If you believe the nubile young lady in the Renault ads, then size really does matter. But just how important is it? The “go for growth” mantra of management consultants has heavily influenced boardroom thinking across the world.
Managing director of Stern Stewart UK, Erik Stern, is typical. He advocates companies to stop thinking about survival and to go on the offensive. “There has never been a worse time to act conservatively in business,” he says. Yet after the demise of the Independent Insurance, many insurance chief executives might surmise that there has never been a better time to show some caution.
Stern's bullish approach is based on the theory that investors are primarily interested in a company's intangible assets. A firm's people, strategy, brands, research and development are therefore more important than its book value. This rationale drove the frenzied interest in the dotcom and telecommunications companies before their collapse.
Tide of false optimism
It is not only the new-economy companies that were carried along on this tide of false optimism. The once great GEC (now Marconi) had, until Lord Weinstock's departure in 1996, a strong balance sheet and a pile of cash. The share price had doubled in the previous five years and the company was in good shape. But this was not enough – the City wanted the company to sell its cash cows and go for growth. After the recent profit warning, which triggered a £4bn plunge in the value of the firm's shares, the new management probably wishes it had resisted this pressure.
Similar casualties litter the insurance industry. The names of insurers such as Orion, Builders' Accident, Drake and Iron Trades must still stick in the gullet of the policyholders whose claims were not paid – not to mention the insurers that have to fund the compensation of the Policyholders' Protection Board.
And then there was Independent. Michael Bright, the firm's chief executive, had high hopes for expansion. “We remain convinced that there is huge scope for future growth in our business,” he wrote early last year.
Bright was right – there was huge scope for growth. Within just 12 months, total gross premiums had soared from £506m to £830m; an increase of 64%. Commercial property premiums grew by a staggering 145%, while the commercial liability account – which had already suffered from big hits in the London Market – still increased by 41%.
It beggars belief that this phenomenal growth did not cause warning bells to ring, particularly among institutional investors such as CGNU, which continued to hold nearly 5% of Independent's shares.
Towards the end, most of Independent's income came from liability business and long-term policies. Having written so many of these long-term policies, the company found itself like a hamster on a treadmill. The full premium was recorded in the year of inception, so there were no renewal premiums until the end of the term. To stop cash flow drying up, more and more policies had to be written to keep the treadmill going.
Independent tried to push pricing increases through on renewals but, by that time, it was too late. When an insurer's solvency is under pressure, increased pricing only makes the solvency position worse. Independent had already passed the point of no return, like the others before it in the insurers' hall of shame.
An idea often promoted by management consultants is that market share is more important than the class of insurance transacted. The theory is that, unless a company is a niche player, it should not do business in a market if its market share is not in the top five.
This approach explains why CGNU is keen, for example, to grow its long-term savings business in the US and its general business in Canada. Last year, after selling its US general insurance operations for £1.7bn and its Canadian life businesses for £133m, a spokesman said: “This is part of our strategy of concentrating our efforts on building top-five positions in our chosen markets.”
Aegon has a similar philosophy and wants to become a top-five insurer in the British life market. It is in talks with Royal & Sunalliance (R&SA) to purchase its life business, worth an estimated £1.7bn. The Dutch insurer already owns Scottish Equitable and it bought Guardian Royal Exchange's (GRE) life business for £759m two years ago.
Growing business
Analysts reckon the sale could reduce R&SA's shareholder value. However, with R&SA mopping up large chunks of former Independent business, a cash injection will help it grow its general business without putting its solvency at risk, particularly as the industry expects minimum solvency levels to rise. The sale may also enable R&SA to gain access to the orphan assets built up in the life funds over many years.
Other major insurers, such as Axa and Zurich, have also grown following recent acquisitions. They too must presumably feel that size is important.
But how should you measure size? The usual yardstick is gross written premium. However, if, like Independent, a company relies heavily on reinsurance, it may seem larger than it actually is. An option is to use net written or net earned premiums as these take account of premiums ceded to reinsurers. Although Independent showed massive top-line growth, its net earned premium remained virtually static last year at £401m because of the effect of reinsurance deals and long-term policies.
None of these measures, though, give any indication of an insurer's financial strength. Some analysts, therefore, prefer to judge companies by the size of their reserves. This can produce some interesting results. On the basis of 1999 FSA returns, the top five UK general insurers by gross written premiums were CGNU, R&SA, Axa, Zurich and Cornhill respectively. However, using the total of shareholder funds and net technical reserves as the measure, CGNU and R&SA stay top, Axa and Zurich swap positions, while NFU/Avon jumps from tenth position to fifth.
No shortage of players
Companies want to grow for various reasons. Being in the top five of a market gives an insurer, in theory, the ability to lead in terms of pricing and therefore profitability. In practice, this benefit is often illusory, as no one insurer has sufficient clout to dictate its terms to the market.
Furthermore, with excess capital sloshing around the financial markets and with ease of entry into the domestic insurance markets, there is no shortage of new players, whether it's the likes of Direct Line or Keith Rutters, The Underwriter. Despite the recent mergers and acquisitions, the number of authorised insurers in the UK is virtually unchanged from a decade ago.
If the big insurers have only a limited ability to lead the market, then increased size must bring competitive advantage through economies of scale – wrong again. From the 1999 FSA returns of UK general insurers, the five largest insurers in terms of gross premium income do not have market leading expense ratios.
Insurers such as Direct Line, NFU/Avon, Fortis and St Paul's have substantially lower net operating expense ratios than the big five. CGNU has the greatest market share, but its expense ratio is 50% higher than NFU/Avon's and a massive 85% more than Direct Line's. R&SA, Axa, Zurich and Cornhill fare even worse.
In the insurance and banking sectors, the trend is for companies to grow through mergers and acquisitions. This is not now necessarily the case in the outside world. For example, the large telecommunications companies are being broken up as the industry recognises that the market is changing too quickly for big, integrated groups to react fast enough.
One of the less publicly quoted reasons for mergers and acquisitions is that the financial viability of one or more of the participants may be in doubt. Independent's now laughable attempt to acquire GRE was probably motivated by the desire to hide its dire financial position within GRE's far larger book.
The irony is that, after Axa took over GRE, it had to put further money into the company to strengthen its reserves. Market rumours suggest GRE was not the only insurer taken over recently to have had insufficient reserves.
Many inside the industry are now spurning the short-sighted “go for growth” philosophy. They recognise that the insurers who survive will be those who have concentrated on growing their business through increased pricing rather than through increased risk exposure. Bottom-line growth is more important than top-line growth. As with so many things in life, it's not size that matters, it's how well you perform.
