With the economic impact of COVID-19 bearing down we thought it was worth trying to understand how General Insurance (GI) industry capital levels are holding up.
FY20 has had more than the usual number of challenges for the industry, that’s putting it mildly. For this note we have focused on the Australian GI sector excluding Lenders Mortgage Insurers.
Nine months ago seems like a lifetime right now, but the records show the GI industry finished FY19 with a solid set of numbers: ROE in the 12-14% range and pretty much in line with the preceding few years. Coming into FY20 the industry had capital of $21.3 billion and a healthy margin over its regulatory minimum requirements of $11.9 billion. FY20 however has so far not been kind.
The first six months of FY20
Starting with the first six months we can see from APRA data that industry performance was well below par. The table below compares key metrics for the December 2019 half-year to the previous three year averages for the industry.
Underwriting performance was well down, no doubt linked to the many natural catastrophe events that occurred during November and December when hail, heavy rain and bushfires cut a swathe across the country. Investment performance was also down driven by low interest rates and the absence of capital gains as bond yields finished the half year roughly where they started. Equity markets had a slightly poor half year (6% annualized) but very little of the industry’s funds are invested that way. With low underwriting and investment returns then of course the return on equity came in at well below average at an annualised 7.5%.
These first six months saw industry capital reduce by $1.0 billion. Some of this can be put down to the fact that net profits ($770 million) were roughly $700 million below average. However it should be noted that insurers also paid out $1.5 billion in dividends during this period, no doubt reflecting expectations set with shareholders at the end of the otherwise successful FY19 year. To be fair this was no more or less than the usual dividend payout ratio, and was mostly paid during the September quarter before the reality of natural disasters struck late in the year. The impact on solvency is summarized below.
The industry closed out the calendar year with an average solvency ratio of 167%, down 12% on the 30 June position. This reflected a net reduction in ‘surplus’ capital over APRA minimum requirements of $1.3 billion, leaving the industry with a buffer of $8.2 billion. Of course few if any insurers have capital management policies that support a solvency ratio below 140% (a degree of caution actively encouraged by APRA), so in reality the effective surplus was at most $3.3 billion.
The March 2020 Quarter
Unfortunately there is nothing to suggest that industry capital levels might have improved during the third quarter of FY20. From a natural catastrophe perspective it really was more of the same:
- Bushfires continued to burn along the east coast. Insured losses moved from a reported level of $500 million at 31 December to a current estimate of $2.3 billion,
- Hailstorms crashed into Canberra and other capitals in late January ($1.4 billion), and
- Storms and flooding combined to extinguish the bushfires but at the same time left their own devastating impact ($800 million).
While some (but certainly not all) of the cost of the bushfires would have already been provisioned by insurers in their December 2019 results, the additional two major events brought the summer season of losses near to a decade high. Given the sheer number of events many insurers will find their reinsurance protections over-delivering as deductibles are fully eroded for horizontal covers and aggregate stop loss treaties come into play. As reinsurance program design is very specific to each insurer it is difficult to guess what share of the March 2020 quarter losses will end up being retained versus ceded to reinsurers. We think the profit impact will likely be on a par with results from similarly high catastrophe loss quarters of the past such as March 2017 (cyclone Debbie) and March 2011 (cyclone Yasi and the Brisbane floods) which led the industry to net quarterly underwriting losses of $670 million and $1400 million respectively. It’s difficult to judge the impact of reinsurance but a $500 million underwriting loss in the March 2020 quarter would not be a surprise. This would be $900 million below the ‘average’ $400 million underwriting profit expected each quarter (ignoring seasonality).
Investment returns unfortunately did not provide much joy either. Capital gains on fixed interest securities would have been made due to bond yields dropping 0.7% as the government pushed cash rates lower in response to market turmoil and the fear of economic damage soon to be inflicted by COVID-19. This was positive for those invested in “low risk” government securities, however, 70% of industry bond holdings consist of lesser rated AA, A and BBB grade securities. While the latter normally provide a little extra yield (up to 1.2% extra recently), when the credit spreads on these securities expanded during the March quarter (as global asset markets became increasingly risk-averse) it effectively offset the impact of the lower risk-free yield and neutralized any gains.
At the same time equity markets came sharply off their highs falling an extraordinary 24% across the quarter. Even though insurers hold only 5% of their investments in this asset class the profit impact is likely to be quite noticeable. So the overall story for investment returns is likely to be higher bond returns more than offset by negative equity returns. The industry overall is unlikely to achieve an ‘average’ investment return (currently around $450 million) for the quarter, we think closer to $250 million, noting that the December 2019 quarter itself only delivered $36 million.
The impact of lower discount rates on liability provisions is a bit more predictable. Given long-tail outstanding claims provisions of about $20 billion the impact this quarter will be of the order of 2% or $400 million. An accompanying lower inflationary outlook is likely to moderate this to some extent so the overall impact coming through as part of the underwriting result could be of the order of $300 million.
The final adjustment is for any dividends paid during the quarter. We are aware via media reports of roughly $1.0 billion distributed in aggregate by IAG, Suncorp and QBE although not all of this would necessarily have come from the balance sheet of the licensed Australian insurer. This is probably a reasonable estimate for the industry in total during the quarter, however what is not clear is whether a number of insurers might have increased their capital levels to improve solvency. We note that more recently (April 7) APRA stated expectations that insurers “seriously consider deferring decisions on the appropriate level of dividends until the outlook is clearer”.
Where is the March 2020 quarter likely to leave the industry from a capital perspective?
The impact of catastrophes, investment returns and lower discount rates in the March quarter looks likely to produce an overall loss of $700 million (somewhere between $500 million and $900 million). A loss of this order will lower the industry average solvency ratio by around 6%, while the payment of dividends could further lower the solvency ratio by 8%. The resulting forecast is for industry solvency to close out the March 2020 quarter at 153% prior to any management actions being taken to either lower risk profiles (say by selling down equity investments) or obtain capital injections. With solvency at such a low level both types of activity seem quite likely.
June 2020 and the impact of COVID-19
In total we estimate the first nine months of FY20 have probably reduced the industry capital base by $2.7 billion and the solvency ratio by 26%. Fair to say the industry has not had an ideal run in to the COVID-19 crisis. With that sharp reduction in capital the industry needs a strong June quarter to help restore its solvency. It’s not out of the question as June is normally one of the better performance quarters, and in this context typically ‘good’ would be a profit of $1.2 billion. At the same time the industry will face a large number of COVID-19 and lockdown generated issues across the range of insurance products and asset classes. In a future article we will explore these potential impacts on insurer profitability and capital adequacy for the June 2020 quarter and beyond.
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