LAGIC – the final wash-upIn this d’finitive we examine the impact of the final piece of APRA’s LAGIC reforms – the Natural Perils Horizontal Requirement, which came into effect on 1 January 2014.

APRA’s latest statistics show that the introduction of the

Horizontal Requirement has resulted in a 10 to 20% increase

in the industry Insurance Concentration Risk Charge (ICRC),

leading to an increase of about 2% in the market’s regulatory

capital requirement.

d’finitive®

Keeping you informed. AUGUST 2014

[ APRA GI statistics ]

In this edition>> LAGIC and the ICRC:

a refresher

>> Impact of the Horizontal Requirement

>> Impact on capital coverage

www.finity.com.au

Sydney +61 2 8252 3300 Auckland +64 9 306 7700 Melbourne +61 3 8080 0900

This is the fifth edition of the APRA GI Statistics d’finitive series, our previous editions covered:

>> Expenses: a penny saved is a penny earned

>> 2013: year in review

>> Spotlight on long tail

>> APRA GI statistics: new data, new insights

To download copies of these d’finitives, visit the publications section of the Finity website www.finity.com.au/publications.

Our assessment

>> The total expense rate for

direct insurers has been

decreasing since 2009

>> The underwriting expense

rate has fallen as a result of

premium growth outstripping

expense growth

>> Commission expenses

have grown in line with

gross premiums over the

last two years

>> Operating expenses have

also been decreasing. Direct

insurers’ focus on expense

control initiatives should see

this improvement continue.

Expenses:

a penny saved is

a penny earned

The expense rate for Australian direct insurers

has been decreasing since 2009. This improvement

has coincided with reporting of healthy net

profits after tax. While premium rate rises and

favourable claims experience have also contributed

to favourable results, there is no denying that

controlling expenses is just as important as

writing good insurance business.

d’finitive®

Keeping you informed. MAY 2014

[ APRA GI statistics ]

www.finity.com.au

Sydney +61 2 8252 3300 Auckland +64 9 363 2894

Melbourne +61 3 8080 0900 Wellington +64 4 460 5213

Underwriting Expenses

Net commission expense

Acquisition costs

Other underwriting expenses

(excluded: levies and charges)

Operating Expenses

Employee-related expenses

Management fees

Professional services and fees

Interest and doubtful debts

Occupancy and equipment

Other operating expenses

In this edition, we:

>> Assess the industry’s expenditures over the past three years

>> Break down the underwriting expenses and operating

expenses for direct insurers

In this edition, we:>> Assess the industry’s performance as

a whole for the financial year ended

June 2013>> Delve into the classes of business data

to uncover the sources of the 2013 result

>> Examine the impact of the LAGIC changes

on minimum capital requirements.

Our assessment:>> The industry’s $4.5 billion insurance result

(17% insurance margin) was its best in six years

>> Performance in 2013 was driven by strong

premium growth, favourable claims experience

and improving expense margins>> Most classes of business generated

underwriting profits>> Investment returns were lower than previous years

>> Minimum capital has reduced under LAGIC

(hence solvency coverage has improved). We

note that the full impact of LAGIC has not yet

emerged, as the ICRC Horizontal Requirement

is not yet in force.

GI Industry Performance – 2013 in reviewThe 2012/13 financial year has been a cracker

for the industry with an insurance result of

$4.5 billion and insurance margin of 17%. In this

d’finitive, we review the key drivers of this

strong performance by looking more closely

at each class of business.

d’finitive®

Keeping you informed. NOVEMBER 2013

[ APRA GI statistics ]

www.finity.com.auSydney +61 2 8252 3300

Auckland +64 9 363 2894

Melbourne +61 3 8080 0900 Wellington +64 4 460 5213

Our assessment:

>> Long tail classes have had low premium growth

in recent years compared to other classes

>> Falling yields and the GFC have had an

impact on claims experience and profits

>> Based on the first nine months, the 2013

financial year is shaping up to deliver a profitable

underwriting result, although it remains to be

seen what the last quarter will bring

>> Investment returns have been strong over the

past ten years, but may be difficult to maintain

with yields at historical lows.

In this edition, we:

>> Focus on two long tail classes:

Public & Product Liability, and Professional

Indemnity including Directors & Officers (PIDO)

>> Comment on what’s been impacting

these classes over the past two decades

>> Consider the outlook for these classes

in terms of future profitability and challenges

>> Analyse investment returns at an

industry level.

APRA GI Statistics –

spotlight on long tail

In our April 2013 APRA GI Statistics d’finitive we

took a look at the new detailed Quarterly General

Insurance Performance Statistics from APRA.

We saw that for all major short tail classes, 2012

was a more profitable year than 2011, owing

largely to benign claims experience and strong

premium growth in personal lines. We now turn

to the major long tail classes.

d’finitive®

Keeping you informed. AUGUST 2013

[ APRA GI statistics ]

www.finity.com.au

Sydney +61 2 8252 3300 Auckland +64 9 363 2894

Melbourne +61 3 8080 0900 Wellington +64 4 460 5213

Our assessment:>> Personal lines premium growth has outstripped

Commercial lines.>> Claims experience is at the mercy of the

weather – 2012 was benign but 2007 to 2011 was one of the worst five year periods since 1967… and 2013 isn’t off to the best start!>> For all major short tail classes, 2012 was

a more profitable year than 2011.>> Return on capital has been improving since 2008 following the GFC, despite the recent spate of adverse weather.

In its debut edition, we:>> Focus on short tail business: two key personal lines and two key commercial classes >> Comment on what’s been impacting these

classes over the last five years>> Provide an outlook for these classes in terms of strengths, vulnerabilities, opportunities and threats

>> Look at return on capital at an industry level

APRA GI Statistics – new data, new insightsAPRA’s Quarterly General Insurance Performance Statistics now contain greater detail by class of business, which is music to our ears at Finity! We’ve dived straight into the pool of data that provides greater insight into the general insurance landscape. In this d’finitive we delve further into understanding what makes the insurance industry tick by marrying the story told by the numbers with Finity’s industry expertise.

d’finitive®

Keeping you informed. APRIL 2013

[ APRA GI statistics ]

www.finity.com.auSydney +61 2 8252 3300 Auckland +64 9 363 2894

Melbourne +61 3 8080 0900 Wellington +64 4 460 5213

2 d’finitive AUGUST 2014

LAGIC and the ICRC: a refresherThe diagram below summarises the calculation of the Prudential Capital Requirement (PCR) for a general insurer under LAGIC. The PCR combines the risk charges, allows for an aggregation benefit, and includes a supervisory adjustment if applicable. The Prescribed Capital Amount (PCA) refers to the PCR before any supervisory adjustment.

The Horizontal Requirement’s introduction from 1 January 2014 comes one year after the broader LAGIC implementation.

The ICRC represents the highest net financial impact of the following three components:

All impacts are estimated on a whole-of-portfolio basis over a one year timeframe.

The ICRC’s predecessor, the Maximum Event Retention (MER), was the retained cost of a single site/single peril 1-in-250 year event. In practice the main changes are that the ICRC includes allowance for the risk of multiple events, and is more explicit about natural perils versus other accumulations.

Component Detail

1 Natural PerilsVertical Requirement

Retained cost of1-in-200 year event

2 Natural PerilsHorizontal Requirement

Higher of:

Retained cost ofFour 1-in-6 year events

Retained cost ofThree 1-in-10 year events

3 Other Accumulations

1-in-200 year accumulation of non-natural peril losses from a common dependent source

Other Accumulations (OA)

Natural Perils Vertical

Requirement (NP VR)

Natural Perils Horizontal

Requirement (NP HR) Prescribed Capital

Amount (PCA)Aggregation

BenefitPrudential Capital Requirement (PCR)

Supervisory Adjustment

Insurance Risk Charge

Asset Risk Charge

Asset Concentration Risk Charge

Insurance Concentration Risk

Charge (ICRC)

Operational Risk Charge

Impact of the Horizontal RequirementThe year’s delay to implementation of the Horizontal Requirement of the ICRC gave insurers time to ensure that reinsurance arrangements (or alternative mitigation strategies) were in place to minimise its impact.

The graph below shows the industry MER at December 2012 (the last date before LAGIC was introduced) and the ICRC at subsequent quarter-ends. The Horizontal Requirement is included for the first time at March 2014. These figures represent the aggregate ICRC for direct insurers only, and exclude lenders mortgage insurers; the ICRC for LMI insurers makes up a much larger proportion of their capital requirements, and is not impacted by the Horizontal Requirement.

AUGUST 2014 d’finitive 3

Changes in the Risk Charges

2.0

1.8

1.6

1.4

1.2

1.0

0.8

0.6

0.4

0.2

0.0

Ind

ust

ry I

CR

C (

$b

n)

INDUSTRY ICRC – DIRECT INSURERS (EXCL LMI)

Dec 2012 Mar 2013 Jun 2013 Sep 2013 Dec 2013 Mar 2014

MER ICRC

HR in

We estimate the introduction of the Horizontal Requirement resulted in a 10 to 20% increase in the non-LMI direct insurers’ ICRC.

Component Detail

1 Natural PerilsVertical Requirement

Retained cost of1-in-200 year event

2 Natural PerilsHorizontal Requirement

Higher of:

Retained cost ofFour 1-in-6 year events

Retained cost ofThree 1-in-10 year events

3 Other Accumulations

1-in-200 year accumulation of non-natural peril losses from a common dependent source

The aggregate ICRC at March 2014 was $1.9 billion. This is around $370 million (24%) higher than the 31 December 2012 industry MER. The March 2014 ICRC is between $150 million (10%) and $330 million (20%) higher than other post-LAGIC quarters, and the primary driver of this increase is the introduction of the Horizontal Requirement.

Prior to LAGIC’s introduction, we collected and collated insurers’ Quantitative Impact Studies (QIS) to estimate the impacts of the LAGIC changes in advance. The results showed that, in the absence of any changes in reinsurance arrangements or other mitigating factors, the industry ICRC was expected to be around 50% higher than the MER. The actual increase of about 24% suggests that mitigating strategies have halved the impact of moving from MER to ICRC.

6 d’finitive DECEMBER 2012

We estimate the introduction of the Horizontal Requirement has increased the market capital requirement by about 2%.

4 d’finitive AUGUST 2014

Impact on Capital CoverageThe chart below shows the industry PCA for direct insurers (once again excluding LMIs) quarterly since March 2013, as well as the pre-LAGIC MCR at December 2012. For simpler presentation, we have apportioned the LAGIC aggregation benefit across the insurance risk, insurance concentration risk and asset risk charges.

Since LAGIC has been in force, the direct insurers’ PCA has remained at around $11 billion. The solvency ratio has been fairly stable at just under 2, and was 1.99 at March 2014 after the introduction of the Horizontal Requirement. Therefore, while the Horizontal Requirement increased the ICRC by 10 to 20%, reductions in the insurance risk and asset risk changes, coupled with an increase in the capital base, meant that the solvency ratio was steady.

We estimate that the introduction of the Horizontal Requirement alone has increased the market PCA for direct insurers (excluding LMIs) by about 2%. This means that if the Horizontal Requirement had not been introduced, the solvency ratio at March 2014 would have been about 2.03.

We estimate that for around two-thirds of non-LMI direct insurers, the ICRC is driven by the Natural Perils component (as opposed to Other Accumulations), and therefore would have had the potential to be affected by the Horizontal Requirement. However, only a proportion of insurers will have had an increase in the ICRC, since some will have changed reinsurance arrangements or used other mitigants. Therefore, while the market solvency ratio impact of the Horizontal Requirement is small, we expect that those insurers who have been affected will have had a much larger proportional change in their solvency ratio. We look forward to examining this in more detail once company level statistics which include the Horizontal Requirement are released in late 2014.

Changes in the Risk Charges

12

10

8

6

4

2

0

Ind

ust

ry P

CA

($

bn

)

INDUSTRY PCA – DIRECT INSURERS (EXCL LMI)

Dec 2012 Mar 2013 Jun 2013 Sep 2013 Dec 2013 Mar 2014

Insurance risk ICRC Operational risk Asset risk F Solvency Ratio

F F F F FF1.98 1.98 1.96 1.99 1.992.02

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Finity ConsultingFinity is one of Australia and New Zealand’s leading actuarial and management consulting firms, specialising in general and health insurance. Finity works closely with large and niche insurers, government agencies and large corporations to deliver world-class actuarial, pricing and strategic advice.

Finity was inducted into the Australian Insurance Industry Awards Hall of Fame in 2012 after being awarded ‘Service Provider of the Year to the Insurance Industry’ in five of the previous six years. Our advice is innovative and practical. It is aimed at helping our clients make decisions that improve their business.

Please contact one of our consultants if you’d like more information on the material presented in this publication.

Authors

David Wilheim david.wilheim@finity.com.au 61 2 8252 3317

Luke Cassar luke.cassar@finity.com.au 61 2 8252 3418

Contact

Karen Cutter karen.cutter@finity.com.au 61 2 8252 3386

HOT OFF THE PRESS – You’ll find a wealth

of industry insights in our 8th edition of Pendulum. Contact Andy Cohen on 02 8252 3346 to obtain

your copy.

d’finitive®

[ APRA GI statistics ]

www.finity.com.au

* This article is based on Finity’s analysis of APRA’s quarterly statistics. It does not constitute either actuarial or investment advice.

While Finity has taken reasonable care in compiling the information presented, Finity does not warrant that the information is correct.

We refer the reader to APRA’s website (www.apra.gov.au) for further details.

David WilheimTel + 61 2 8252 3317david.wilheim@finity.com.auSydney Office

Luke Cassar Tel + 61 2 8252 3418luke.cassar@finity.com.au Sydney Office

Contact the Authors