UK: Mild Optimism. The Future of the U.K Household Insurance Market

Article by Harold Clarke, James Rakow and Catherine Barton

Contents

• Mild Optimism

• Changing The Face Of Distribution

• Premium And Loss Trends

• Small Is No Longer Beautiful

Deloitte has always maintained that while the performance of the motor market is driven by premiums, the household insurance cycle is influenced most heavily by claims. So the recent increases in insurance spending, coupled with a relatively benign few years in terms of catastrophes, has meant the outlook for household is fairly optimistic.

The emphasis, though, has to be on that qualifier: fairly – our optimism is no more than mild. Part of the reason is that dramatic market swings appear to be a thing of the past. While expenses continue to show a certain amount of volatility, the rest of the landscape looks fairly stable – the claims hangover we expected from the 2003 dry summer didn’t seem to happen, and apart from Boscastle there were no major disasters or adverse trends in perils. The improvement in fire and theft claims also looks like levelling out in the coming years.

There are certainly interesting things happening in distribution, but perhaps the biggest challenge for insurers comes from an analysis of the market figures. Few of us would like the market to become more volatile, since that usually means great losses, but since the volatility seems to have left the market, so too have more than adequate profits. We may be optimistic, but is mild enough?

The main category in the FSA Returns is Property which covers Commercial and Household business. In order to identify the trends in the Household market we have considered the FSA returns at both the accounting class and risk group levels. At the class level only those insurers whose property portfolio contains more than 75% household business were included in the review.

Gross written household premiums have risen steadily from just over £4 billion in 2000 to just under £6 billion in 2003. During that period the Net Operating Ratio ("NOR") has been around 100%. However the make up of the NOR has changed over the period with the Net Expense Ratio increasing from 35% to 41% while the Net Loss Ratio has decreased from 68% to 59%.

The market movements conceal the usual variety of individual performances. The average gross loss ratio was 58% and of the four big players who control around half the market, Royal & SunAlliance and Norwich Union outperformed while Zurich and Churchill had just worse than the average market gross loss ratio.

Lloyds TSB’s good gross loss ratio result looks much more average when expenses are taken into account. With Direct Line, however, it is the opposite story, with their very good NOR being due to a much lower than average expense ratio.

Expenses have also been a decisive factor in the performance of Esure whose rapidly reducing expenses have brought its NOR down from 244% to 149%. It will be one to watch for next year. Other notable movers were Prudential whose over 50 percent decline in market share was balanced by gains from Churchill.

While last year’s subsidence claims turned out worse than we had expected (£390million), 2004 did not show signs of the ‘hangover’ effect we saw in the mid-90s, a sign perhaps of proactive claims management within the industry. Since 2004 was much damper, the forecast for 2005 should be closer to £200 million.

Freeze and flood claims were also low, with Boscastle the only notable incident. The ABI has changed the way it compiles its statistics, however, so the figures now do not include domestic incidents such as flooding from washing machines.

With no major dramatic storms in 2004 either, wind perils seem reasonably benign, while the average size of fire claims continues to rise alongside the fall in UK unemployment. The number of claims, though, is falling – a pattern repeated in theft claims which have shown a downward trend since the early 1990s. However, it will be interesting to see if we have a continuation of the striking 12% reduction from 2002 to 2003.

Our recent survey of insurance industry leaders elicited two particularly interesting responses on the subject of distribution. Firstly, when asked whether insurers or intermediaries had the upper hand in the industry, 43% thought the relationship was equal. Asked for their thoughts on how distribution might change in the coming years, 50% pointed to internet growth as the major new channel.

Both responses confirm what our analysis has shown – we are seeing significant shifts in the way the market is structured, but not the emergence of a single dominant form of distribution. To meet the consumer demand for a wide range of service and the insurers’ drive for volume, the dominant strategy is to develop multiple channels to market.

Although independent brokers have continued to lose market share to banks, building societies and the brands, they are still the largest single channel for household insurance. As a recent Insurance Times survey showed, the phone and increasingly the internet may be major channels for motor insurance, but in household face-to-face remains as important as purchasing by post.

There is therefore plenty of consolidation activity among broker firms with their rise in income fuelled by mid-market acquisitions in the regions. This trend should continue as large insurers such as Norwich Union turn away from brokers in favour of other distribution channels, and smaller brokers struggle with new FSA regulations and the burden of keeping up with costly technical upgrades.

Another driver behind the consolidation of the broker market is the age of the owners of independent businesses, many of whom are reaching retirement age and looking to sell their businesses. With brokers still playing a key role in the market, the better performing companies will remain attractive acquisitions for their peers and insurers.

There is increasing evidence, however, that the larger insurance companies are placing more emphasis on direct distribution, which looks set to become the largest channel by 2006. The difficulty insurers face, however, is raising brand awareness, and the growth in advertising spend is rapidly making this channel prohibitive to new entrants.

This is where banks and building societies have a distinct advantage. Having increased their share of household distribution, largely on the back of increased mortgage lending, they have been able to exploit their naturally strong marketing capabilities – 84% of their marketing spend is currently going on direct mail, sent out with regular communications such as bank statements.

In this climate, it is no surprise brands such as Boots, Marks & Spencer and Tesco are looking to gain market share on the back of their reputation and broad customer base. The key to success in this area, however, is in a good partnership arrangement between insurers, who can provide the product, and distributors who can offer the potential volume of sales.

Some businesses continue to look for new niches such as the ‘mid-net worth’ sector, while Norwich Union is starting to compete against NFU Mutual’s continued dominance of the rural property sector. Specialisation, whether in markets or types of distribution will continue. However, all the major insurers now have direct arms and broker clubs, branded and affinity relationships, and links with banks and building societies. In a hardening market, they want profitability and volume – and the central strategy for delivering this is multi-channel distribution.

Last year we forecast that premiums would rise by 7%, against an actual result of 6.5%. We forecast 5% for 2004 and we expect to remain at this level for 2005, after considering influences such as inflation, the increased level of insurance penetration and demographic changes such as the rise of single occupancy households.

We forecast a 5% aggregate rise in theft and fire claims, although it will be interesting to see if the government’s current anti-smoking push will result in a medium-term decline in fire claims. Another benign year in terms of weather, suggests that wind, flood, and subsidence claims should remain at the average level for the past five years, while in 2004 we have allowed about £30 million to come through for Boscastle.

There was a big spike in 2001 to 37% and a fall back to 33% the following year. We called another improvement for 2003, but 2001 turned out not to be a blip after expenses rose back to 37% again for 2003. We are therefore taking the middle ground for 2004-5 and calling 35%. One of the key factors to consider here is the balance between the insurers and the distributors because commission rates will clearly have a big influence on the final result. We’re assuming that much the same level of premium will be ceded to reinsurers. We thought 2004 might see the market softening, but after the events in Florida, rates will probably remain at the current level for another year.

Our benchmark for an adequate performance is a NOR of 100%. For 2003 the results was 102% - with a 65% Net Loss Ratio and 37% Net Expense Ratio. However, since 2004 has been fairly kind on the claims front, and because of some good premium growth, it looks like we might see a 96% NOR result for that year.

2004 has proved to be one of the most benign years on record and 2005 looks like offering a similar level of profitability. So there are some causes for optimism – but two good reasons to be wary. Firstly, with profits very much in the margins a single period of bad weather will spoil the party. Secondly, the current benign climate gives no more than an adequate return – and not the kind businesses or investors would ideally like to see. Any optimism will be short lived unless rates start to harden.

And this opens up a larger question – if insurers are barely getting the profits they need during one of the market’s most benign periods, why write household insurance at all? It is true that on top of the forecast 4% underwriting profit for 2004, businesses can benefit from investment income, but the question still remains: why household?

The only answer is that the household market has to raise its profitability on a consistent basis – and since there is little volatility in the results, that means increasing margins, particularly on expenses.

Perhaps the most important step, however, is in attitude. Many companies tend to accept that in household insurance a small profit is a good profit. They should start to challenge that assumption, and instead of welcoming the lack of significant loss events, should ask why these benign conditions produce a result no better than 96%.

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