation). This was followed by 50% identifying technology as a key concern (double the figure in 2013). Regulation and staff development tied for 3rd place with 38%. 75% of insurance brokers worried about an excessively competitive rates environment, up from 43% last year. 63% indicated concerns regarding staff retention, also up on last year. Reinsurers flagged regulatory issues as their key concern, followed by excess capital and competition in the market. 4

5 Part 1: Editorial Comments Australia Equity Research 5

6 Macro backdrop for Australian insurers Australia s economic environment had been a relative safe haven compared to global peers but that may be set to change The J.P. Morgan economist s base case for Australia is for below trend growth but still positive for the 24th year in a row. We note history suggests that the end of mining booms are often associated with recessions Siddharth Parameswaran, Alvin Liu, J.P. Morgan The economic environment since the global financial crisis (GFC) of 2008/2009 proved to be one of low global growth prospects, but without the extreme downside economic outcomes feared. Australia had been a relative outperformer when compared against other developed economies although the prospects going forward may be different with the US and UK rebounding and Australia facing the prospects of falling commodity prices, and considerably reduced business investment. From a global perspective, 2014 saw modest rates of economic growth in developed economies such as the US and UK but weak growth in Europe. Europe continues to show uncertainty with the initial recovery seen from Mar13 to Mar14 appearing to have plateaued between Mar14 to Sep14. With weak growth in Europe our J.P.Morgan economists expect the ECB to announce a 500m sovereign QE program at its next meeting on 22 January 2015, which may be able to stimulate growth going for CY15 1. Unemployment rate for Europe remains high at 9.6%, although below its peak of ~10% for the Jun13 quarter. The U.S. appears to be recovering, showing real GDP growth of 2.2% for CY14, which is in line with their long term average and unemployment has improved significantly from ~10% in Dec-09 to ~6% in Jun-14. Similar positive trends have also been observed for UK. Figure 20 - Figure 21. Australia arguably faced fewer concerns than some of its developed world peers during 2014, but arguably it was sub long term trend levels. The J.P. Morgan Economist and Strategists suggest there may similar pressures for Australia in 2015 being sub-par growth and increasing unemployment 2. This may have implications for the Australian economy, and ultimately for our insurance sector. We focus in this section of the report on the macro drivers affecting the outlook for the general insurance industry. Economic indicators in Australia The outlook based on recent research by the J.P. Morgan Economist is that Australia could grow close to trend in 2015 (CY15) at 2.9%, which is above the 2.7% expected for He does, warn that the composition of the growth will be driven largely by exports stemming from previous capital expenditure in mining (as the resources are extracted and sold overseas, thereby boosting net exports), rather than consumption or investment led growth. As such he suggests that much of the growth will not be apparent to other parts of the economy. The unemployment rate in Australia was 6.3% in November 2014 according to statistics from the ABS and has been rising slowly from 5.8% a year earlier. This is above the generally accepted target for NAIRU (non-accelerating inflation rate of unemployment) of 5%; however, we note in recent times the NAIRU may be considered to have increased slightly above this level 3. The J.P. Morgan Australia 1 We reference research by J.P. Morgan Economist on 9 January 2015 Global Data Watch. 2 We reference research by J.P. Morgan Economist on 9 January 2015 Outlook for Australia in 2015: is there an echo in here?. 3 We reference research by J.P. Morgan Economist on 19 November 2010 Australia: lack of slack to change inflation tack & on 20 January 2012 Does the RBA care about the distribution of growth? to form our view on the NAIRU. 6

7 Economist predicts an increase in the unemployment rate to peak at 6.5% in the second half of 2015 as a result of continued forecasted sub-trend GDP growth. 4 RBA currently has a record low cash rate of 2.5% which gives RBA less room for further monetary policy expansion should it be needed (having already used this tool see Figure 7). According to the J.P. Morgan Australia Economist, RBA may jettison their "period of stability" comment the RBA made last February and our economist forecasts that there will be a rate hike in late Housing sales volumes and prices were strong in 2014 and the J.P. Morgan Australian economist expects this to continue to be the case in 2015 although at a slower pace than in Our economist expects an increase in home construction will follow solid house price growth (forecasted at a single digit pace) for The Australian dollar touched a five year low of US$0.81 this month following comments by RBA that they preferred a lower AUD as the method to deliver easier monetary conditions. A depreciating Australian dollar can pose some cost push inflation risk for insurers. 4 We reference research by J.P. Morgan Economist on 9 January 2015 Outlook for Australia in 2015: is there an echo in here? 5 We reference research by J.P. Morgan Economist on 9 January 2015 Outlook for Australia in 2015: is there an echo in here? 7

8 Figure 1: Unemployment rate Australia Figure 2: Real GDP growth in Australia Source: Bloomberg (12/1/20115) Figure 3: Government fiscal rectification a drag to GDP growth Figure 4: Investments as % of GDP mining /non-mining Source: JPM Source: JPM Figure 5: Price in US$ of commodities falling (Iron ore, Oil) Figure 6: A big risk is a highly leveraged consumer Source: Bloomberg Source: JPM 8

9 Figure 7: Inflation rate indices vs. bond yields Australia Figure 8: A$ weakened but arguably still too strong for RBA s liking Source: Bloomberg Source: Bloomberg Claims: some inflation risks worsened by any economic deterioration Consumer price inflation metrics are within the RBA s long-term target range of 2-3%, with the inflation rate for the year to September 2014 being 2.4%. The generally soft economic environment, and falls in petrol prices may offset some of the cost-push inflation that may be expected from a depreciating exchange rate. If CPI remains at reasonable levels, this is positive for the insurance industry particularly short tail insurers (to the extent that CPI can be used as a proxy indicator of claims inflation). Average Weekly Earnings rose 2.4% in the year to May 2014 (ABS), which is at the lower end of recent historical levels. This is unsurprising given the softening economic climate. This may be a slight negative for some classes such as workers compensation whose premiums are levied as a % of wage roll (whereas certain claim costs such as medical and legal may move independently of wage inflation). However, for other classes, there are likely to have a positive effect to the extent that the wage components of repair costs could increase at a slower rate in short tail lines, and costs of compensation in court awards (where the award takes into account salary levels) could be subdued in long tail lines. Another key area highlighted in terms of claims inflation is the legal environment, with respondents referring to a slow and effective erosion of tort reforms over time. This particularly affects the liability and CTP classes, however, we believe the impact is still quite limited, and the reforms have by and large held up quite favourably. 9

10 Catastrophe costs globally have been benign in Figure 9: Australian catastrophe loss experience favourable in 2014, but has had increasing trends over the past 5 years Catastrophe experience 2014 catastrophe losses were below-trend for the global insurance industry, according to our estimates. A similar benign CAT environment was observed in Australia, where catastrophe claims were significantly below the 10 year trailing average. Figure 10: US industry catastrophe trends ($bn) inflation adjusted, but not exposure adjusted Source: J.P. Morgan estimates, ICA. Note: the 2014 figure includes the latest ICA estimate (11/12/2014) of the Queensland hailstorm of ~$804m. The figures are inflation and exposure adjusted Source: J.P. Morgan estimates, Insurance Institute Information Figure 11: Lloyds CAT claims ( m) in 1H14 was extremely benign Figure 12: 1H14 a relatively light period for catastrophe losses worldwide Source: J.P. Morgan estimates, Lloyds. Note: All figures are indexed to 2013, except 1H2014, which is indexed to 1H14. These trends are inflation but not exposure adjusted. Source: Swiss Re, Munich Re.. Inflation but not exposure adjusted. 10

11 Figure 13: Normal season for parts of eastern Australia - Forecast for 3 months to February 2015 In Australia, weather changes can be a significant driver of catastrophe costs. Adverse trends can impact loss ratios in short tail classes (fire/isr & householders in particular). The current 2014/15 summer has neutral conditions forecast for the Southern Oscillation Index (which seems to be a major driver of catastrophe costs) according to the Bureau of Meteorology. This continues a shift away from the La Nina episode of 2011 and prior, which saw higher rainfall and cyclone activity particularly on the east coast of Australia. The charts below show a forecast for a below average cyclone season in 2014/15 and a relatively dry period for the 3 months to February Figure 14: Average to below-average cyclone season most likely for Australia Source: Bureau of Meteorology Source: Bureau of Meteorology The shift from La Nina to more neutral conditions, according to the Bureau of Meteorology, could benefit insurers in terms of catastrophe costs. On average since 1967, neutral years have had an average catastrophe cost (excluding earthquakes) of $902m, which is significantly below the $3,043m during La Nina years. Compared to the overall average annual catastrophe cost of $1,098m since 1967, a neutral year would represent on average a ~$200m benefit to the general insurance industry. 11

12 Figure 15: Catastrophe losses, excluding earthquake (A$m in 2011 normalised costs) against the Southern Oscillation Index (indicator of El Nino, Neutral and La Nina Years ) Figure 16: Average catastrophe losses (excl. earthquake) for El Nino, Neutral and La Nina years using ICA data for catastrophes (excluding earthquake losses). Source: ICA, BOM, J.P. Morgan estimates. Note: the latest ICA estimate (11/12/2014) of the Queensland hailstorm of ~$804m is included for Source: BOM, ICA, J.P. Morgan estimates. Note: the latest ICA estimate (11/12/2014) of the Queensland hailstorm of ~$804m is included for Yields on fixed income assets appear to continue to fall, albeit at a slower rate than previously observed between This is a concern for long tail lines in particular. The extent of reductions is large enough to even affect short tail RoEs. Investment markets falling investment yields hurting outlook for all classes. Yields on fixed interest investments (typically held by insurance companies in Australia to back their liabilities), have been falling as the RBA continues to work to boost the economy through monetary stimulus in light of global and domestic weakness. Falling yields have been further exacerbated by credit spreads contracting in line with a hunt for yield by investors. As seen below, current yields on fixed income assets of 3-year duration in Australia (of all credit grades) are even lower than the levels seen during the GFC. We note that yields post the as at date for the survey had not moved substantially. Figure 17: Yields on fixed income assets of 3 year duration in Australia Source: Bloomberg Equity markets were volatile in 2014, but the ASX200 Accumulation index ultimately finished up 6% including dividends. 12

13 Figure 18: ASX 200 Accumulation Index Figure 19: ZCB bonds rates has flattened considerably signaling uncertainty and weak outlook for the economy Source: Bloomberg Source: Bloomberg 13

14 Growth in UK in particular has improved over the past 2 years but latest trends for Europe continue weak, having initially shown positive trends in FY14. Figure 20: Real GDP Growth Selected Developed Markets Macro factors overseas impacting global insurance markets Macro trends in the U.S. and U.K. improving but still uncertain for Europe The charts below show that in the US and UK, economic growth data is now at levels matching Australia. In Europe also, growth has recovered (still below other markets). Unemployment levels there still remain challenging. Our global economics team 6 is forecasting an improvement in developed market growth driven in part by lower oil prices and continued central bank stimulus in Europe and Japan. Top-line (i.e. premium) growth may return in such an environment. Historically there has often been a correlation between weak economic activity and a rise in claims. Given that we didn t see that pressure in any region when economic growth was weak this cycle, we think that it is unlikely we will see an improvement in claims trends in line with expected economic growth trends. Figure 21: Unemployment Levels U.S. and U.K. Source: Bloomberg (15/12/2014) Claims trends are potentially a concern with inflation remaining and low yields as seen in previous years Source: Bloomberg (15/12/2014) Inflation continues to remain while real yields remain weak The threat of high inflation in conjunction with negative real yields is a very detrimental combination for insurers. Yields in the US fixed income markets have been improving although are still at historically low levels. As a result the continuing low yielding environment continues to be a threat to the insurance industry as the inflation drivers of claims (now and in the future) were arguably remaining constant, while the expected investment earnings on the assets backing claims liabilities remain poor. Figure 22: Implied inflation and real yields in U.S. bond market Source: Bloomberg (15/12/2014) 6 Deus ex Machina: 2015 Global Outlook, Bruce Kasman 14

15 US$000s Australia Equity Research With the view in the market that tapering of the U.S. Federal Reserves asset purchase programme is likely, long-term interest rates have been starting to rise, which is a boost for investment income available for insurers on government bonds. Upward pressure on interest rates, which should be a benefit for the insurance industry, although we note that in the US due to accounting standards that do not require insurers to mark assets to market, disclosed running yields we think are still likely to increase. Commercial rates trends have continued to slow - trending to zero. Premium rates increases tending to zero but capital levels are strengthening The outlook on global premium rates has weakened since the peak in 1Q13 and there has been negative to minimal premium rate growth observed in 2Q14 and 3Q14 across the small, middle and large corporate market. Capital levels however are still quite strong in the U.S. and appear to be trending positively (see Figure 24). Figure 23: Premium rate movements in U.S. commercial markets Figure 24: U.S. surplus capital - from amalgamated accounts Source: CIAB Source: Insurance Information Institute Reserve releases are expected to decline going forward in the U.S. (see Figure 25, based on information from the Insurance Information Institute) although there still appears to be the ability to support reported profits to some extent through reserve releases. Inflation data overall remains relatively subdued. Figure 25: U.S. P/C surpluses JPM estimate of surpluses in the market reducing (JPM Australia estimate of the US market). 50,000,000 40,000,000 30,000,000 20,000,000 10,000, % 12% 10% 8% 6% 4% 2% 0% US Industry Reserve Surplus / (Deficiency) - Direct business excluding latest accy (LHS) Current Surplus for all accident years / Latest Annual NEP (RHS) Source: JPM analysis on reserve surplus position of the US market at Dec

16 Figure 26: U.S. Towers Watson inflation indices 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% Source: CIAB * Auto, subtotal Workers compensation Other, bodily injury Other, property damage Fire Commercial multiple peril CPI, all items Figure 27: U.S. Towers Watson inflation indices (superimposed) 8.00% 6.00% 4.00% 2.00% 0.00% -2.00% -4.00% -6.00% -8.00% * Auto Workers' Other Bodily injury Other, property damage Fire Commercial multiple peril Source: Insurance Information Institute Global reinsurance rates have been trending downwards as expected, as a result of a benign CAT environment as well as the excess capital in the market. In the US, there has also been a significant growth in collateralised reinsurance over the past 4 years. Figure 28: Global rate-on-line index by region, Figure 29: US Reinsurance Trends sharp rise in collateralised reinsurance over the past 4 year Source: As of Jan Guy Carpenter Source: Insurance Information Institute Implications for the outlook for Australian Insurers The 2015 outlook for the Australian economy appears relatively weak with similar sub-par growth trends observed in 2014, likely to be seen in For Australian insurers this should mean weaker growth prospects and increasing competitive and claims pressures. Low investment yields continue to be a concern. For long tail lines in particular, this can make a substantial difference to returns in the absence of adequate premium rate increases. Globally, economic trends are strengthening in the US and UK, which should boost premium volumes in those markets. Growth remains challenging in Europe, with some reinsurers entering into deals with brokers to increase capacity in the market, in what is a low growth environment. In the U.S. rate increases are trending towards zero. Australian insurance companies in this environment are likely to receive no favours from the economic cycle for the growth or profit prospects. 16

17 What history / the survey say about growth Siddharth Parameswaran, Alvin Liu; J.P. Morgan Sharanjit Paddam, Kevin Gomes; Taylor Fry In this article, we provide thoughts on the outlook for growth in the general insurance industry in Australia. We examine historical statistics on growth in premiums around the world, outline views from participants in the survey on growth prospects and overlay that with our thoughts on forward looking challenges the industry faces. Historical GWP Growth statistics Australian Experience We have analysed growth and profitability data from the last 20 years of data in the Australian industry. Whilst that is a very long history, we caution about using this alone as a guide to future growth prospects due to the following: (1) 20 years of data is a little limited and can be influenced by the number of phases of different insurance cycles that are included (if more up-swings in the cycle than down-swings are included, it can limit the extent to which one can draw meaningful conclusions (2) the data is impacted by collection problems as there are significant periods where APRA / ISC did not collect data, which led to us interpolate some premium figures; We also note that APRA has not been consistent over time in its definition of profits and premium - which can distort the trends seen (3) there have been changes in government involvement in underwriting some workers' compensation schemes that has influenced growth seen (and this may not continue in the future) (4) history does not always repeat. In Australia, Premium growth averaged close to GDP in the last 20 years- but this may have been influenced by 3 hard cycles and only 2 prolonged soft cycles Home has been the class showing the strongest growth, along with professional indemnity. Motor and Workers Compensation have been the weakest classes for growth. Long Term Average Growth ~ matches GDP: The charts below show that nominal growth in GWP has matched nominal GDP. The 20 years to 2013 showed average GWP of 6.61% p.a., whilst nominal GDP averaged 6.33% p.a. We think this trend was artificially boosted in part by the very high initial figure in 1994, driven by a very sharp hard market (poor profitability) and some exceptionally strong growth in workers' compensation. Excluding GWP grew about 0.4% p.a. lower than nominal GDP. Figure 30: Australia GWP growth vs. Nominal GDP growth Time Series APRA/ ISC statistics Growth is currently slowing in Australia as (a) the economy is slowing (b) there is a soft market market in commercial lines and no signs of superimposed inflation (c) competition in personal lines Source: ISC, JPM interpolation, APRA, Bloomberg. APRA has been inconsistent in its definition of premium (it was prospective contracts at one stage, in between matching the accounting definition of GWP). They also did not collect data between 2002 and 2004 (we have interpolated figures). 17

18 Figure 31: Australia GWP growth Time Series vs. Normalised RoEs APRA/ ISC statistics. JPM Source: ISC, JPM interpolation, APRA, Bloomberg. APRA has been inconsistent in its definition of premium (it was prospective contracts at one stage, in between matching the accounting definition of GWP). They also did not collect data between 2002 and 2004 (we have interpolated figures). JPM Estimates of RoEs. using consistent calculation of Capital Home and professional indemnity have shown strongest growth: The charts below show the growth by class of business. It appears that professional indemnity and home have been the fastest growing classes. Workers' compensation and motor appear to be quite weak. Within home the last 4 years have boosted that average growth figure by 1.3% p.a., reflecting the extent of rates increases we have seen in the class in recent times. In fact in the last 4 years it has only been home and Fire/ ISR that have been driving the growth at an overall level above long run averages (all other classes have been at or below long run averages). The long tail classes have been influenced by 3 factors in our view: (1) superimposed inflation that can take a while for insurers to recognise but is then followed by extremely high rate increases (2) tort reforms that often follow the rate increases - which then lead to gradual reductions in rates (3) changing investment yields - which if large can influence the premium rates environment. In the early and late 1990s we saw elevated levels of inflation that lead to reforms, and that then resulted in prolonged soft markets. Figure 32: Australia GWP growth % p.a. Time Series by class of business APRA/ ISC statistics Source: ISC, JPM interpolation, APRA, Bloomberg. APRA has been inconsistent in its definition of premium (it was prospective contracts at one stage, in between matching the accounting definition of GWP). They also did not collect data between 2002 and 2004 (we have interpolated figures). 18

19 Figure 33: Australia Average GWP growth by class 1993 to 2013 Class Average Growth % Fire and ISR 6.69 Houseowners/householders 8.12 CTP Motor vehicle 7.00 Commercial Motor Vehicle 5.59 Domestic Motor Vehicle 5.91 Professional Indemnity 8.47 Public and Product Liability 6.31 Employers' Liability 5.09 Other 6.14 Commercial Direct 6.00 Personal Direct 7.08 Total ex Re 6.61 Nominal GDP 6.33 Source: ISC, JPM interpolation, APRA, Bloomberg. APRA has been inconsistent in its definition of premium (it was prospective contracts at one stage, in between matching the accounting definition of GWP). They also did not collect data between 2002 and 2004 (we have interpolated figures). Figure 34: Growth in GWP in Fire and ISR Australia Figure 35: Growth in GWP in Home Australia Source: APRA, ISC Source: APRA, ISC Figure 36: Growth in GWP in CTP Australia Figure 37: Growth in GWP in Commercial Motor Australia Source: APRA, ISC Source: APRA, ISC 19

20 Figure 38: Growth in GWP in Domestic Motor Australia Figure 39: Growth in GWP in Prof Indemnity Australia Source: APRA, ISC Source: APRA, ISC Figure 40: Growth in GWP in Public and Product Liab Australia Figure 41: Growth in GWP in Employers' Liability Australia Source: APRA, ISC Source: APRA, ISC Figure 42: Growth in GWP in Commercial Direct Australia Figure 43: Growth in GWP in Personal Direct Australia Source: APRA, ISC Source: APRA, ISC 20

21 US Experience We have 43 years of data on growth in premium and return statistics from the US. Given the long time periods included, and the very limited involvement of government as an underwriter, growth statistics are likely to be less impacted by the phases of different insurance cycles or significant changes in government involvement in underwriting. Insurance premiums in the US grew slightly slower than nominal GDP. Within this, most years were sub nominal GDP whilst there were a few very large peaks that made up for this. If history is a guide - soft cycles remain soft for quite long periods of time. Long Term Average Growth slightly below GDP: The charts below show that nominal growth in Net Written Premium in the US P&C industry has averaged 6.21% p.a. since This is slightly below nominal GDP growth (6.72%p.a. since 1971). This suggests that historically the growth of the sector has been averaged 0.51 p.a. slower than GDP. For investors assuming constant margins, we think that all else being the same we think this implies a PE that should have been ~0.5x lower than the broader market assuming a 15% RoE for both. Figure 44: US P&C Nominal Net Premium Growth Time Series Source: III, AM Best Figure 45: US P&C Nominal Net Premium vs. Nominal GDP growth Source: III, AM Best,. Bloomberg 21

22 Figure 46: Difference between P&C NWP and GDP growth Source: III, AM Best Likelihood that a weak growth period will continue for some time: What is clear is that most periods show NWP growth being lower than GDP (i.e. the mode [most commonly occurring outcome] is for NWP growth to be less than GDP). This is however offset by a few periods (hard cycles) where the growth in NWP is well above GDP. If history follows that pattern, it suggests that when growth in premium starts slowing, it will remain weak for some time. The last 2 hard periods (mid 1980s and 2001) were triggered by several preceding years of falling profitability (see below) in part driven by competition causing premium growth to be well below inflation, and also the response of insurers to acknowledging some superimposed inflation. Figure 47: US P&C Net Premium Growth against US P&C RoEs Source: III, AM Best US recently showing some growth: The current environment in the US has shown a return in the last 3 years to growth in Net Premium in line with GDP (largely premium rate driven - although this is petering out). Other experience We show in the table below inflation adjusted (i.e. real ) growth in regions according to Swiss Re. 22

23 Growth in premium is stronger than GDP in countries where per capita income, and capital stock values are low but where both are growing quickly. What it shows is that there has been reasonably strong growth in South and East Asia and to some extent Africa. Growth in most other regions has been rather weak. It seems that growth in premium is stronger than GDP in countries where per capita income, and capital stock values are low but where both are growing quickly. Figure 48: Growth in inflation adjusted P&C Premium by Region Source: Swiss Re, JPM compilation of figure We think GWP growth rates are influenced by: - Nominal economic growth - Perceptions/ experience on catastrophe costs - superimposed inflation / tort reforms - yields - capital / returns - rate of improvement in risk management - extent to which new products of insurance arrive Our explanation of drivers of growth We think the drivers of growth in GWP include the following: 1. Nominal Economic growth (see Figure 30 which shows a strong link between the two). As the economy grows, more material goods and potential future production can be insured. 2. Catastrophe Events: A collection of these (or lack of) can lead to changes in estimates on long term claims costs / as well as some retrospective pricing. This usually has a lagged impact on GWP growth (it takes a year or more to feed changed perceptions on risk into achieved increases in rates). The increases in Fire / ISR and home post 2009 were arguably driven by such events. Figure 49: Catastrophe against short tail cat exposed premium growth (LHS = growth; RHS = $m gross catastrophe costs I n 2011 dollars) Source: JP Morgan, ICA, APRA / ISC 23

24 3. Superimposed inflation / tort reforms: As we have explained earlier, in ~1994 and ~2000 we saw some very hard markets in long tail classes stemming in part from re-estimates of inflation. Post 2002 in particular, there were very significant tort reforms across Australia that curbed court awards in liability and professional indemnity and to some extent CTP classes. In 1999 there were reforms affecting NSW CTP / Workers Compensation. All of these lead to a significant soft period in long tail lines. See Figure 36, Figure 39, Figure 40, Figure 41. As a general rule most insurers believe that there is underlying superimposed inflation (in terms of average claim size) evident in most classes over time perhaps as society believes that it can compensate more generously for loss as it gets richer over time. 4. Changing investment yields: In 2009 in response to large falls in yields, there were large increases in rates on long tail lines to compensate for reduced investment income. 5. Capital levels: Increased capital levels usually are caused by the factors described above (e.g. a lack of catastrophe can boost retained earnings). Nevertheless it is often mechanistically quoted as a factor leading to reduced rates (we think it is at best only part causation, part correlation). We think high levels of profits attract incremental capital into the market. The chart below shows that profitability is now very high by historical standards suggesting that there could be some incremental. Figure 50: Historical Notional Industry ROE* (smoothed investment return, hypothetical capital based on current APRA standards - if capital levels were set for a large diversified insurer) Source: JPM calculations, J.P. Morgan Taylor Fry Barometer 6. Improvements in risk mitigation / management: We think some classes such as motor and workers compensation have seen ever reducing costs of risks on a per unit basis, which means that GWP growth has tended through the cycle to be less than for many other classes. We show this in the charts below. In motor for example, fatality rates have been falling for a very long time (we estimate that between 1970 and 2010 the rate of improvement was 3.3% p.a.). We can also see that whilst vehicles have been growing faster than population (suggesting motor should be a growth class), the statistics show that GWP growth has been weaker than nominal GDP (and actually one of the weakest classes) and that despite the weak GWP trends profitability has not been affected. This all suggests that underlying frequency of risk must be getting much better (i.e. cars are getting safer etc). We argue that the only reason that motor insurance has not been a class that declined quicker is that average claim size has risen as the components in cars have become more expensive to replace. Similar improving statistics are 24

25 Figure 51: Frequency of Road Deaths Australia. Improved dramatically evident in workers compensation (see below) where we estimate that between 2001 and 2013 the serious injury frequency rate improved by 3.1% p.a. Figure 52: Growth in Motor Vehicles vs. Population Growth - Australia Source: ABS, DITRD Source: ABS Figure 53: Growth in GWP in Domestic Motor Australia Figure 54: Combined Ratios and premium rate increases in Australia Domestic and Commercial Motor Combined Source: APRA, ISC Source: JP Morgan Taylor Fry Barometer, APRA Figure 55: Workers' Compensation Serious Injury Frequency Statistics (per 1000 employees) - Australia Age Group p Change from 2001 to 2013 <20 years % years % years % years % years % years % years % years % years % years % Total claims % Source: 7. New classes / heads of damage: Given our comments above that we think that frequency in most classes are likely to be improving, we think that insurance companies have to keep innovating to find new risks to insure. As an example, we note that the insurance industry has recently started providing much greater coverage for flood on home insurance policies. This would have increased some 25

26 Most survey participants thought that in the near term the industry would be a sub GDP growth business. In the medium term it was more mixed but most seemed to think that the industry was either a GDP or sub GDP growth business of the costs of the events. Other examples of growth into new areas include growth in cyber insurance and pet insurance. It is notable that both of these are being pioneered by overseas insurers operating here either through their Lloyds or domestic license. As such the large domestic insurers are largely not partaking in that new growth at the moment. Thoughts on growth from survey participants As part of this survey, we specifically included questions on the issue of growth prospects for the industry. We outline below a summary of the survey participant's responses: Survey Participants expectations on growth: In the section of the survey Issues Confronting the Underwriters we summarise answers from respondents where we asked participants questions about growth. These included (a) whether they saw the general insurance industry as a growth industry, (b) whether the industry was expanding its product range and (c) whether alternatives e.g. alternative capital, mitigation of risks were reducing demand for traditional insurance. We also separately asked about the cycle. We outline below the findings: Most think the general insurance industry is a GDP or sub GDP growth business. In the short run - many made comments about the cycle in particular and competition in personal lines being a near term headwind. The more bullish participants said that in the medium term improved risk management would be offset by higher weather related claims from climate change, new products and privatization of government insurance schemes. Nevertheless, in the long run most participants thought growth would be GDP or sub GDP. Table 1: Responses in Survey from Participants on whether General Insurance is a growth industry in the near term and medium term (number of respondents) Near Term ~Medium Term Sub GDP ~GDP More than GDP Sub GDP GDP More than GDP Source: JPM Taylor Fry Barometer There were 16 respondents but some left responses blank or did not provide enough information to decide exactly where they stood on this issue We also asked 3 questions about (a) the cycle (b) which class respondents saw the greatest change in capacity and whether it was positive or negative (c) which class respondents saw the greatest risks to profits. Figure 56: Questions asked of respondents on competition in personal lines and commercial lines Please indicate the level of competition in the personal and commercial lines markets, on the following scale: Personal lines Commercial lines Not competiitve, rates falling, Rates and Excessively competitive, premium rates lapse rates lapse rates rising, rates rising holding falling significantly Please indicate how rational you believe the pricing in the personal and commerical lines markets to be, on the following scale: Personal lines Commercial lines Source: JPM Taylor Fry Barometer Not rational, Target ROEs Very profitable, above unprofitable being met target profit levels

27 Table 2: Answers to competition question Average Personal lines competition Commercial lines competition Personal lines rationality Commercial lines rationality Source JPM Taylor Fry Barometer Table 3: Answers to capacity question and profit risks. Greatest change in capacity Profit Risk Votes Positive Negative Votes Domestic Motor Vehicle Householders 2 1 1* 1 CTP(NSW & QLD) Underwritten Workers' Comp (WA) Underwritten Workers' Comp (TAS ACT & NT) Fire / ISR 6 3 3* 2 Commercial Motor Vehicle Public & Product Liability Professional Indemnity Directors' & Officers' 1 0 1* 2 Source: JPM Taylor Fry Barometer. * we think these respondents said the class faced a negative change in capacity when they intended to say they had a positive change in capacity. What is clear is that there is considerable pressure on premium rates in commercial and personal lines according to the industry, with participants saying both classes had scores near 4 ( lapse rates rising, premium rates falling ). In commercial lines there was a bit more concern about the pressure leading to irrational rates. In terms of change - participants signaled large increases in capacity in domestic motor, householders and Fire / ISR. In terms of changes in profitability - it seemed that participants were most concerned about growth in capacity in Fire / ISR, motor and householders. We are very cautious on growth prospects: - current growth rates are lowest ever - competition is very strong in personal and commercial lines due to all time high RoEs JPM Views on Outlook for growth In the near term we are very cautious about the outlook for growth in the industry, due to the following: Growth now slowest rate in the last 20 years: A confluence of factors has led to the GWP growth trends in the 2 quarters to September 2014 being the lowest they have been in the last 20 years (see charts below). We don t think there is any respite likely in the quarters ahead. - economic growth could be a lot slower - frequency has been falling at 3% p.a. + in key classes - there are no offsetting claims size inflation driven drivers boosting growth - domestic insurers not expanding into new classes 27

28 Figure 57: Long Term trends on GWP Growth Australia Figure 58: Latest trends on GWP growth - current levels of Growth are the lowest in 20 years - Australia Source: APRA, ISC, JPM estimates Source: APRA Cycle: We believe that premium rates in both personal lines and commercial lines are under pressures. RoEs are as high on an underlying basis as we have ever seen them which is inviting competition in from overseas (e.g. Lloyds) as well as domestically e.g. from banks in personal lines. Superimposed Trends: There have been no signs of superimposed inflation for some time which means growth in premium in response to this is unlikely. There are also likely to be fewer incremental boosts to profitability to come from weakening claims trends in long tail lines in our view (insurers are getting much closer to setting assumptions assuming minimal inflation). Lack of expansion into new classes: There are no new classes that domestic Australian insurers seem to be pushing in a big way to make up for some of the pressures we have seen. Most of the expansion into cyber insurance / pet insurance has been made by foreign insurers. There could be some respite from privatization of South Australian compensation schemes. Frequency continuing to fall but maybe even claim size: Classes such as motor could see accelerated reductions in frequency from new technologies. There is even a risk that average claim sizes could start falling in classes such as motor due to the new technology, and the cost of that technology coming down. This is something we have not seen for a while. 28

29 Table 4: Summary of JPM Views on Growth Outlook Driver Outlook - in terms of impact on premium rates Comment Growth -ve This is expected to be weak Catastrophe - Arguably 2014 may be slightly above average Superimposed inflation flat to ve This has not been evident for some time. Insurers are talking about reducing assumptions on these. Changing investment yields +ve Interest rates could fall - thereby forcing insurers and regulators to consider increases in long tail rates Capital -ve There is still inflow of capital into commercial markets, returns are at all-time highs in the sector. Risk Mitigation / Management -ve The outlook for motor in particular in the long run (driverless cars, technology assisting in avoiding collisions) should be weak in the medium to longer term. This may be offset partially by some increases in property classes from climate change related risk New classes Flat At this stage - the domestic industry has been slow to embrace new classes such as cyber insurance etc. Source: JPM 29

30 The Impact of Technology on Insurance Kevin Gomes, Sharanjit Paddam, Catherine Weston; Taylor Fry Siddharth Parameswaran, Alvin Liu; J.P. Morgan The current strongly competitive market is driving demand for innovation in insurance. Technology is supplying innovation, and is impacting all aspects of insurance from products, through rating, distribution, and claims management. In this article, we discuss the different opportunities and challenges to insurers from recent and future technological advances. Products The major impact of technology on insurance has been the potential for new insurance policies to cover new and emerging risks, including cyber insurance, transport networking companies, home sharing, and drones. However, each of these new products presents new challenges for insurers. Cyber insurance Technology has transformed businesses over the last twenty years as companies have gone online in order to access customers, and to store their information in the cloud. However, this has also exposed them to the risk of a cyber attack. Traditional commercial insurance products often did not respond to these risks, as they generally only provided cover for tangible property. Cyber insurance has been offered for many years now, and covers loss due to a cyber-attack, data protection laws, and the mismanagement of personal data. Policies are usually written on a claims made basis, with the main cover being liability, and additional coverage provided for legal, investigation, fines and other expenses. Damages from a cyber-attack can be large. Publically known examples of cyber attacks include the recent hacking of the Sony corporate network, including the demand for the movie The Interview not to be released. However, many cyber attacks, particularly those affecting small and medium companies, will go unreported. Given the lack of historical data, Cyber insurance can be difficult for insurers to price. There are, however, at least two risk modelling companies in the process of cyber risk modelling. 7 Transportation Network Companies (TNCs) The smartphone app taxi service, Uber, has risen in popularity since expanding its services in 2012 to UberX with non-luxury cars and non-commercial drivers. Other relatively new companies in the US based on a similar ride share model are Lyft and Sidecar. Low costs are possible not only due to the nature of drivers owning their own vehicle, but also because TNCs typically take out contingent insurance (details varying depending on the country) - effectively a Plan B to the driver s personal insurance policy

31 The insurance implications for Uber users are particularly concerning in Australia, as The Insurance Council of Australia (ICA) is not aware of insurance products in Australia that cover ride sharing 8. A car ride share warning was released by the ICA in June 2014 stating any motorist considering providing a ride sharing service should first discuss this with their insurer to check the impact this might have on their motor vehicle insurance policies, in particular third party property or comprehensive car insurance 9. If an insurance company proves a driver s actions to be illegal (for example, a non-commercial driver in a non-commercial vehicle receiving a fee for service), a claim against the insurance policy can be declined. In Australia, Uber requires drivers to have a full license, CTP coverage and third party property damage insurance, however it is likely that a personal insurance claim will be denied. Uber therefore provides contingent coverage (in the event that a driver s personal insurance does not apply) in the amount of US$5 million for bodily injury and property damage to third parties. This would still leave the driver s vehicle uncovered in the case of a personal comprehensive claim being declined. 10 TNCs provide unique challenges for insurers, including if any such service is in fact legal. A Roads and Maritime Services spokeswoman stated that while Uber is not breaching the Passenger Transport Act 1990 by offering the service, motorists transporting passengers for a fare are. NSW Roads and Maritime Services has issued five $2,500 fines, threatening legal action against UberX drivers. The Victorian Government issued more than $50,000 worth of $1,700 fines to drivers around May Airbnb The home hosting website, Airbnb, has faced similar insurance issues to TNCs, providing secondary liability coverage which push the insurance onus onto primary insurance - the host s home insurance policy, which will often not cover commercial activity. This was put to the test as described in December 2014 by The New York Times, reporting that one host: talked to an agent about her rental activity, it quickly became clear that it could not offer her any kind of liability rider and no longer wanted her as a customer 12. Another insurance company in the US sets a cap on rental income, which appears to be a good interim measure until sufficient Home hosting data can be analysed to better determine appropriate insurance cover and pricing. It appears that in the US, where Airbnb has 177,539 listings (and over 1 million worldwide) 13, the insurance industry is not well prepared. CNBC reported in December 2014 that "If Airbnb succeeds in sharing risk with personal insurance companies, then everyone's premiums have to rise to cover it.... Insurance companies could solve this by asking all policyholders about their hosting habits, but none of the 10 contacted said that they had made any changes to their policies as home-renting has grown." zsabx.html 9 ride%20share%20warning.pdf zsabx.html as at 22 December

32 Drones Drones have been used for military purposes for many years, however drones have also been tested for the delivery of books and food (including pizza, taco s and Indian food). The first regulatory hurdle in Australia for the use of Remotely Piloted Aircraft (RPA) is obtaining an Unmanned Operators Certificate (UOC), which is approved by the Civil Aviation Safety Authority (CASA). CASA also recommends that you contact your insurance provider to obtain information surrounding public liability insurance. Insurance costs can be significant and could influence your decision to apply 15. The UOC requirement and the insurance issues could be factors in drones being slow to take off in Australia. Rating The pricing of insurance products is improving with more accurate rating factor data and the introduction of additional rating factors available due to advances in technology. An example of this is using mapping technology to assess fire and flood danger zones to price property insurance. Information such as the landscape on the property, the proximity to bush-land or rivers and the construction of the building itself can be valuable in assessing the risk of bushfire or flood. Another example of advances in rating factors is telematics, used for motor vehicle insurance. Telematics The data collection for pay as you drive (PAYD) is designed to capture usage based driving and driver behaviour. The question: are you willing to put a black box in your car? is a rating factor in itself. Customers who drive less often, less often in peak hour, and less often in dangerous areas have a lower claim risk due to the nature of their usage. Steering, braking and acceleration are assumed to be factors in motor vehicle claims risk and are used for telematics. The less erratic a driver is, the lower risk of a claim and therefore the lower the premium. There may be a critical point in time whereby insurers not offering telematics may be left with the worst drivers. Telematics is also assisting insurers in the faster management of claims as well as being used as a launch pad for other services such as traffic alerts, collision warning systems, anti-theft, fuel consumption analysis and post-accident services. Another insurance line that has plans to utilise monitoring/tracking technology in 2015 is pet insurance. In the UK, an insurer is offering a 20% discount on a pet insurance policy if the pet wears a micro chipped GPS collar 16. The collar will not only be used for lost pets, but its primary purpose will be to track the exercise routine of the pet due to increasing costs in pet insurance which are assumed to be largely due to higher obesity levels. Lower premiums and other rewards will be given to owners who follow the applicable exercise guidelines. To date, telematics has not seen widespread take-up in Australia. One factor has been the large expense associated with installing a black box in a policyholder s car. Recently however, smartphones with inbuilt GPS chips have provided an alternative, and much cheaper means of tracking individual drivers, although such data is more difficult to verify e.g. was the policyholder a driver or a passenger when the data was collected?

33 Distribution Technology has changed the way insurance is sold and has also allowed insurers to segment their markets and target specific groups of customers. Arguably many new entrants to the Australian motor and home markets have been successful in cherry picking profitable segments of the incumbents market through the use of sophisticated data analytics. Insurers have also started to make use of additional sources of data on their customers, such as credit card purchase history, loyalty programs, social media, general smart phone and tablet use, as well as equipment such as GPS all of which are now part of everyday life. Internet giants may also prove to be an insurance industry game changer, as Google makes further inroads into the insurance industry. In 2012, Google launched Google Compare, providing quotes in the UK for banking products, motor vehicle and travel insurance. Google s plans for 2015 are to expand its insurance interests and sell motor vehicle insurance online in the US. 17 Claims management After the Brisbane storms of November 2014, a record proportion of claims were lodged online rather than over the phone. There are several possible reasons for this, including: the possibility that people are less likely to require human advice for hailstorm claims; smartphone use becoming mainstream; as well as customers preferring the convenience of the online channel compared to being kept on hold on the phone. Automated claims management software is also being used to identify high risk claims in much shorter time frames than previous manual processes. Once a claim has been accepted, advances in technology can be used to reduce claims cost. One example is the robotic spraying of cars which reduces repair expenses. Claims costs are experiencing a long term reduction in frequency, both through reduced numbers of accidents and a reduction in fraudulent claims. Cameras have been used for many years in reducing fraudulent claims. Telematics can be used to encourage better driver behaviour. Driverless cars have the potential to significantly reduce accidents by removing the component of human error. Driverless cars Driverless cars are not the fictitious idea they once were, having been approved to be tested in several states in the US, albeit with a hefty insurance bond requirement - California s requirement being USD 5 million 18. Germany and the UK have also been making inroads. Germany has tested driverless cars on the Autobahn, and the UK recently announced a government project to test the suitability of driverless cars. The UK testing aims to investigate driver behaviour, and will also include examining issues such as risk, liability and insurance as well as the practicalities of integrating driverless cars with traffic and pedestrians. Kenny Leitch, the Global Telematics Director of the firm that won the contract, RSA, said: "Driverless cars are a fantastic innovation which will fundamentally change the world of motoring and car insurance. There are many unanswered questions around how these cars will be

34 insured and through our involvement in this project we will be one of the first insurers to gain first-hand knowledge of the technology. As a result, we ll be strongly positioned to educate drivers and also offer the most appropriate insurance for these cars. 19 Testing driverless cars has expanded, with plans to test the car on multi-level highways in Shanghai and Beijing. 20 Driverless cars are a game changer and insurers will have to make considerable adjustments in order to adapt to a world with driverless cars. We expect the following changes to occur: Fewer accidents as human error is removed as a potential cause of accident, provided the technology used is sound and durable New challenges to materialise for lawmakers regarding licensing, responsibility for vehicle operation and liability Fewer cars on the road if this technology is employed successfully Insurers will need to be able to respond to these social and technological changes, and the following represent real challenges insurers will need to address. Who is liable? If an accident occurs where an autonomous car is at fault, who is deemed liable? Would liability fall on the car manufacturer, the technical systems manufacturer, the network supplying GPS information, or will the occupant still be deemed as having ultimate responsibility for the vehicle s operation? If manufacturers are considered liable, we could expect an increase in the number of product liability claims and an increase in premiums. Any alterations to the concept of liability which stems from system failure that result in accidents will carry across to CTP insurance. If manufacturers are deemed liable, the concept of driver fault may come under pressure and some of the Australian CTP schemes may need to change. Determining premiums How will premiums for autonomous vehicles be determined? Removing driver judgment and ability from the equation means a 21 year old male may have the same expected claims cost as a 40 year old female. The usual rating variables of age, gender, license tenure and claims history will no longer be good predictors of claim frequency and severity. We might expect an increase in repair costs for autonomous vehicles damaged in road accidents relative to conventional vehicles. These automobiles are likely to require the services of specialised repairers when system repairs are needed. This would impact the premiums paid by the owners of both the driverless and regular cars, the latter incurring higher expected repair costs upon colliding with a driverless car. Insurers will have to establish premiums in the absence of a claims history and judicial precedents. Provided the technology employed is reliable and durable we

35 could expect the reduction in claim frequency to be sizeable. While we acknowledge that other factors will need to be considered in the setting of premiums, when looking at the effects on premiums from this angle alone, we may expect comprehensive motor premiums to reduce for autonomous cars compared to their driver operated counterparts. Premium setting for shared vehicles Given that autonomous cars have the potential to be easily shared between owners, how will premiums be set? Should a large scale car sharing scheme be introduced there will be fewer cars on the road, less cars manufactured and a reduction in the number of cars that require insurance. If cars are able to drive to their owners, car sharing becomes easier and the demand for taxis will reduce. Insurers will need to consider that such cars will be on the road more often and factors including where located and if garaged will have less relevance where there are multiple owners. Whilst the propensity to cause an accident may be lower in the case of driverless cars, the frequency of not at fault collision, storm and windshield claims may increase due to increased time vehicles are on the road. Will insurance premiums change on a trip by trip basis, depending on whether the driver will be in control or not, or even depending on the weather forecast and time of day? Additional challenges in a driverless car society The proliferation of autonomous cars must be accompanied by stable and secure infrastructure. In other words, there can be no network crashes and back-up systems must be installed in vehicles to seamlessly take over if components fail. In addition, this increased reliance on technology means the risk of system hacking needs to be minimised and consideration should be given to what type of personal information is collected and stored. In highly automated commercial aircraft, pilot error is still reported as the leading cause of aviation accidents 21. Despite simulator emergency training and currency requirements, there have been several major accidents where the pilots have failed to undertake the most basic of recovery procedures, such as recovering from a stall. Would drivers of driverless cars lose their skills, becoming reliant on automation? Society will need to consider these issues and respond if driverless cars become part of everyday life. Conclusion Advances in technology have the potential to transform and challenge the insurance industry. Improvements in rating and fraud detection are already being seen on the international insurance scene. These are clearly benefits to the insurance industry, and those not keeping up with technology could suffer. For example, a strong increase in the number of insurers offering competitive telematics car insurance could leave the cautious insurers with the worst drivers. Challenges to the insurance industry are the emergence of companies such as ride-sharing and home hosting, where insurance companies would benefit from reconsidering their insurance provisions. A little further away is the driverless car society, which is likely to reduce claims from driver error, however introduce complexities such as liability and technology malfunctions and/or hacking. Will advances in technology increase the demand for Cyber insurance, or would breach notification legislation be the driver for Cyber insurance demand?

36 The Political Impact of Climate Change on Insurers Sharanjit Paddam, Taylor Fry Climate change is likely to exacerbate affordability issues for Australian homeowners, as noted in a recent research paper: Can actuaries really afford to ignore climate change? by actuaries Jon Harwood, Sharanjit Paddam, and Jessica Egan, and Andy Pittman, Professor of climate science at UNSW. 22 These affordability issues will pose significant challenges for insurers, who already face widespread negative publicity for increases in insurance premiums for properties located in areas exposed to natural perils, such as bushfires, cyclones and flood. In turn, these will generate political issues, as consumers perceive higher premiums as being unfair. A number of potential changes in climate systems could also have a significant and relatively sudden impact on claims costs. As home insurance policies usually only offer cover on an annual basis, this could leave communities exposed very abruptly if there is significant increases in premium, or the removal of cover, or the exit of insurers from unprofitable markets. Location, location, location Figure 59: Buildings insurance premium as a proportion of annual income under various climate change scenarios Source: Harwood et al. The box-chart above shows the variation in ratio of buildings insurance premiums to average annual income for different geographic locations across Australia. It is based on the current premium rating structure of a major Australian insurer (Base 22 Available at pdf 36

37 Scenario), and also shows the same information under different future climate change impacts on Bushfire, Cyclone and Flood perils. The base scenario already shows substantial variability in the affordability of buildings insurance. To some extent this affordability is underestimated in the chart, as properties that are currently uninsured have been excluded from the sample set. The chart shows that Climate change impacts are likely to be minimal for the median household as most Australian homes do not have any significant material bushfire, flood or cyclone risk at the current time. However, the worst affected homes could see buildings premiums of about 38% of annual income under certain scenarios by This is a significant affordability problem that impacts homes in high risk areas. As the real estate saying goes, it s all about location, location, location. In terms of increases in buildings premiums under the modelled scenarios, over 300,000 households could see a buildings increase of up to 48% by ,000-80,000 households could see increases of up to 104% by These changes will exacerbate existing affordability issues. Political impact of risk pricing vs risk pooling As increasing amounts of data on natural perils becomes available in particular flood maps, and cyclone studies insurers have been increasingly pricing property insurance based on the risks to individual properties, rather than pooling the risk across a wide geographic area. As noted in a recent report by the Australian Government Actuary, this increased risk pricing for cyclone losses has been the main driver of recent substantial increases in premiums for home, contents and strata insurance in Northern Queensland compared to other parts of Australia. This trend is likely to continue into the future as insurers seek to remain competitive in low risk areas, but reduce cross-subsidies of premiums to high risk areas. These trends pose significant political problems, particularly for politicians whose constituents live in high risk areas and perceive the relatively higher premiums as inequitable. Unlike insurers operating in a free market, politicians tend to prefer risk pooling to risk pricing. 37

38 Figure 60: Increases in premium rates for Northern Queensland compared to Brisbane, Sydney and Melbourne Premium per $1,000 sum insured, 2005/06 = 100. Source: Australian Government Actuary s Report on Home and Contents Insurance Prices in North Queensland, November 2014 Figure 61: Expected home buildings claims costs by peril relative to Northern Queensland North Queensland = 100. Source: Australian Government Actuary In October, the Commonwealth Government pre-empted the report s findings by announcing a range of initiatives to tackle the high cost of insurance in North Queensland, including: Establishing a comparison website to help consumers to compare home building and home contents insurance. Clarifying that licensed brokers can sell policies from foreign insurers where they offer consumers a substantially better price. 38

39 Developing a program of engineering assessments for strata properties in North Queensland, to improve information available on buildings susceptibility to storm damage and promote resilience. Of these changes, the first is likely to have a limited impact as in the long run, insurers are unlikely to reduce premium rates below the expected cost of claims, especially for relatively small and volatile markets such as North Queensland. The second is not actually a change in policy, and again, in the long run foreign insurers are unlikely to under-price the risk. The last initiative is likely to exacerbate individual risk pricing by insurers, leading to an even wider range of premiums, and possibly even higher premiums for some properties. Mitigation, Mitigation, Mitigation In the longer run, the government has recognised that Australia s resilience to natural perils needs to be substantially improved. Insurance can assist during a transition period, but over the long term, the risk to property needs to be brought under control or insurance becomes unaffordable. The government has commissioned a Productivity Commission Inquiry into National Disaster Funding Arrangements, which produced a draft report in The draft report noted that price signals provided by insurance can be an effective way to convey information about risk and encourage risk management and that the signal should not be distorted by insurance taxes or subsidised premiums. So whilst painful, the insurance price signals act as an incentive for the householder to reduce their risk. There is a cost to risk management, whether it is through transferring the risk or reducing it, and this cost needs to be traded off against stakeholder risk appetites and financial capacity. Insurance is a risk transfer for the householder, however when the risk being transferred to the insurer is high, the associated cost may prove prohibitive. Ideally the risk needs to be reduced to an acceptable level; however there is a cost to this as well. The economic benefits need to outweigh the costs of the risk reduction and the cost of doing nothing in order for change to occur. There are a wide range of potentially effective mitigation measures that require political support and action. Examples include building flood levees and changing land use laws to prohibit construction on flood plains or storm surge red zones. In the absence of mitigation, policyholders may need to take adaption measures, such as raising floor height and retrofitting houses to current cyclone building standards, and governments can encourage such activities by subsidising the cost of adaption. One recent example of effective flood mitigation is in the town of Roma in South West Queensland. Roma had been flooded three times in as many years from 2010 to Since 2008, Suncorp had paid out over $100m in claims and consequently, in addition to steep price increases for renewal customers at risk, had decided to not underwrite new business in the area. Suncorp declared it would continue this strategy until the town took steps to mitigate against the unacceptable level of flood risk. The local council did respond and a flood levee was built in early 2014 at a cost of $16m. Suncorp subsequently honoured its commitment by resuming cover in the area and passing through significant premium reductions, with a 30% reduction for the average home, and as much as 80% for high risk properties. The Productivity Commission recommended that local councils, insurers and governments will continue to work together to improve risk mitigation, leading to increased resilience, and the continued affordability and even viability of insurance. 39

40 Alternative Capital Kevin Gomes, Sharanjit Paddam; Taylor Fry In this article, we summarise ongoing developments in alternative capital solutions for reinsurance (including catastrophe bonds, industry loss warranties and collateralized reinsurance) and examine the implications for the Australian insurance industry. Alternative Capital Growth Alternative capital market capacity is growing more quickly than traditional reinsurance capital. Although precise measurement of the total alternative capital market size is problematic (particularly for collateralized reinsurance), we estimate that approximately US$50B in capital in 2013 came from alternative markets. Although this appears relatively small compared to the global reinsurer capital of US$540B, alternative capital enjoyed significantly higher growth than global reinsurer capital over each of the 3 preceding years, with further significant growth (as yet unquantified) likely to have occurred during Figure 62: Alternative Capital Market Growth Alternative Capital Pricing Spreads The pricing spread on a catastrophe bond represents the additional interest payment made to compensate investors for the catastrophe insurance risk. The pricing spread will typically increase as the level of expected catastrophe loss increases, with the ratio of pricing spread to expected loss equating conceptually to a loss ratio. Catastrophe bond pricing spreads for given levels of expected loss have reduced significantly over time. For example, a catastrophe bond issued in 2000 with 1.5% expected loss may have been placed with a 7% pricing spread (i.e. loss ratio of 1.5/7 = 21%). In comparison, a catastrophe bond with 1.5% expected loss issued in 2014 would have a significantly lower pricing spread of approximately 4.5 (i.e. loss ratio of 1.5/4.5 = 33%). The lower pricing spreads are resulting in catastrophe bonds being seen as increasingly competitive relative to the rates offered by traditional reinsurers. 40

41 Figure 63: Catastrophe Bond Pricing: Spreads vs Expected Loss 2000 Cat bond pricing spreads continue to reduce 2014 Source: InsuranceLinked.com Implications for Australia There has been limited direct use of alternative capital by Australian insurers to date, partly due to regulatory hurdles whereby insurers need to apply to APRA to have alternative capital instruments recognized in their Insurance Concentration Risk Capital calculation. Nonetheless, the growth in alternative capital has had secondary effects in Australia, with the increase in alternative capital global capacity leading to increased overall reinsurance capacity which has in turn contributed to lower reinsurance rates globally (including Australia). Furthermore, reductions in pricing for alternative capital globally are putting increasing price pressure on traditional reinsurance. Although the observed impacts have been mainly on property classes to date, we may see some spill over into casualty classes over time. Longer term, we may also see alternative capital competing for a share of the direct insurance market as capacity chases risk. 41

42 Part 2: Survey Participants Australia Equity Research 42

43 Survey Participants The participants in this year s survey are listed below. Where an international organisation is shown, the response is from its Australian-based subsidiary or branch. Underwriters AIG ACE Insurance Limited Allianz Australia Insurance Ltd Axis Calliden CGU Chubb Insurance CommInsure Brokers Aon Risk Services Australia Fitzpatrick & Co. Insurance Brokers Jardine Lloyd Thompson Macey Insurance Brokers Marsh Reinsurers Berkley Re Hannover Re General Reinsurance Hollard Liberty International Underwriters NTI Onepath RACQ Suncorp TIO Zurich OAMPS (Wesfarmers) Philp, Newby & Owen Steadfast SCOR Asia Pacific Swiss Re 43

44 Analyst Certification: The research analyst(s) denoted by an AC on the cover of this report certifies (or, where multiple research analysts are primarily responsible for this report, the research analyst denoted by an AC on the cover or within the document individually certifies, with respect to each security or issuer that the research analyst covers in this research) that: (1) all of the views expressed in this report accurately reflect his or her personal views about any and all of the subject securities or issuers; and (2) no part of any of the research analyst's compensation was, is, or will be directly or indirectly related to the specific recommendations or views expressed by the research analyst(s) in this report. For all Korea-based research analysts listed on the front cover, they also certify, as per KOFIA requirements, that their analysis was made in good faith and that the views reflect their own opinion, without undue influence or intervention. Important Disclosures Company-Specific Disclosures: Important disclosures, including price charts, are available for compendium reports and all J.P. Morgan covered companies by visiting calling , or ing with your request. J.P. Morgan s Strategy, Technical, and Quantitative Research teams may screen companies not covered by J.P. Morgan. For important disclosures for these companies, please call or [email protected]. Explanation of Equity Research Ratings, Designations and Analyst(s) Coverage Universe: J.P. Morgan uses the following rating system: Overweight [Over the next six to twelve months, we expect this stock will outperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Neutral [Over the next six to twelve months, we expect this stock will perform in line with the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Underweight [Over the next six to twelve months, we expect this stock will underperform the average total return of the stocks in the analyst s (or the analyst s team s) coverage universe.] Not Rated (NR): J.P. Morgan has removed the rating and, if applicable, the price target, for this stock because of either a lack of a sufficient fundamental basis or for legal, regulatory or policy reasons. The previous rating and, if applicable, the price target, no longer should be relied upon. An NR designation is not a recommendation or a rating. In our Asia (ex-australia) and U.K. small- and mid-cap equity research, each stock s expected total return is compared to the expected total return of a benchmark country market index, not to those analysts coverage universe. If it does not appear in the Important Disclosures section of this report, the certifying analyst s coverage universe can be found on J.P. Morgan s research website, Coverage Universe: Parameswaran, Siddharth: AMP Limited (AMP.AX), Insurance Australia Group (IAG.AX), NIB Holdings Limited (NHF.AX), QBE Insurance Group (QBE.AX), Steadfast Group LTD (SDF.AX), Suncorp Group Ltd (SUN.AX) J.P. Morgan Equity Research Ratings Distribution, as of January 1, 2014 Overweight Neutral Underweight (buy) (hold) (sell) J.P. Morgan Global Equity Research Coverage 43% 45% 12% IB clients* 57% 49% 36% JPMS Equity Research Coverage 43% 50% 7% IB clients* 75% 66% 59% *Percentage of investment banking clients in each rating category. 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47 Rob Stanton, Head of Research (61-2) J.P. Morgan Australasia Research Responsibilities Banks Healthcare Scott Manning (61-2) Steven Wheen (61-2) James Nicholias (61-2) Anasuya Ramesh (61-2) Bharat Anand (61-2) REITs Insurance Richard Jones (61-3) Siddharth Parameswaran (61-2) Rob Stanton (61-2) Ismar Tuzovic (61-2) Scott Molloy (61-2) Diversified Financials Ismar Tuzovic (61-2) Emerging Companies Siddharth Parameswaran (61-2) Russell Gill (61-2) Russell Gill (61-2) Garry Sherriff (61-2) Armina Soemino (61-2) Media Jarrod McDonald (61-2) Resources Thomas Beadle (61-2) Lyndon Fagan (61-2) Mark Busuttil (61-2) Telecommunications Andrew Muir (61-2) Paul Brunker (61-2) Joseph Kim (61-2) Thomas Beadle (61-2) Luke Nelson (61-2) Transport Scott Carroll (61-2) Energy Megan Freeman (61-2) Ben Wilson (61-2) Daniel Butcher (61-2) Beverages & Food, Paper & Packaging, Chemicals Stuart Jackson (61-2) Richard Szabo (61-2) Strategy Gaming Paul Brunker (61-2) Matt Ryan (61-2) Cheryl Ng (61-2) William Loh (61-2) Retail Economics Shaun Cousins (61-2) Stephen Walters (61-2) Uma Joshi (61-2) Tom Kennedy (61-2) Ben Jarman (61-2) Infrastructure Carolyn Holmes (61-2) Megan Freeman (61-2) Quantitative & ESG Berowne Hlavaty (61-2) Utilities & Building Materials James Eustace (61-2) Jason Steed (61-2) Chris Laybutt (61-2) ESG Keith Chau (61-2) Carolyn Holmes (61-2) Megan Freeman (61-2) Property Developers & Contractors Anthony Passe-De Silva (61-2) Database William Loh (61-2) Stephen Blagg (61-2)

48 2014 J.P. Morgan Taylor Fry General Insurance Barometer Direct Underwriters, Reinsurers and Brokers 48