Time to take note and action following the latest Dear CEO

27 June 2018

On 31 May, the PRA released one of its strongest letters to date, raising serious concerns about the sustainability of some London Market insurers’ business models amidst one of the longest soft cycles faced by the market.

Our view, based on findings from our annual PwC market view analysis of London Market data, is that the PRA is right to call out their concerns so strongly.

Below are the important takeaways from our analysis and the PRA’s letter. Although it’s the larger firms (Categories 1, 2 and 3) who have been asked to respond by the 27th of July, we expect smaller firms will be subject to similar scrutiny, through ongoing supervisory dialogue with the PRA, as the results of our analysis indicate the same issues across firms of all sizes.

  1. Our market view analysis suggests that following cat losses led by Hurricanes Harvey, Irma and Maria (HIM) in 2017, rate increases of c.4% were expected and achieved in 2018 across most business classes. However, the boost is only relative following a prolonged soft market. As an example, direct Energy, where anticipated rate changes although positive were only c.2%, follows years of significant pressure with a cumulative rate change of c. -35% since 2012.
  1. Concerns over potential optimism in business plans are compounded by observed year on year reserve deteriorations. For example, in Cargo we have observed loss ratio deteriorations of between 8% and 40% for each of the 2014 to 2016 years of account from initial plan reserve levels, taking the business from loss ratios in the mid 80% levels to loss making. It is imperative that companies robustly test reserve adequacy and avoid reserving to optimistic plan ratios where possible, waiting for evidence of portfolio changes first.
  1. Across the market we observe that, on average, business written through binding authorities is expected to perform at a loss ratio approximately 7% greater than direct business placed in the open market. Combine this with increasing proportions of business written through such arrangements, being “new” and without historic experience, the concern is only compounded. On the other hand, we have also observed that business written through other delegated arrangements, such as lineslips, is not expected to perform worse. This highlights yet another potential source of optimism.
  1. Getting these assumptions wrong will not just affect firms’ pricing. To the extent that they feed into capital modelling, there will be underestimation of capital positions (economic or regulatory). Optimistic reserves and planned profit directly impact required capital.
  1. Though for most HIM losses were absorbable, a deeper look at the results indicate clear areas of unknown exposures. Exposure management remains a critical area of focus for the PRA. Our data suggests firms have become more prudent in recent years in their view of catastrophe risk. However, exposure management must improve if firms want to avoid the surprise of non-modelled losses.

It's a long list, so what can you do? Review your systems of governance and control over pricing, underwriting and reserving - and be ready to demonstrate that they are effective and embedded in practice, with evidence to support your conclusions. Above all, don’t dismiss the letter and the messages - you need to be disciplined in critically evaluating your business models and may need the courage and foresight to make decisions if all the facts are pointing to lack of profitability in the long term. Our analysis suggests that the firms to best survive the continued challenges of this prolonged soft cycle will be the ones taking the right action now.

Talk to us if you want to discuss the issues in more detail, including the practical steps you’ll need to take - and how we could help.

 

Jerome Kirk

Jerome Kirk | London Markets Lead Partner
Profile | Email | +44 (0) 207 213 5001

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