Innovation or irrelevance—it's your choice

A number of well-known and respected figures in the re/insurance industry have made outspoken comments of late about the lack of innovation in the insurance industry and the sector’s diminishing importance to businesses and the wider economy.

Pat Ryan, the founder of Aon and, more recently, of Ryan Specialty, said in an interview with this magazine that insurers must act quickly to reverse the declining levels of insurance being purchased by corporates. He said the small and medium-sized enterprise (SME) sector in particular has been ignored by the industry and yet this is a sector that could generate growth if the correct products were offered.

He said that the whole industry—insurers, reinsurers and brokers—must create and offer more innovative products to smaller businesses that will help them view insurance as a tool that adds value rather than as simply a cost. “The risk of not doing this, especially given the ongoing economic downturn, will be a shrinking market—something that will ultimately hurt reinsurers too,” Ryan said.

His views have now been echoed by Mike McGavick, the group chief executive of XL. He has made several speeches on this theme of late and at a panel discussion hosted by the organisers of the Monte Carlo Rendez-vous he gave a particularly damning long-term assessment of the property/casualty (P&C) industry.

McGavick noted that although global GDP grew by an average of 3.8 percent per year between 2002 and 2011, the total size of the P&C insurance industry grew by just 2.5 percent. Premiums in P&C during the period went from around $1.1 trillion to $2 trillion. To look at it another way, the industry’s contribution to global economic activity has fallen to 2.8 percent from 3.4 percent.

“The stark fact is that we are becoming less relevant to society as a whole in the P&C space,” he said. “We either reverse this trend, and therefore see our value in the economy grow, or we fail to reclaim our space and our relevance, and we will undergo continued decline.”

McGavick warned that a long-term consequence of this trend would be that the industry will attract less capital. “This is a reality and a trend we must act to reverse.”

Shrinking—but which parts?

Ryan and McGavick come to the argument from slightly different perspectives but their concerns amount to the same thing: that insurance— and reinsurance as a consequence—is becoming less important to companies. They fear the industry will shrink and become less influential unless it innovates to keep its products relevant in a rapidly changing world.

But do their fears really stack up? First of all, it is worth clarifying that their worries apply only to the non-life sector of the insurance industry. To assess the relative growth of the life and health market in relation to global GDP is another research project in itself, but projections for this sector are relatively healthy.

According to data from the Organisation for Economic Cooperation and Development, for example, the entire insurance sector as a percentage in the US—the market focused on by Ryan (and McGavick to a lesser extent)—grew from 9.3 percent in 2002 to 11.4 percent in 2009. Similar data for the entire globe actually show a small decrease in the same period but as more populations in developing markets increasingly use insurance, future projections are positive.

So, focusing only on non-life, Ryan’s argument is based on the claim that the amount businesses spent on insurance has been declining for some 20 years in the US. “US insurance take-up as a percentage of GDP has been declining in the SME sector for the past 20 years,” he said. “The industry needs to provide innovative products to smaller businesses and develop its offering in discretionary insurance.”

A number of studies indicate this trend in different ways, and the same is true of reinsurance. According to research by Aon Benfield, in the 10 years prior to 2011 US insurers consistently decreased their reliance on reinsurance, with the percentage of US gross written premiums ceded to reinsurers falling from a peak of around 17 percent to 12 percent in 2010.

This is backed up by data from rating agency AM Best, which also showed a long-term trend of US insurers retaining more risk. This has continued in the past two years with retentions still increasing—by about 3 percent last year and again this year.

Lies, damned lies and insurance statistics

There are several mitigating factors within all this that mean the figures should be approached with caution and in context. For a start, different sources of data do tend to indicate varying trends. But there are some things we know.

First of all, most agree that the majority of the decreases are attributable to companies buying specifically less casualty coverage and there are specific reasons for this; in part, it is because of a long-term reduction in the claims attributable to this sector.

Ryan said that many companies have reduced their insurance spend on this side of the business to buy only minimal coverage. They will purchase workers’ compensation coverage because they are obliged to, but recent loss trends have discouraged them from purchasing liability coverage. “Many owners are looking at the frequency of recent liability losses, and deciding: ‘I can handle that frequency’.

“They may buy upper limit liability protection in case something catastrophic happens, but they could be purchasing a lot more,” he said.

Meanwhile, it seems the same problem can be seen in reinsurance. “Demand for reinsurance for non-catastrophe perils continues to decline,” said Aon Benfield in a report into the health of the reinsurance sector. “The value proposition of reinsurance in most non-catastrophe lines has declined as insurers have witnessed nearly a decade of steady declines in loss frequency and manageable increases in loss severity—the need to transfer risk that seems not to be occurring has decreased.”

This dynamic will not necessarily last, however. Despite the long-term decreases in casualty premium—especially in reinsurance— there is also little reason that the sector won’t eventually see a rise in demand. Partly, this could be driven by a hardening of insurance rates in that market generally—insurers tend to buy more coverage when this happens.

“Ryan and McGavick come to the argument from slightly different perspectives but their concerns amount to the same thing: that insurance—and reinsurance—is becoming less important to companies.”

Meanwhile, there is evidence that a change is also occurring in the claims environment in the US, especially on specific professional lines such as directors & officers (D&O) business. A new wave of claims has been spreading through the market with law firms targeting this type of coverage for claims normally filed purely against the corporate itself. This too could lead to companies buying more coverage. But if casualty has been faltering as a sector, property-catastrophe insurance and reinsurance, on the other hand, have been making up for it and remain very strong as a sector and in demand, according to Aon Benfield. “The reinsurance business has become an increasingly property catastrophe-centric business. US hurricane risk continues to drive the capital requirements of most reinsurers,” the report said.

There is no doubt that Ryan’s call for innovation is one that should be heeded by the industry. But things might not be as bad as they seem. The property-cat market clearly remains in rude health and some long term trends starting to emerge could start to change the dynamic in the casualty sector.

Size matters—to some clients

Ryan’s assessment of the shortcomings of the insurance industry aligns with that given by McGavick in one important sense: that the industry is not creating products relevant to the modern risks faced by companies.

Ryan even noted that insurers have shied away from more complex risks rather than try to solve them through innovation—not doing them any favours with clients. “By excluding them, the pool of potential coverage shrinks and with it the amount clients are willing spend on policy coverage,” he pointed out.

He admitted that some sectors have responded to this challenge. The specialty and surplus line markets have achieved growth in recent years.

“The Lloyd’s and US surplus lines markets had both proven themselves to be engines of innovation,” Ryan said.

He argued that the industry has largely ignored the potential of the SME sector. In part, this has been because its potential premium income is small relative to the cost of administering it.

“But it’s a key part of the market and you’ve got to get your costs right to deal with the small buyers—I’m talking about distribution costs so you can reach them, and administrative and underwriting costs so that you can service them.”

If the industry can do this and provide innovative solutions, it can expect a corresponding uptick in discretionary premium, Ryan concluded.

McGavick similarly criticised the industry’s inability to solve modern day problems and risks. He highlighted the diminishing involvement of the insurance industry in the world’s two biggest and most influential business sectors: technology and energy.

In terms of technology, he noted that the shift of so many industries on to internet-based applications and smartphone devices means fewer tangible assets to insure. And he criticised insurers for failing to provide adequate solutions to the unique risks that face this sector, such as cybercrime.

“This market is worth about $1 billion but we are barely making a dent in it,” he said. “We estimate that 70 percent of companies that could use this product do not—that means either we are not relevant or they are unaware. We are only scratching the surface.”

He also noted the market capitalisation of the five largest companies. They comprise three technology companies: Apple, Microsoft and IBM, and two energy companies: ExxonMobil and China Petroleum. At more than $700 billion Apple is currently the largest in terms of capitalisation— the combined capital of the entire US P&C industry is just $176 billion.

In energy, arguably the most critical industry to the smooth functioning of global economies, he said the ability of the industry to cover some of the massive risks involved was so limited that energy companies have learned to operate without insurance. He cited the example of BP, which long ago chose to self-insure and thus, during 2010’s massive oil leak in the Gulf of Mexico, insurers barely played a part.

“They looked at their balance sheet, they looked at our entire sector’s balance sheet, and said, ‘frankly you can’t really help’.” The energy sector’s capitalisation—at more than $800 billion—is five times larger than the P&C insurance sector.

“When we get too small, we can become irrelevant,” McGavick said. He also said that “buyers of insurance are becoming less important in larger organisations as their purpose is no longer seen as essential for the protection of the balance sheet”.

He added that balance sheet protection isn’t the only service the P&C industry can provide to its clients, including the energy sector. “I actually disagree with BP—I think we can help these companies,” he said. “Our expertise and risk management alone can help in a claim like that. But our size as an industry in comparison to energy makes us irrelevant in many cases.”

New risks need new solutions

The shortcomings of the industry don’t relate only to its ability to help the biggest industries. McGavick touched on the inability of the insurance industry to grasp another modern liability: contingent business interruption risks. This issue came to the fore following several recent catastrophes in Asia when the industry was taken by surprise by the scale and complexity of some of these global claims.

“This had been on the agenda for 20 years but these global interdependencies were laid bare following the recent disasters and it become clear we did not understand them,” he said. “The response of the industry was to sub-limit or exclude these risks. That is fine but we cannot exclude our way to relevance. It is not good enough.”

He said that the industry must invest in providing solutions that really matter to clients. “We cannot solve every problem immediately but that is no excuse for not trying. And we cannot leave our best talent working on profitable business. We must invest in solving these modern risks and put our best people to work on them.”

Ryan and McGavick may be scathing about the industry’s lack of innovation, but they are also individuals keen to drive change in the industry and do something about it.

McGavick said that XL has invested heavily in understanding and building solutions around cyber liability risks. But he said the industry must move faster to provide solutions and commit to putting its best talent on problems such as this while also working with clients and brokers to completely understand the risk and find solutions.

“Rather than employing your most talented people in lines that are the most profitable they should be assigned to dealing with business which is the most challenging. We’re investing in that right now,” he said.

The challenge to innovate will not be an easy one for the insurance industry. And its overall health is perhaps not as bad as it might sometimes seem. But Ryan and McGavick are right in terms of its long-term relevance—and putting the industry’s best brains on to the problem would be no bad thing.