Running on empty: Reserving risks raise more questions over London market pricing

As rates continue to creep downwards, many London Market insurers have been relying on reserve releases and relatively low catastrophe losses to maintain profitability. Yet as reserves come under pressure, is it time for a rethink of pricing assumptions and longer term strategy?

After several years of consistently double digit returns on capital, a different story has been much in evidence in London Market insurers’ recent half yearly results.

A year-on-year rise in catastrophes losses has been blamed for the disappointing results ($30 billion in the first half of 2016 compared to $19 billion in the first half of 2015[1]). Yet the cat losses in the first six months of 2016 are in line with the ten-year average ($31 billion). And our analysis indicates that if 2015 had been an average year for claims, then many market participants would have recorded a financial loss. This suggests that soft rates rather than cat claims are the real reason for the dip in returns.

Unsustainable strategy

With rates so low, the bulk of the profits recorded in 2015 stemmed from the release of prior-year reserves, rather than underwriting returns. Reserve releases in 2015 (as measured by the percentage of reserves brought forward) were the highest for over 30 years[2].

As the latest financial results highlight, London Market insurers can’t continue to rely on the cushion of reserves and favourable claims experience to offset unprofitable rates.

“One of the big sources of concern is the extent to which overly optimistic reserve assumptions are fuelling unsustainable pricing levels”.

Our analysis of reserving adequacy highlights particular vulnerabilities within casualty business, a situation which history shows has always posed a risk to the London Market[3]

A related concern is the markets’ technical view of rates for ‘new’ business. In many cases, these are exposures that have been deemed too risky and hence relinquished by other firms, rather than being genuinely new. They should therefore attract a higher rather than lower premium. Yet a counterintuitive view within the pricing assumptions on this business is driving down prices and will ultimately have a negative impact on reserves.

Questioning assumptions

The latest in a series of ‘Dear CEO’ letters highlights the Prudential Regulation Authority’s (PRA) concerns over developments in rates and reserves.[4] Drawing on our analysis of current and historic trends, we would certainly echo the call for more realistic pricing and reserving. With the two so closely linked, it’s important to question prevailing assumptions and apply the closest possible scrutiny to ‘new’ business.

The real ‘new’

Yet, with no upturn in rates expected any time soon, this still leaves the challenge of how to sustain returns. The challenge is heightened by the fact that the new IFRS will make it harder to offset bad years against good years (see ‘Shake-up in the numbers: How will your earnings look under the new IFRS?’).

This underlines the importance of seeking out new sources of revenue, rather than simply undercutting rates on core lines. Fast growth, high margin opportunities such as cyber risk are a clear case in point and play to the London Market’s strengths, though this will require innovative new approaches to risk evaluation, pricing and transfer[5] (see ‘Sharpening underwriting performance: How next generation business intelligence can give you the edge’). London is also well placed to develop the risk pricing and regulatory engagement needed to capitalise on market growth in Asia, Africa and South America.

Therefore while London Market insurers can no longer rely on their reserves to sustain returns, the necessary refocusing on underwriting profit will provide a valuable catalyst for innovation and differentiation that plays nicely to London’s strengths.

Contact us

Jerome Kirk

London Markets Lead Partner, PwC United Kingdom

Tel: +44 (0)7718 976 962

Follow us