State of the Market - Market lowdown

The company data in the Top 100 ranking reflects the information filed in the Financial Services Authority returns and accordingly this essentially represents business written in the UK. For the reinsurers, and other London market companies, this business will nonetheless reflect their international books. In particular this frequently means a significant degree of exposure to the US.

For the non-London market companies however, the numbers essentially reflect the state of the domestic UK non-life market - although some of the major companies will inevitably have some non-UK business in their data.

To focus on the domestic UK market therefore, for the rest of this summary report we exclude as much as possible the traditional London market lines of reinsurance, marine and aviation.

All data in this report is taken from AM Best's statement file non-life UK, a database of UK insurer Financial Services Authority returns.

Market structure

Total gross written premiums for the UK non-life market in 2002, broken down by class, are shown in Figure 1.

However, removing all reinsurance, marine and aviation business - business more commonly written in the London market - gives the breakdown shown in Figure 2.

Financial strength and capital adequacy

Despite seemingly attractive pricing in most lines of business the financial strength of UK non-life insurers overall remains significantly below historic levels. This reflects the twin impact of adverse loss development and asset losses eroding balance sheet strength.

When analysing individual UK insurers to produce an interactive financial strength rating, AM Best uses its risk based capital model to help evaluate capital adequacy. This combines by-line premium, reserve and asset risk and relates this to the insurer's economic capital. It also incorporates the firm's catastrophe risk exposure, growth rate and other risk factors.

Clearly, much of the detail required for the model is not public and, hence, it is not possible to use this integrated risk-based capital approach to create a picture of total UK market capital adequacy.

However, even just using information in the public domain, a clear picture of reduced capital strength overall emerges. In particular, both underwriting leverage (underwriting to capital - see Figure 3) and reserve leverage (reserves to capital - see Figure 4) have increased significantly since 1997. This is reflected in AM Best's ratings for domestic market UK companies which, while still mainly in the secure range, have moved downwards significantly in recent years.

While the current hard market is helping restore strength to a degree, institutional investors in stock insurers are now very focused on the risk adjusted return on their investment. This leads to a natural limit to the amount of capital they are prepared to see an insurer carry and hence a limit to insurer balance sheet strength. Accordingly, while rated insurers often stress a goal of achieving A+ or even A ratings, AM Best believes that investor appetite for providing the equity levels necessary to support this is limited.

Underwriting performance

The four years from 1997 to 2000 showed a significant level of underwriting losses for the market overall. An improvement began in 2001 and 2002 has shown significant further progress (see Figure 5).

The 1997-2000 results reflected excessive price driven competition in motor business, combined with loss cost inflation and adverse development in liability lines. As shown in Figure 6, the adverse development still being experienced in liability means that, despite the apparently severe losses initially reported for 1998-2001, these were actually very optimistic.

The true numbers, using only the adverse development reported to date, represent between a 10% and 30% worsening of the initial gross paid and incurred loss ratios for each accident year.

2001 underwriting results overall improved despite liability losses because of the significant improvement in motor. For 2002 the benefit of the continued hard market is showing through, again led by improvements in motor. These results continue to be under pressure, however, from further adverse developments in liability.

More positively for insurers, the often severe tightening of policy wordings and raised deductibles, is curbing attritional losses.

For 2003 AM Best expects to see some further improvement in the overall underwriting results for the market, although again constrained by adverse development.

Property, which performed well through recent years despite the flood losses, should remain profitable. However, there is strong evidence of softening in motor which may negatively impact the 2003 result and almost certainly 2004.

Investment income and asset quality

The low inflationary, or even potentially deflationary, environment expected by most economists for years to come, means that UK insurers will not be able to achieve significant amounts of investment income to cover underwriting losses.

While the potential for investment income obviously varies widely by the tail of different underwriting lines, even long-tail business will typically need to be written at an underwriting profit for a reasonable risk-adjusted return on capital employed to be achieved.

The bear market has led UK insurers to significantly reduce their exposures to equities. Consequently, fixed income returns on both reserves and capital are likely to be the primary future source of investment returns. While this is generally positive for insurer financial strength (reducing asset risk and hence enhancing risk-adjusted capital adequacy) it further reduces the likely contribution of investment income.

UK insurers are currently carrying significant unrealised losses in their books. This is part of the pressure on capital adequacy and, indeed, is supporting the hard market. Subject to equity markets now stabilising, and following the relative recovery since the year-end, insurers should generally be able to unwind these positions over time.

Finally, the reduced financial strength of reinsurers overall is also increasing the recoverables risk for primary companies, putting additional pressure on risk-adjusted capital adequacy.

- Stuart Shipperlee is managing director of AM Best Europe.