Spiralling Costs of Insurance in Ireland

Spiralling Costs of Insurance in Ireland Presented to the Society of Actuaries in Ireland Dermot O Hara FSAI David Costello FSAI November 2002

Note The opinions contained in this paper are expressed in an individual capacity by the respective authors and do not represent the opinions of Employers of the working party members; The Society of Actuaries in Ireland; or Any other trade or professional body.

Spiralling Costs of Insurance in Ireland Part 1 Summary 1 Part II Detailed Findings 1 Motor 2 1.1 Introduction to Motor Insurance 1.2 Where does the premium go? 1.3 History of Premium Increases 1.4 Motor Insurance Profitability 1.5 Consolidation in the Irish Market 1.6 Factors affecting Claims Cost - What has changed? Investment Returns Claims Cost Inflation Claims Frequency Non-Compensation Costs Uninsured\Untraced Drivers 1.7 Summary Household 15 2.1 Introduction to House Insurance 2.2 Where does the premium go? 2.3 History of Premium Increases 2.4 House Insurance Profitability 2.5 Expense Ratios 2.6 Retail Sales 2.7 Underinsurance 2.8 Storm Events 2.9 Summary

Part 1 Overview This report is written in light of the recent increases in insurance premiums in Ireland. These premium increases have occurred across most lines of business. This report studies motor insurance and household insurance separately and highlights the following main conclusions: Motor 1) Insurance business is very cyclical. Premiums show little or no increases for periods and then increase significantly to catch up. It is not appropriate to study any 2-3 year period in isolation; 2) Insurance costs have not spiralled over the past 10 years wage and medical inflation outstripped insurance premium inflation in this period; 3) The motor insurance market in Ireland made losses in 1999, 2000 and 2001. These losses are explained by the premiums charged failing to keep up with the underlying elements affecting premiums. Household 1) Household premiums are also cyclical. However, the cycle is not as pronounced as motor premiums; 2) Insurance costs have not spiralled over the past 10 years wage and rebuilding inflation outstripped insurance premium inflation in this period; 3) The household insurance market in Ireland made losses 2001. While premium increases over the period 1995 to 2001 have been sufficient to cover increases in the underlying premium drivers, underinsurance in the market has led to insurers moving from a point of profitability in 1995 to loss in 2001. 1

Part II Detailed Findings 1 Motor 1.1 Introduction to Motor Insurance The motor insurance market has grown by over 60% in the last 10 years. There are 1,769,684 motor vehicles currently registered in Ireland with a written premium of 1,669.3m. The law on motor insurance in Ireland is set out in the Road Traffic Act 1961 and subsequent regulations. Unlimited third party liability cover is compulsory for all cars in Ireland. It is also compulsory to get third party property cover up to a limit of 114K (IR 90K). However, it is common to purchase other optional covers such as: comprehensive insurance which protects the insured against accidental damage to the insured s vehicle; accidental death benefits which provide a fixed payment on accidental death of the insured; windscreen insurance which pays for damage to the vehicle s windscreens; Insurance companies operate a no claims discount ( NCD ) scale where the insured gets a reduction for each year of claims free driving up to a maximum discount. 2

1.2 Where does the premium go? The following diagram highlights the main outgoings of insurance companies: Figure 1.1 Motor Insurer Outgoings Injury Injury Compensation Legal Fees Claims Damage Insurer Outgoing Uninsured Drivers Expenses Expenses Commission Reinsurance In 2001 outgoings totalled 112 per 100 of premium received. Investment income is used to compensate for the difference in premiums received and insurance outgoings. However, investment income did not completely bridge the gap and insurers had an overall loss in 2001. 3

Figure 1.2 Motor Premium Composition Commission Expenses 15 2 Reinsurance Uninsured 7 47 Personal Injury 21 Damage 20 Legal Costs (Breakdown based on AXA Insurance Data). Claim costs (including legal fees) represent 85% of total insurer outgoings. The main categories of motor claims are: Personal Injury (including legal costs) Accidental damage Third party damage Other (eg windscreen) Personal Injury claims account for over 70% of the total claims cost. Therefore, to understand motor claim costs it is important to understand the characteristics of personal injury claims. Personal Injury claims can take a long time to settle, on average about 3 years is typical. Personal Injury claims can be further subdivided into the following subsections - commonly called heads of damage: Future Loss of Earnings Cost of Care General Damages (pain and suffering, whiplash) Legal Costs 4

Loss of earnings and cost of care awards depend on the occupation of the claimant, the expected absence from work and, in the case of severe injuries, the age of the claimant. The type of injury is critical as it determines the expected absence from work and the level of care required. General damage awards are determined by the judge and vary from case to case. The total award per case is limited to 254K by court precedent. Legal costs can be very significant as a percentage of the settlement amount. In 1998 non-compensation cost accounted for 28% of total claims cost (source MIAB report 2001 page 414). In the Irish market claim settlements are made as a single lump sum payment. This lump sum is designed to be sufficient to cover the claimant s future needs. The claimant is assumed to earn investment income on the lump sum. An assumed discount rate is therefore taken into account when the lump sum is determined. The same discount is usually used for all settlements and is determined by a court precedent. However the rate may change if a new precedent is set. A discount rate of 4% was assumed in most settlements prior to 2002. However, settlements at lower discount rates have been made during 2002 and the precedent at this stage is unclear. Increases in personal injury claims costs are a mixture of: Wage inflation Cost of Care inflation Legal cost inflation General Damage Inflation Court award inflation Discount Rate changes 5

1.3 History of Motor Premium Increases Motor premiums increased significantly in 2001. However, when viewed over the past 10 years motor premiums have not increased by unusual amounts: Figure 1.3 Motor Premium Increases (Year on Year) 25.0% 20.0% Percentage Increase 15.0% 10.0% 5.0% 0.0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Motor Insurance Inflation Medical Inflation Source: MIAB Report page 546 Figure 1.4 Motor Premium Increases (Cumulative) Base 100 200 190 180 170 160 150 140 130 120 110 100 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year Motor Insurance Inflation Medical Inflation Wage Inflation Source: MIAB Report page 546 6

Motor premiums have increased by less than medical and wage inflation over the period 1990 to 2001. This could not be classed as spiralling costs. The cyclical nature of motor premiums is evident in the graphs. Premiums increased significantly in 1991. Between 1992 and 1996 premiums increased by less than 6% in total over a five year period. This was followed by rising increases between 1997 and 2001. This report deals with the period 1995 to 2001. Motor premiums increased by an average of 6.6% per annum in this period. 1.4 Motor Insurer Profitability Figure 1.5 details the profits made by the motor insurance market over the period 1994-2001. Insurers made underwriting losses in all periods. This is not unusual as investment income should compensate. However, in recent years investment income was not sufficient to compensate for the large underwriting losses and insurance losses have been made. The gap between the underwriting result (yellow line) and the technical result (blue line) is narrowing owing to the reducing investment returns achieved over the past five years (see section 1.5). Figure 1.5 Motor Insurance Profitability 'm 200 100 0-100 -200-300 -400 1994 1995 1996 1997 1998 1999 2000 2001 Loss Year 15% 10% 5% 0% -5% -10% -15% -20% -25% % Premium U/W Result Tech Result U/W Result % Tech Result % Source : IIF Factfile (Investment Income approximated for 2001) The return on capital achieved by Irish insurance companies has been much lower than that achieved by Irish Banks over the past 6 years. In recent years losses have been made despite the large increases in insurance premiums. 7

Figure 1.6 Return on Capital Insurers v s Banks 30.0% 20.0% Return on Capital 10.0% 0.0% -10.0% -20.0% -30.0% 1995 1996 1997 1998 1999 2000 2001 Year Irish Motor Insurers Irish Banks Source : Banks annual accounts. Insurance statutory returns and IIF data. Insurance capital assumed to be 40% of written premium. 1.5 Consolidation in the Irish Market In 1994 11 companies wrote 90% of premium income in the motor insurance market. In 1999 5 companies wrote 84% of premium income in the motor insurance market. It is clear from section 1.3 that this consolidation has not increased insurer profits. These mergers may have been caused by insurers withdrawing from an unprofitable market or a result of the merger of international companies. 8

1.6 Factors affecting claims costs What has changed? Investment Returns There can be significant delays between receipt of premium income and payment of subsequent claims, particularly in the case of personal injury claims. During this time insurers earn investment income on reserves. Most insurers purchase fixed interest bonds to match the term of their liabilities. Reductions in fixed interest rates therefore lead to premium increases. Figure 1.7 5 Year Bond History Percentage Yield 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jan-95 Jul-95 Jan-96 Jul-96 Jan-97 Jul-97 Jan-98 Jul-98 Jan-99 Month Jul-99 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 The returns on government bonds decreased by about 5 percentage points between 1995 and 2001. Assuming a mean term of liabilities of 3 years, a 5 percentage point decrease in investment returns results in a premium increase of approximately 15%. Over the 6 year period premiums would need to increase by on average 2.4% per annum to compensate for the falling investment returns. 9

Claims Cost Inflation As discussed in section 1.1 claims costs are made up of many different elements. No simple index can be used to capture claims cost inflation. Medical inflation applies to cost of care awards. Wage inflation applies to loss of earnings elements. General damages can increase in an ad-hoc manner. Motor insurance claims have increased significantly in recent years. Based on AXA data, the average bodily injury award across the European markets is about 12,500. In Ireland, the average award is between 50,000 and 60,000. The average award has increased by between 8% and 10% per annum between 1996 and 2001. As claims account for 85% of total motor insurer outgoings a 9% per annum increase in claims costs increases the premium by 7.5% per annum. This figure incorporates increases in legal costs and uninsured drivers as well as general claims inflation. Claims Frequency Personal injury accident frequency decreased by about 28% between 1995 and 2000. Figure 1.9 Personal injury accident frequency Number ('000) 9 8 7 6 5 4 3 2 1 0 1995 1996 1997 1998 1999 2000 0.70% 0.60% 0.50% 0.40% 0.30% 0.20% 0.10% 0.00% Number Frequency Source : MIAB report page 48. This reduction may be due to factors such as increased safety awareness, national TV safety campaigns and Garda safety initiatives. The above reduction in serious injuries would led to a reduction in premium of about 17% over the five year period. This is equivalent to an average annual decrease of about 3%. 10

Note that the above frequencies relate to the number of accidents involving a personal injury. The actual number of personal injuries is higher as some accidents involve more than one injury. Property damage accident frequencies have also decreased in the period. However, the decrease is not as marked as personal injuries. Figure 1.10 Damage accident frequency Number ('000) 30 25 20 15 10 5 0 1995 1996 1997 1998 1999 2000 2.00% 1.50% 1.00% 0.50% 0.00% Number Frequency Source: MIAB report page 45 Damage accident frequencies reduced from 1.57% in 1995 to 1.49% in 2000. The small percentage improvement coupled with damage being a low percentage of the total claims cost means that the annual effect on the premium is very small. Accident and injury figures are calculated from Garda accident reports from the accident scene. The figures do not account for changes in: 1) Gardai procedures in completing the reports; 2) the proportion of accidents attended by the Gardai; 3) the subsequent reporting of claims after an accident. 11

Non-Compensation Costs Non-Compensation costs have increased as a percentage of total claims costs from 25.6% in 1996 to 28.3% in 2000. This leads to an average increase in premium of 0.7% per annum over this 4 year period. Figure 1.11 Non Compensation Costs Percentage of Total Costs 29% 29% 28% 28% 27% 27% 26% 26% 25% 25% 24% 1996 1997 1998 1999 2000 Year Non-Compensation Costs Source: MIAB Report pg 416. Non-Compensation costs in the above graph cover costs paid to parties such as solicitors and experts employed by the insurer on behalf of the defendant policyholder and also those employed by the plaintiff. No internal expenses of insurers are included. Average plaintiff s costs and average defendant s costs are over four times higher in Ireland than in the UK (source: MIAB report page 433). 12

Uninsured \ Untraced Drivers The Insurance Industry undertakes to pay for claims arising from accidents where the driver is either uninsured or untraceable. These claims are paid through the Motor Insurance Bureau if Ireland ( MIBI ) which is funded through levies on Irish insurance companies. The insurance premium paying population indirectly pay for these claims through higher premiums. An increase in the number of uninsured drivers or a change in the mix of uninsured drivers towards more risky groups leads to higher premiums for premium paying drivers. Figure 1.12 MIBI Incurred Costs Levies \ Earned Premium 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 1995 1996 1997 1998 1999 2000 MIBI Levies The MIBI incurred costs have increased by 4% over the period 1995 to 2000. This directly increases premiums by 4%. This increase is implicitly included in the claims inflation section. 13

1.7 Summary Motor insurance premiums have increased by an average of 6.6% per annum over the period 1995 to 2001. This average increase is lower than either wage or medical inflation over this period. Increases have not however been uniform over the period. The general population have noticed the large increases applied recently while forgetting the years of relatively small increases in the mid-90s. To match the underlying cost drivers and maintain insurers level of profitability premiums should have increased by 6.8% per annum during this period. This explains why insurers have gone from a position of profit in 1995 to a position of loss in 2001. 1995-2000 Premium Increases 6.6% Claims Inflation 7.5% Uninsured Claims 4.0% Non-Compensation 0.7% Investment Returns 2.4% Frequency Improvements -3.0% Combined Effects 6.8% 14

2 Household 2.1 Introduction to Household Insurance Household insurance is mainly designed to cover household buildings and contents. The major perils covered are: Fire Subsidence Escape of water Storm Flood Theft Optional extensions to cover are also available: Personal valuables ( Cash, Visa Cards) Personal Accidents Public Liability With the exception of liability, claims are reported and settled quickly. The short tail nature of household business means: companies are more quickly aware of changes in the claims environment than in the motor market and hence are able to act faster; Insurance premiums are not as affected by changes in investment returns as motor premiums. Household insurance is not compulsory. There is no fund to pay for uninsured claims. This removes a potential source of premium inflation. 15

2.2 Where does the premium go? In 2001 outgoings totalled 115 per 100 of premium earned. Investment income is used to compensate for the difference in premiums received and insurance outgoings. However investment income did not bridge the gap and insurers had an overall loss in 2001. Figure 2.1 Household Premium Composition Expenses 8 Commission 16 Reinsurance 14 78 Claims Claims represent 68% of total household insurer outgoings. Factors affecting claims inflation have a large effect on premium inflation. The main factors affecting claims inflation are: Frequency of large events (i.e. floods, storms, freezes) and possible climatic changes Changes in claim frequencies Changes in the cost of getting repairs done The following factors can also have a big effect on household premium increases: Reinsurance Costs Commission and Expense inflation 16

2.3 History of Premium Increases Household insurance premiums increased significantly in 2001. However, premium inflation did not match rebuilding cost inflation in the period 1991 to 2001. Figure 2.2 Household Premium Increases (Year on Year) 25% 20% Percentage 15% 10% 5% 0% 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year House Premiums Wage Inflation Re-Building Inflation Figure 2.3 Household Premium Increases (Cumulative) Base 100 200 190 180 170 160 150 140 130 120 110 100 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Year House Premiums Wage Inflation Re-Building Inflation Source CSO: The calculations allow for increases in building costs and contents as a percentage of the rebuilding cost. 17

2.4 House Insurance Profitability Household insurance profits have been volatile over the period 1994 to 2001. Volatility is a necessary feature of household insurance as the claims are sensitive to large weather related events. Figure 2.4 House Insurance Profitability 'm 30 20 10 0-10 -20-30 -40-50 -60 1994 1995 1996 1997 1998 1999 2000 2001 Loss Year 15% 10% 5% 0% -5% -10% -15% -20% % Premium U/W Result Tech Result U/W Result % Tech Result % Source : IIF Factfile (Investment Income approximated) The impact of large weather related events on insurance company profitability can be seen from the graph. There was a large freeze event in 1995. There was a very significant storm in both December 1997 and December 1998. There was also significant weather related events in both 2000 and 2001. 18

2.5 Expense Ratios Expense ratios have decreased between 1994 and 2001. However, the average expense per policy has remained reasonably stable. Figure 2.5 reflects the increase in average premium more than the reduction in average expenses. Figure 2.6 Household Expense Ratios % Premium 16% 14% 12% 10% 8% 6% 4% 2% 0% 1994 1995 1996 1997 1998 1999 2000 2001 Loss Year Source : IIF Factfile 19

2.6 Retail Sales The CSO produce an index of durable goods inflation. This index increased by a very small percentage over the past 4 years. The CSO also calculate inflation in retail sales. It is clear that while the cost of a particular good has not increased people are trading up to more expensive goods. Retail sales inflation has been running at an average of 8% over the past six years. Figure 2.7 Durable Goods v s Retail Sales 15% 10% Percentage 5% 0% -5% -10% 1996 1997 1998 1999 2000 2001 Year Durable Goods Retail Sales 2.7 Under-Insurance Underinsurance developed in the Irish household market when the re-building index increased by more than inflation clauses in the household policies. Some of the large premium increases in 2001 are due to a catch up of underinsurance. 2.8 Weather Related Large Events and Reinsurance There have been a number of large claim events in the period of investigation. In particular December 1997 and December 1998 had large storm events. Reinsurance is usually purchased to provide some protection against these events. The insurance company returns show that reinsurance paid as a percentage of premium increased from 11% in 1995 to 13% in 2001. However, the real reinsurance costs are difficult to determine from public figures as there 20

may have been significant reductions in reinsurance cover. The real reinsurance costs increased dramatically in recent years in response to the frequency and size of large weather related events. Reinsurance costs have increased by at least 10% of written premium between 1995 and 2001. This equates to an annual increase in premiums of 1.6% per annum. It is worth noting that 2002 has seen dramatic changes in the reinsurance market. This is partly a result of September 11 2001 attacks. Also, there was a large flood event in February 2002 and a significant freeze in January 2002. This will increase the 2002 and 2003 premium costs. 2.9 Summary Premium increases over the period 1995 to 2001 have been insufficient to cover increases in the underlying premium drivers, moving insurers from a point of profitability in 1995 to loss in 2001. 1995-2001 Premium Increases 5.2% Claims Inflation 7.3% Re-Building 6.5% Retail Sales 8.0% Expense Ratio Improvements 0.0% Reinsurance Costs 1.6% Combined Effects 9.0% Household premiums may continue to increase in excess of inflation over the next few years as: reinsurance costs continue to increase; climatic changes could lead to an increased incidence of large events; claims inflation could be outstripping the buildings cost index; claims inflation still lags the buildings cost inflation index when viewed over the past 10 years; more houses are being built on flood planes then in the past; changes in household construction could lead to more claims. 21