MARKET OVERVIEW AND OUTLOOK

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1 MARKET OVERVIEW AND OUTLOOK edition 1 September 2012 Willis Uk Retail Market Overview and Outlook for 2013 In this bulletin we look at the long term view of the UK market cycle, a global view of the key insurer metric of the combined operating ratio (COR) and a brief analysis of the impact of the extreme 2011 catastrophe losses. We review trends in claims inflation that continue to run far ahead of price inflation and of course are of great concern to insurers. Of equal concern is the impact of claims farming and fraud. We look at the issues of concern to insurers, how rates have moved in the past year and our outlook for the next 12 months. OVERALL MARKET ANALYSIS The chart below (Figure 1) shows an impressive rise in aggregate commercial premiums over the past 35 years, peaking in 2003 as the very hard market began to turn. However, this is somewhat deceptive as it is not adjusted for inflation or growth in the underlying economy. U.K. COMMERCIAL PREMIUMS 1977 Millions 18,000 16,000 14,000 12,000 10,000 8,000 6,000 4,000 2, Figure 1 Source: ABI/Willis Analysis Year Figure 2 (below) shows premiums as a percentage of Gross Domestic Product. This eliminates the impact of growth and inflation, so it gives a good proxy for where rating is at any given time. U.K. COMMERCIAL PREMIUMS AS % OF GDP % 1.4% 1.2% 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% Figure 2 Source: ABI/Willis Analysis Year Airline Insight June & July

2 A relatively long period of softening, starting around 1990, reached its nadir at the end of the 90s before beginning to climb. The UK and indeed the global market began hardening in the early part of But as many of you will remember, the sharpest increases came towards the end of 2001 with the combined effect of the long soft market, investment losses, the Independent Insurance Company failure and the World Trade Centre disaster. These events are reflected in the peak during late. However, by the middle of 2003, rates had already begun to soften. When the ABI produce their numbers for 2011, we expect the downward slope to continue. This is despite the commercial motor market seeing average rises over the past two years of around 7.5%. Global Combined Operating Ratios The Chart below (Figure 3) shows the reported Combined Operating Ratios (CORs) for 2011 for a wide range of insurers and reinsurers worldwide. The line drawn at 96% is merely a guide to the minimum COR most companies would consider to be a desirable goal in order to make an adequate return for their investors in the longer term. Of course, many target a lower ratio, especially those that write a higher proportion of more volatile cat (catastrophe) business. The left hand side of the chart is heavily influenced by the unusual degree of cat losses in 2011 of which more below. The insurers and reinsurers towards the left tend to write a far higher proportion of cat business. The general impact of these losses can be seen in the differences between 2011 and the year before which was relatively quiet in cat terms. The insurers to the right tend to write cat business and it had a big impact on their global property results but in overall terms the impact is softened by their more diversified portfolios. REPORTED WORLDWIDE COMBINED OPERATING RATIOS 96% 153.6% 143.3% 134.3% 131.1% 125.4% 120.9% 119.9% 118.6% 118.5% 115.6% 114.2% 113.9% 112.9% 112.3% 109.0% 108.0% 107.5% 107.4% 107.3% 105.1% 105.1% 104.5% 104.5% 104.3% 102.6% 101.6% 99.6% 99.5% 99.3% 99.0% 99.0% 98.8% 98.4% 98.4% 98.3% 97.8% 97.8% 96.9% 96.8% 96.8% 96.5% 95.9% 95.3% 94.9% 94.6% Flagstone Platinum Re Omega Montpelier Re Partner Re Hardy ARGO Renaissance Re Everest Re Aspen Fairfax Transatlantic Endurance Axis Capital Chartis Amlin XL Capital Liberty Mutual Munich Re Travelers Novae SCOR Hartford Hannover Re Catlin Swiss Re Brit Hiscox Berkshire Hathaway Beazley Validus Zurich CNA Alterra Arch Capital White Mountains Allianz Mapfre Aviva QBE Generali Allied World Chubb RSA ACE Lancashire Source: Willis Analysis FY 2011 FY 63.7% Figure 3 The reported combined operating ratio is the sum of claims and expenses divided by premium with adjustments for changes in prior year reserves. Catastrophe Losses in was one of worst years for catastrophe losses in recent history with a reported total of $120 billion. The largest losses arose in Japan, Thailand and New Zealand the three most expensive insured catastrophes ever outside of the US in total representing half the 2011 burden. However, the exceptional loss tally of $18 billion from the US storms and tornadoes in April and May, meant that insured US losses were also higher than usual. The US had a relatively unusual tornado season. Tornados hit the usual places but also appeared in other locations with more insured property where they visit less often leading to the usual assertion that there is an increasing trend. However as is evident from the chart on the right (Figure 4), showing records going back over 60 years, there is no exceptional trend. In response to these losses, cat rates increased quite significantly through 2011 and during the first quarter of However, they have already moderated with some reinsurers describing the 1st July 2012 reinsurance renewals as disappointing. So far the direct impact on UK rating, with the exception of global property risks, has been muted - indeed absent. Year Number of Tornadoes Figure 4 Beginning in 2007, NDAA switched from the Fujita scale to the Enhanced Fujita scale for rating tornado strength. * Chart derived from National Oceanic and Atmospheric Administration (NOAA) research

3 CLAIMS TRENDS Claims cost inflation continues to be a concern for insurers. The results of our survey of leading insurers are shown in (Figure 5) below. Figure 5: Claims inflation costs Employers Liability and PL bodily injury 6 10% Motor Accidental Damage 2-5% Motor Third Party Damage 3-5% Motor Third Party Bodily Injury 8% Source: Willis UK interviews with leading insurers Bodily injury claims have tended to rise much faster in cost than the general level of inflation. Two of the key drivers are : continuing advances in medical science and the ingenuity of the legal profession in extracting fees from the system. Medical advances mean that seriously injured people can be kept alive for much longer. Currently, there are a significant number of motor bodily injury claims involving people who have been seriously and permanently injured with settlements or reserves in the range of million. These are a major factor for insurers in their reserving and pricing models. Only a small minority of claims are actually litigated. For example for Employers Liability the figure is below 1%, yet most insurers estimate that legal costs can be as much as 40% of the claims cost. Lord Justice Jackson has recommended sweeping changes to litigation funding and solicitors costs to address this issue. Unsurprisingly, these reforms have encountered opposition and they have been deferred until However, the issue of greatest concern to Motor and Employers Liability insurers is the impact of claims farming, the practice of virtually every party involved in an accident playing an elaborate game of pass the parcel with referral fees being paid by and to insurers, garages, the police, trade unions, vehicle recovery companies, claims management companies, hire car companies and of course lawyers. The impact of referral fees on motor claims is graphically illustrated in the following charts (Figures 6 & 7), reproduced by kind permission of Allianz Commercial. Based on data from the Department of Transport, road traffic fatalities, accidents and injuries have declined quite markedly in the past 10 years. Yet in the same period, the number of road traffic accident claims has nearly doubled. One of the big issues is whiplash, where it appears relatively easy to bring a claim even if the injury is minor and susceptible to quick recovery. Many market observers are convinced that the majority of whiplash claims are either fraudulent or grossly exaggerated and play a huge part in the rapid growth in claims. There is support for a change in the law requiring a minimum speed for whiplash claims, as applies for example in Germany. Naturally, certain parties disagree. REFERRAL FEES IMPACT ON MOTOR CLAIMS Figure 6 Numbers of Incidents (DfT) 4,000 3,500 3,000 2,500 2,000 1,500 1, Source: Allianz Referral Fee Ban Lifted RTA Fatalities (DfT) RT Accidents (DfT) (00s) Calendar Year RTA Injuries (DfT) (00s) RTA Claims, calendar year (CRU, weighted) 800, , , , , , , ,000 0 Claims Notified to CRU A referral fee is a fee paid to an intermediary generally a Claims Management Company (CMC) for a client referral. A client referral occurs when the client s contact details are passed on to a solicitor. Referral fees are frequently as much as 800 but can be up to 1000 for low value claims. Recipients include CMC, lawyers, trade unions and insurers. [ABI Quote Referral Fees]

4 If further evidence is needed, the Institute and Faculty of Actuaries, in its 2012 report on third party motor claims ( found inter-alia: A staggering 18% increase in the proportion of third party accidents involving bodily injury (third party bodily injury/ third party damage ratio) from to This change alone increased costs to insurers in excess of 400m. Hotspots of third party accidents with bodily injury claims were found - mostly in the North West and West Midlands, in particular Liverpool, Manchester and Birmingham. Previously these hotspots were contained to city centres but the 2011 data shows they are now spreading out to more rural areas within these regions. (This data is described graphically in the report) the worst area of the UK for third party injury claims, the North West, overtook the worst areas of the US in terms of the proportion of accidents involving a bodily injury claim. An important aspect of claims farming is the rapid escalation in credit hire illustrated in Figure 7. This data is from Allianz and although the actual volume is excluded for commercial reasons, the huge increase in the past 10 years is self-evident. ACCIDENT YEAR REPORTED CLAIMS Figure 7 08/12/2012 Copyright Allianz. Strategic Partner Forum 07/12/11 In addition to the issues described above, fraud is an unfortunate and serious component of the escalation in motor bodily injury claims. This is illustrated in the pie charts below. The ABI estimates the total of all fraudulent commercial and property claims at 2 billion or around 5% of total premiums with motor producing over 50% by value. This is a reflection of the number of staged motor accidents with multiple claimants. FRAUD FRAUD VALUE VALUE 2 BILLION 2 BILLION 5% 5% Volume Volume Value Value Property 53% Motor 31% Other 7% Property 53% Motor 31% Other 7% Liability 5% Liability 5% Travel 4% Travel 4% Motor 51% Motor 51% Liability 23% Liability 23% Property 20% Property 20% Other 5% Other 5% Travel 1% Travel 1% Source: AllianzSource: Allianz Figure 8 Source: Allianz Although the issues described above have the greatest bearing primarily on personal motor insurance they are spreading into the commercial vehicle sector. For example, many of the fraudulent staged accidents involve self-drive hire cars. This has had a profound impact on the cost and availability of cover.

5 The results can be seen in the Deloitte analysis of motor market profitability illustrated in the following chart (Figure 9) NET CR (%) Figure FINANCIAL YEAR Source: Deloitte Motor Insurance Seminar 2012 The sharp decline in profitability since is the combined effect of intense competition and the impact of escalating claims cost. The change since reflects the 30% - 40% rate increases in personal motor and the more modest average increase in commercial motor premiums at the more stately 7.5% - 10%. Claims farming is a dilemma for the whole insurance industry because insurers fall into two groups. Those that are steadfastly resisting all referral fees and those that have become somewhat more dependant on them. Of course this is a zero sum game because, ultimately, all of these costs are included in total claims costs. KEY FACTORS INFLUENCING UK INSURERS These are: Solvency II: To date the UK insurance industry including Lloyd s has spent over 500m preparing for these EU-wide requirements on capital adequacy and risk management. When it actually arrives, it is likely to have unintended outcomes. It definitely favours larger insurance groups with a more diversified premium and capital base. However, even for these insurers, it may make some smaller lines of business less economic. It is very unfriendly to smaller or mutual insurers with limited access to capital. In theory, Solvency II should drive rate increases but, despite the readiness of the UK industry, the can keeps being kicked down the road with the latest implementation date deferred until The continuing low interest rate environment: most insurers do well to achieve around 3% across their portfolios. Higher returns require higher risks but since the collapse of tech stocks in the early part of the century, most insurers have maintained relatively conservative investment strategies. Claims cost inflation: as illustrated above, it is not going away anytime soon. Weather-related losses: despite the apparent exceptional rainfall earlier this year, there is limited evidence that there is a worsening trend discernible from normal variation. What continue to be important are changing land use and management of drainage with flood waters finding their way into rivers more rapidly. For the personal lines sector, there is an agreement between insurers and the government that flood insurance will be generally available until the agreement expires in The agreement is conditional upon continuing investment in flood defences yet, in real terms, the funds available have not kept pace with perceived need. Despite an announcement by the government on 11 July 2012 that said, we are continuing to make progress towards a new agreement on the future of flood insurance, the two sides are still far apart. There is a real prospect that the agreement will end resulting in a free market that will almost certainly reduce cover for risks in the worst affected areas. Recession: historically, recession is perceived to bring increases in malicious damage and arson losses although the statistical underpinning for this is limited. The bigger concern for insurers is the impact on demand. The private sector in the UK is widely quoted in the financial press as holding cash in the region of 750 billion. However, new investment is limited and there is no let up in the sector s demand for value and savings. This continues to drive competitive pressure.

6 Surplus of capacity: Many insurers now question if there will ever be another hard market of the type seen in. Shocks like the credit crunch only demonstrate the resilience that the industry has built in the past 10 years. Of course there is some increase in rates as we describe below. However, as soon as the industry appears to be achieving an adequate level of profit, competition returns. The Euro: Some in the industry believe that a serious dislocation in the Euro zone will be a game changer. However, making predictions in this area is fiendish and there are many diametrically opposed views. Perhaps the only prediction that can be made is if and when something big happens, it will catch everyone by surprise. PREMIUM RATE TRENDS AND OUTLOOK FOR THE NEXT 12 MONTHS Willis has gathered data from a variety of internal and insurer sources to produce the following broad premium rate trends for the past 12 months: Figure 10: Premium Rate Trends Commercial Motor + 7% Property: + 3% other than cat exposed risks as below Liability: Flat SME Commercial Combined: +3% Overall: +2% - 3% For property, there have been exceptions: global risks with cat exposure to for example South Eastern United States and Caribbean windstorm, earthquake in Japan, California, Chile and New Zealand and of course flood in Thailand. Businesses with operations in these zones will have seen some quite sharp increases over the past 12 months; waste recycling, energy from waste, risks with a high degree of combustible insulation and alternative green fuels have all shown a propensity to catch fire that may somewhat defeat their objective; the market for these risks has contracted and rates and terms have hardened. Most classes of liability cover have been surprisingly competitive. Many insurers would say that Employers Liability was one of their lowest margin businesses but it continues to attract quite intense competition. In motor, after two years of 10%+ rises, increases have moderated. The exceptions are self-drive car hire, mentioned above, heavy haulage, bus & coach and more hazardous risks such as waste disposal, where the market is tighter. In the SME commercial segment most insurers are claiming rate increases in the 3-5% range. However, for many insurers, when they claim they are getting rate, they may be doing so at the expense of retention which can fall as low as 80%. With respect to the outlook for the next 12 months, whilst in all segments, we expect to see more insurers seeking rate increases, we also expect the pattern described above to continue. Market capacity and our negotiation skills will moderate the impact. As always, for risks where the information is good and there is a positive approach to risk management, the market will respond. Risks with poor claims records and inadequate risk management will find life getting gradually tougher over the next 12 months. The issues concerning flood described above will not disappear. There are many areas where effective risk management is relatively low cost, e.g. claims defensibility preparation or driver training and awareness. Furthermore insurers will often share the costs associated with such risk improvements. Naturally, we will be pleased to advise on the measures you can take.

7 If you need more information about the content, please talk to your Willis service team or contact Paul Maynard direct at the address below. Paul Maynard, Chief Placement Officer Willis UK Retail This newsletter contains public sector information published by the Department for Transport and licensed under the Open Government Licence v1.0 This newsletter offers a general overview of its subject matter. It does not necessarily address every aspect of its subject or every product available in the market. It is not intended to be, and should not be, used to replace specific advice relating to individual situations and we do not offer, and this should not be seen as, legal, accounting or tax advice. If you intend to take any action or make any decision on the basis of the content of this publication you should first seek specific advice from an appropriate professional. Some of the information in this publication may be compiled from third party sources we consider to be reliable, however we do not guarantee and are not responsible for the accuracy of such. The information given in this Bulletin is believed to be accurate at the date of publication shown at the top of this document. This information may have subsequently changed or have been superseded, and should not be relied upon to be accurate or suitable after this date. The views expressed are not necessarily those of the Willis Group. Copyright Willis Limited All rights reserved. Willis UK Retail is a trading name of Willis Limited, Registered number: England and Wales. Registered address: 51 Lime Street, London, EC3M 7DQ. A Lloyd s Broker. Authorised and regulated by the Financial Services Authority for its general insurance mediation activities only. FP1339/11127/09/12