The good times in UK personal lines are over. Insurers that have been enjoying profitable business for the past four or five years will see their profits slashed in half this year compared with 2007, warns an Oliver Wyman report, writes Lauren MacGillivray.

The international management consulting firm’s report, UK Personal Lines – Time to Change Tack?, says that core business profitability has actually been poor, but this has been masked by strong investment returns and increasing prior year reserve releases. The prediction is that this will “reverse sharply”.

“Although we expect a period of marked price hardening, particularly in the motor market, this will not be sufficient to offset a reversal in investment income and a decline in reserves available for release,” says Richard Thornton, a partner at Oliver Wyman and the report’s author.

This statement is backed by Fitch, an international ratings agency and business consultancy, EMB. “Our expectation is that investment income will be dramatically reduced from recent levels and this, together with lower reserve releases will put great pressure on earnings,” says Greg Carter, head of Fitch’s Europe, Middle East and Asia Insurance Ratings team.

Peter Lee, a partner at EMB, adds: “Reported market results are likely to be worse in 2009 – although the underlying average market loss ratio is likely to marginally improve, there will be less reserve releases and investment income to prop up the result.

“Quoted rates have been hardening for the past 12 months or so but distribution changes have slowed the impact onto sold business. Talking to our clients, there is now increased resolve to increase rates onto sold business.”

Meanwhile, Aviva UK says it agrees with some of the report but believes the overall view is “too pessimistic”.

“We do not believe that profitability is likely to reverse sharply or that underwriting profits will halve between 2007 and 2009. We have been taking positive action on many fronts to ensure profitability is protected,” says a spokesman.

The report estimates that the UK personal lines profit pool was about £3bn (before the effect of the July 2007 floods, which accounted for around £1.5bn in losses). This includes £1.1bn for motor, £1.2bn for household (excluding flood impact), and the remaining £0.7bn for other lines, mainly creditor insurance.

However, it says all of this profit came from sources other than current year underwriting. Of the £3bn total, £1.1bn came from reserve releases and a further £1.9bn was from investment income. This actually left marginally negative accident year underwriting profits.

Returns on investment

The economic crisis has meant investment returns of 5% or more long enjoyed by UK personal lines providers are over.

Research from Fitch shows that industry earnings have been highly dependent on investment income. Carter says: “A pure year technical profit was only recorded in three of the 12 years reviewed (from 1996 to 2007).”

But some insurers such as Fortis Insurance UK are still producing solid results. In its 2008 results released in April, the company boasted non-life profit before tax of £76m, up from £30m in 2007.

Non-life gross written premium (GWP) was slightly up to £760m from the £758m it reported in 2007.

Its investment values increased by £43m over 2007 levels. “At Fortis, we have a low-risk, high-quality investment portfolio, which significantly outperformed the market in 2008,” says a spokesman.

Fortis also announced its 2009 first-quarter results in May, reporting that its UK non-life GWP grew by 11% from £177.7m in the fourth quarter of 2008 to £197.4m in the first quarter of 2009.

Meanwhile, a spokesman for Aviva says: “Unsurprisingly, investment returns have fallen since their peak in 2005/6. However, we reduced our exposure to equities in the second half of 2007 replacing them with cash-based securities. Derisking the balance sheet in this way provides a more stable source of investment return.”

But Thornton says the full impact of the credit crunch on investment income is still to come.

“The effect is really coming through from investment income, and it takes a while to feed through. Also, in the Q1 results, a lot of insurers only give a combined ratio rather than a profit figure so that doesn’t include investment income. But I expect when we get the half-year results, we see investment income tailing off.”

EMB’s Lee adds: “General insurers will have typically invested heavily in fixed incomes assets (both cash and bonds) with some equities depending on their mix of business and hence length of liabilities. Interest rates have fallen significantly so undoubtedly there will be less investment income so there is an increased need to increase underwriting profits.”

Reserve releases

According to the report, insurers’ ability to subsidise underwriting through prior year reserve releases is likely to “decline sharply”.

Over the past five years, it finds, the trend has been for reserves to increase steadily as underwriting profits declined.

In 2007, prior year in personal lines peaked at £1.1bn, three quarters of which was from motor. But analysis, based on historic claims and cyclical reserving, reveals that the windfall is about to end.

In the next three to four years, Oliver Wyman expects releases of no more than £600m annually – about half the level in 2007.

Thornton explains: “I don’t think reserves are depleted; I think the reserves were particularly rich in the past few years and those excess reserves were gradually released. The reason they were released was because insurers needed to boost their profits. But they’re now back to a normal level.”

Aviva also does not expect the “exceptional levels” of releases seen in 2006 and 2007 to continue.

“We continue to manage our reserves to an appropriate level, but it would not be appropriate to estimate a sustainable value for reserve releases as there are many things that can influence the level of reserves. Nevertheless, it is important to note that our balance sheet and reserving remain strong,” says a spokesman.

According to EMB, the release of reserves relate to heavy bodily injury inflation periods of the late 1990s and early 2000s, when significant retrospective legal changes were made to areas such as general damages and NHS costs.

Lee says: “The industry as a whole expected these changes to have a continued severe impact on both future experience and existing outstanding claims – bodily injury burning costs inflation rates in the 1990s were around 10% a year. Inflation rates for the first half of this decade turned out to be more like around 6% to 7% a year. This led to a release in reserves over the last few years.”

Fitch’s Carter concludes: “Reserve releases from prior year’s underwriting have been a regular contributor to profits, with positive reserve development in nine of the 12 years.

Fitch expects that the profits emerging in this way, which have been significant in recent years, are likely to be sizeably less in the coming years, although still positive.”

Positive action required

The report cites “overwhelming evidence” that the motor pricing cycle bottomed out in 2008, and that the market is now hardening. It expects to see motor prices rise by up to 7% each year within three years, with lower rises in the “less volatile and historically more profitable” household market.

This still is not expected to offset the declining investment income and reserve releases.

But Thornton says: “It’s not just a doom and gloom story; there is a lot you can do about it. There’s still a whole other wave of expense and claims savings to be had for most insurers … the point we really wanted to make was that unless insurers take action to try and offset the impact, they shouldn’t expect to rely on a market hardening alone to solve the problem.”

What you can do

1. Launch a separate business dedicated to aggregators. Instead of using of the same brand for both aggregators and direct, develop distinct businesses to compete in the two channels. Differences should include product design, pricing and underwriting, and marketing.

2. Rethink your direct brand and marketing approach. Consider broadening the range of product providers you offer (for example Aviva’s move to show competitors’ pricing on its own website). Or, identify customers who can be tempted away from aggregators and reach them with brands that have greater personal appeal.

3. Reduce operating expense and claims costs. Do this by making the process faster, improving customer experience and reducing third-party costs.

4. Increase customer persistency. Better understand renewal traits of customers, time reminder mailings better and anticipate potential policy lapses.

5. Increase cross-selling. Try offers such as multi-product discounts or develop loyalty schemes.