David Worsfold
The perfect storm is brewing for the UK’s general insurers. Premium rates remain low, investment returns are on the floor and the regulator is starting to ask tough questions about the strategy of maintaining profitability by dipping into reserves. The only vaguely shiny cloud on this bleak horizon is the benign claims environment but even that can be seen as a mixed blessing.
Last week Chris Moulder, director of general insurance at the Prudential Regulation Authority (PRA), wrote to all UK general insurer CEOs questioning their policy of bolstering returns by using reserves. It came as close as a regulator is likely to come in a public letter to saying this can’t go on.
Nobody should be surprised. Moulder fired a shot across the bows of the general insurance market last December with a three-page letter drawing attention to the deteriorating reserves and setting out the PRA’s expectations. That obviously didn’t have the desired effect because the first six months of 2016 have confirmed that trend. Indeed, the Insurance Investment Exchange started to warn earlier this year that it was not sustainable but insurers have appeared to take little notice.
Now Moulder has issued a ten page missive making it crystal clear that the PRA thinks there is a big problem and that insurance company boards had better start waking up to it. Using data from returns, especially the more detailed returns under Solvency II, he sets out very clearly the extent of the challenge facing insurers. 
“We observe that reserve releases in 2015 as measured by the percentage of reserves brought forward have been the highest for over 30 years.
“Inevitably this raises the question as to whether these reserve releases are sustainable.”
The PRA did not identify a single trend to explain the increase in reserve releases but outlined several possibilities.
These include insurers’ one-off exercises to clear out any excess reserves left in accounts from previous years; a movement towards a Solvency II best estimate basis; pressure to maintain levels of profitability; and speeding up the reporting and settlement of claims, reflecting improvements in claims processes. The regulator acknowledged these factors could help speed up claims settlements, but Moulder added: “We would also expect insurers to understand how much credit is being taken for these trends – noting that not all of these may yield the benefits anticipated.”
The almost forgotten enemy – inflation – also rears its ugly head in the PRA analysis. It looked at how firms estimated future claims inflation as implied by their book reserves. In several cases, it found that the implied future claims inflation was lower than that indicated in the historic data.
To illustrate the point, the regulator estimated that a reasonable assumption for historic claims inflation to be 5% per year, but to obtain the insurer’s booked reserves would imply an assumption of -2%. 
“This would suggest that if the future trend is in fact in line with past inflation, booked reserves would need to be 25% higher than currently assumed,” Moulder said. That’s a very large gap potentially looming in insurance company accounts.
He added: “We expect insurers to consider the impact of a range of inflationary assumptions so that boards are able to understand the sensitivities in this area.”
The collapse in the value of the pound since the EU referendum will undoubtedly sharpen the PRA’s focus on this area. Despite weakening economic performance, the expectation is that inflation will start to pick up. This is likely to have a disproportionate effect on claims costs as many large commercial claims are paid in dollars and the type of heavy manufacturing plant most frequently requiring replacement in large commercial claims is made in Europe, in particular Germany. That could already be 10% more expensive than a month ago.
When Moulder talks about taking account of a range of inflationary assumptions, these are the sort of factors he will be expecting to see boards addressing. The problem boards face is how to manoeuvre themselves out of this dependency on dipping into reserves.
Without a series of major claims, the prospects for getting premium rates up look remote, especially in the light of some of the other figures Moulder produces showing European and American insurers with more comfortable margins between the current market price and technical price for most major lines. They are unlikely to blink first as the autumn round of reinsurance pricing discussions that still largely determine the rates for the following year get underway.
It all adds up to yet more pressure on investment teams to squeeze more value out of their portfolios and that too in the short-term.