Quarterly Review. Overview. Argenta Insurance Research Limited (AIRL)

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1 May 2017 Inside This Issue Overview Lloyd s Results Brexit and Lloyd s Europe Lloyd s India Lloyd s China Forecast as at 31 December 2016 Quarterly Review Argenta Insurance Research Limited (AIRL) Overview The closed 2014 year of account has produced some of the highest returns on capacity achieved in recent years, due to the combination of favourable claims experience, reserve releases and significant foreign exchange gains (specifically the strengthening of the US Dollar against Sterling). Profits for Argenta clients were on average 13.1% of capacity for the 2014 account, which is 2.2 points above the Market average of 10.9%. This result was better even than 2013 (an average profit of 12.7% for Argenta clients and 9.2% for the Market) and continues the pattern of exceptionally good returns that investors have enjoyed in recent years. Contact Details Jeremy Bray jeremy.bray@argentagroup.com T +44 (0) Andrew Colcomb andrew.colcomb@argentagroup.com T +44 (0) Robert Flach robert.flach@argentagroup.com T +44 (0) Argenta Insurance Research Ltd 70 Gracechurch Street London EC3V 0XL In this Quarterly Review we look at the annually accounted result for 2016 for the Lloyd s market, declared at the end of March, as well as how the open underwriting year of account results for 2015 onwards are developing. We expect the final result for 2015 to be better than the 5% profit currently estimated by managing agents and, although still on risk, believe that a mid-single digit profit is achievable for In current market conditions, these will be good results, especially when considered as returns on capital employed. But as we are constantly reminded, the margins at which some participants are operating in the wider insurance market are unsustainable. Although there are signs of retreat in certain quarters, capital continues to enter the Market, competitive pressures have not diminished, and there are few signs that conditions will improve in the near term. Capital has not yet been impaired by major losses - Not enough pain as the Chairman of Willis Re International recently put it.

2 As always it is instructive to read the Underwriter s report in the individual syndicates Report & Accounts (available at There you will find not only more about the difficulties faced by your underwriters, but also the strategies they are adopting in this environment to maintain returns. Richard Trubshaw, underwriter of MAP Syndicate 2791, in his review of current trading conditions observes: In a desperate search for yield technical analysis is rationalised to a premium over expected loss, blindly following proprietary models, which means that there is little or no margin for the unforeseen. He describes this as delusional exactitude which only the pain of loss activity will cure, but encouragingly there are early signs in certain areas that this is starting to occur. Toby Drysdale, in his underwriter s report for Atrium Syndicate 609, tells us: What has become apparent is that the overall premium charged today is simply not able to cope with these expected attritional losses. Therefore Underwriters are relying on luck (hoping that they have not written the policies with losses) rather than building a portfolio of risks that can deliver a profitable return over time. The aviation and upstream energy accounts have been cut back to bare bones as We simply do not believe that current pricing levels will cover a normal year s loss activity. These are underwriters who have experience of previous soft markets and have outperformed, not just the insurance market average, but the Lloyd s average (more detail in the section on Lloyd s Results below). The message from underwriters across the Lloyd s Market is that they are exercising underwriting discipline, whilst protecting the core book of business, and as always, looking for growth opportunities. Michael Meacock, who has been active underwriter of Syndicate 727 longer than most people working in the Market have been alive, sums up the prospects for 2017 in characteristically measured tones: Producing a materially positive result for the 2017 Account of Syndicate 727 is as daunting a task as any of the many challenges that have presented themselves over the years, but it is a challenge that I am as keen as ever to accept and, it is to be hoped, meet.

3 This last comment points to the perennial underlying positive outlook of market practitioners, in spite of the challenging conditions. Surplus capital is often mentioned as the obstacle that prevents improvement. Dominic Christian, CEO of Aon UK, says that surplus capital is not the problem, rather it is the fact that there are too few products we do not sell enough insurance. At a seminar in February, Mike McGavick, CEO of XL Group plc, gave a talk in which he outlined his vision of the insurance industry embracing the radical explosion of data and connecting devices. With more data, for example around flood risk, insurers will be able to offer cover which they have previously excluded. The connected world creates new risks; cyber is barely scratching the surface of the real risk. Policies will be switched on and off in real time. Unnecessary cost will be driven out of the system. His view was We should not be afraid of the current surplus capital, because we are going to need it, quite soon. Lloyd s Results Lloyd s declared results for the Market for the year ended 31 December 2016 on 30 March At 2.1 billion, the Generally Accepted Accounting Principles (GAAP) accounted profit was almost identical to the previous year, although the constituent parts of the result are very different and indicative of the increasing strain on the insurance industry. The combined ratio increased from 90.0% to 97.9% and only three of the eight main product sectors managed to deliver an underwriting profit. These were reinsurance, energy and aviation. The accident year result (i.e. the result before taking into account the movements on old years) was a loss for all sectors. The motor market experienced a deterioration on old years (which was almost entirely down to the change in the Ogden discount rate for personal injury claims in the UK), but all other sectors were able to release reserves (which under GAAP accounting refers to 2015 and earlier underwriting years). Although substantial, the aggregate reserve release was nonetheless smaller than for a number of years, reducing the combined ratio by 5.1 percentage points from an accident year combined ratio of 103.0%. Catastrophic loss activity was higher than we have seen for a number of years, although (as we point out elsewhere in this Review) the catastrophe losses are really no more than average. For the first time since 2012, the positive impact of reserve releases was smaller than the negative impact of catastrophe and major losses.

4 In recent years, the Lloyd s market has outperformed the combined ratio of an index of competitor insurers and reinsurers by an average of almost five percentage points. Lloyd s performance was again better than the competitor peer group in 2016, although the margin was much reduced at just 0.4%. The good news for third party capital providers at Lloyd s is that the subset of syndicates to which they allocate their capacity has performed better than the Lloyd s market average and by extension the wider insurance and reinsurance universe. Syndicates supported by private capital have produced average combined ratios around three percentage points better than the Market average over the five years to As with Lloyd s market performance in 2016, the margin of outperformance was smaller than for a number of years, with private capital syndicates average combined ratios only 0.3 points better than the Lloyd s average. Private Capital Syndicates Outperform While Lloyd s typically outperforms the competition on underwriting performance, the rising expense ratio has eroded this advantage in recent years. The increase in expenses was less in 2016, with expenses now accounting for 40.6p of every 1 of net premium income, up from 40.1p in Nevertheless this is a measure that has increased from 34.6p in 2009.

5 Lloyd s position as a wholesale market does increase brokerage costs and, in part, the upward trend can be explained by an increase in the amount of direct business written at the expense of reinsurance business. The evolving split of account between reinsurance (in shades of pink) and insurance (shades of blue) can be seen in the chart below. Commissions paid to brokers are lower for reinsurance business, which are paid out of premiums for which one set of acquisition costs has already been deducted. Nonetheless, expenses are an issue that all in the Market acknowledge needs to be addressed; Lloyd s reports that this will be an area of particular focus during Split between reinsurance and direct business is changing The principal area where there was an improvement in the results was the investment return. The Market return was 1.3 billion, up by more than 200% on the 402m recorded in The figures reported by Lloyd s reflect the investment earnings of the Market as a whole; this means that both the returns on members funds at Lloyd s and on the central assets are included in the financial statement. Returns on syndicate investments, which are included in the syndicate results, made an annualised return of 2% on values, up from 0.8% in Although Lloyd s headline results look good (with the total Market return commensurate with the level achieved in 2015), they were achieved in a year where catastrophe experience was historically unexceptional and with the help of a decent release from older years. On an accident year basis, the Market was in fact worse than break-even. To a large degree, recent results have been flattered by low catastrophe activity, large releases from reserves and, for 2016 in particular, the gains to Sterling-based capital providers arising out of a 25% fall in the value of Sterling.

6 Brexit and Lloyd s Europe Lloyd s has announced that it will establish a new insurance company in Brussels which will allow the Market s syndicates to continue to write business in the 27 countries of the European Union (EU) and the three of the European Economic Area (EEA) after the UK has left the EU. It is expected that Lloyd s Europe will be in place and able to accept new and renewal business by 1 January In 2015, around 3 billion (or 11%) of Lloyd s gross premium income was generated in the EU and the EEA. Although some of this premium is not subject to passporting rights, Lloyd s estimates that without the access to the single market provided by the new insurance company, half of this 3 billion of premium income is at risk. Multinational companies may buy a single insurance policy for their global operations. Without Lloyd s Europe, Lloyd s syndicates would not be able to participate in a policy that included assets in European countries in which the individual syndicate was not an established insurer. However, other major insurers, which are established in Europe, would be able to underwrite such business and the Lloyd s syndicates would lose out by not being able to offer cover. There is no impact on existing business or new or renewal business written in the interim while the UK remains a full member of the EU. Lloyd s trading rights outside the EU are not impacted by the decision to leave the EU. Once the UK leaves the EU, UK insurers (including the Lloyd s market) will continue to be subject to Solvency II, with the resultant requirements being incorporated in UK law. Major changes to the regulatory regime are not anticipated. Lloyd s India Lloyd s has formed a reinsurance company in India and opened an office in Mumbai. Lloyd s India acts as a domestic reinsurance branch of Lloyd s. At present, Lloyd s can only write reinsurance business, with MS Amlin the only managing agent signed up to write business out of this office. Lloyd s anticipates growth in the number of managing agents using the platform and in business volumes. Lloyd s China Currently there are 27 managing agents underwriting business on behalf of their syndicates out of Lloyd s China. Business written by Lloyd s China can either be 100% ceded back to one syndicate or can be written on a subscription basis, with the business ceded back to the original syndicates in proportion to their written lines. Gross premium income written through Lloyd s China was 238m in 2016 (up from 104m in 2015). The Indian and Chinese platforms are seen as central planks in Lloyd s delivering its Vision Forecasts as at 31 December 2016 Alongside the results presented on the annual accounting basis, syndicates released results and updated forecasts on the traditional underwriting year of account basis, which many would say gives a more accurate representation of actual performance.

7 We have prepared our usual forecasts for the open years, including (where appropriate) an update to the forecast for the 2017 year of account Year of Account The graph below shows the marked improvement in the final quarter of the 2014 year of account, attributable to reserve releases and foreign exchange gains Year of Account The 2015 account has now assumed the reinsurance to close of the 2014 and prior year liabilities and movements on those years during 2017 will have a significant effect upon the final result. The outlook for investment rates is slightly more optimistic than for a number of years, with the US Federal Reserve increasing rates for only the third time since the financial crisis. Although the inflation rate in the UK is likely to exceed the Monetary Policy Committee s target of 2% in the next few months, there has not yet been an increase in UK base rates. Interest rate increases are generally a good thing for insurers, although there can be a short term negative impact as the value of a bond portfolio goes down as interest rates increase. For this reason, the majority of syndicates investments are currently held in shorter dated stock. We expect a modest uptick in the return on investments achieved by syndicates over time, although in the medium term such increases are unlikely to reach the levels that were enjoyed before the financial crisis. As noted, a major element of the final result will be the performance of the closed years. A release has been made from reserves in each year since the close of the 2003 account and, as the Market softens, this part becomes increasingly important. There is always pressure to bolster the current result by taking an optimistic view of reserves and this

8 pressure tends to increase as the Market weakens. Yielding to temptation usually comes at a cost to the future results; indeed studies show that it is reserve inadequacy that causes the majority of insurance company failures, rather than catastrophic loss experience. We monitor reserving trends closely, and comment on each syndicate in our annual Syndicate Profiles publication. In general, we view the core group of syndicates reserving position as extremely strong. The release from reserves added 4.7 percentage points to the average result of an Argenta client s 2014 year of account result. Despite this, one of the key indicators of reserving strength (being the ratio of provisions for claims incurred but not reported to noted outstanding claims (IBNR/OS)) continued to strengthen at the close of 2014, giving us comfort that reserve releases will continue to contribute positively to members bottom line returns. There are however caveats on this observation. The first is that the absence of significant losses, especially catastrophe losses, reduces the ability of claims managers to post the reserves from which future releases can be made. The second is that the overall portfolio of claims continues to change; as short-tail claims are settled the residual liabilities are often more complex and could be subject to greater volatility. Comfort in Reserves

9 As shown in the graph below, our current expectation is that the 2015 account will close with a profit better than forecast by the managing agents, although we think it unlikely to experience the final upward kick that we saw in the final quarter for Year of Account 2016 Year of Account Managing agents are not required to make a formal estimate of the 2016 account until the end of the fifth quarter i.e. as at 31 March The forecasts will be arriving shortly and will be posted on the Argenta website. We expect that managing agents forecasts will be more pessimistic than our own, largely because we build in an expectation of prior year release for those syndicates that we believe have sustainable reserving strategies that will lead to consistent releases from old years. Our forecast for the 2016 account has deteriorated slightly from our Q3 forecasts because attritional loss experience has been worse than projected. Although the 2016 calendar year escaped significant catastrophe loss, there was a marked increase in the levels of attritional loss and loss ratios are running higher than 2014 and 2015 at the same stage. As argued in our January Quarterly Review, we think that early loss ratios in recent years are flattered by the changing business mix of our syndicates, with a smaller proportion of catastrophe reinsurance business, an increase in business written under facilities and binders and also in the longer tail element. This is amply illustrated by the development of the 2015 account which was clearly below all recent years after 12 months but has now caught up with the 2014 account at the 24 month stage. We would anticipate the 2016 account will follow a similar pattern. While we are more sanguine about reserve releases (as we can now see how much reserve remains after the

10 close of 2014) and investment income (as interest rates are set for small increases), the spate of small losses in 2016 has caused us to downgrade our forecast profit for the pure year from 6% to 5% of capacity. Losses impacting the year include: wildfires at Fort McMurray in Canada; the spillage from a pipeline in Saskatchewan; a fire at a large clothes warehouse in New Jersey; cargo spoilage claims following the bankruptcy of a South Korean container transportation company; an explosion at a chemical plant in Mexico; the loss of a communications satellite at launch; the scrapping of an oil platform in the Norwegian North Sea following cracks emerging in the platform s legs; damage to a floating production storage and offloading vessel off the coast of Ghana; an earthquake in New Zealand, as well as the more widely publicised Hurricane Matthew. Although natural catastrophes exerted a larger toll on insurers and reinsurers in 2016 than any year since 2011, the overall losses cannot be described as anything but average, when compared with the years 2005 (the year of Hurricanes Katrina, Rita and Wilma) and 2011 (a year of international losses including earthquakes in New Zealand and Japan and floods in Thailand). The chart below shows development of the net loss ratios for Argenta client portfolios since An important but technical point to note is that we have changed the basis of this chart in order to make it consistent with Lloyd s reporting and business planning. It shows net incurred claims divided by premiums, net of reinsurance but gross of acquisition costs. It previously showed net incurred claims divided by premiums, net of reinsurance but net of acquisition costs Net Loss Ratio Comparison

11 2016 is already some 2.5 points worse than 2015 at the same stage. We anticipate that it will develop more rapidly in the second and third year as there has been a shift towards business with a longer reporting tail, such as binder business and casualty, at the expense of catastrophe reinsurance. As a reminder, risks are allocated to a year of account according to the year in which the policy incepts. Therefore an airline policy which incepts on 1 November 2016 (and many do) will be exposed throughout the majority of the 2017 calendar year. Much business is written by way of facilities and lineslips and again business is allocated to the inception of the policy. In this instance, a syndicate could grant a binding authority to a managing general agent (MGA) on 1 December The MGA would write business to the binder throughout the next twelve months, possibly adding the last declaration for 12 months on 30 November In this example, the last live risk under a 2016 year of account binding authority would remain on risk until 29 November This shows why catastrophe events often impact two or more underwriting years at Lloyd s and explains why the losses mentioned above that occurred in 2016 will fall to 2015 and 2016 underwriting years Year of Account

12 2017 Year of Account We will receive the first set of data on the 2017 year of account with the imminent first quarter figures. Apart from some very small changes relating to expected investment income or the long term average performance of reserves, there is little change to our figures from those published in our previous Quarterly Review. Three syndicates are worthy of note. We have reduced our forecast profit for Blenheim Syndicate 5886, which commenced underwriting on 1 January 2017, from 5% to 4% of capacity. Although the managers are very happy with the support they have received from clients and brokers and state that they have seen a very large proportion of their targeted reinsurance book, the syndicate was not able to write as much of the direct property book as they had hoped and now estimate that income will fall short. We have also downgraded the forecast for Standard Syndicate 1884 from a loss of 2% to a loss of 5%. Our prognosis for the 2016 Year of Account is not good. Both the cargo and the hull accounts are underperforming (these two elements account for more than half the syndicate s projected premium volumes) while the expense base is high and the proposed diversifying lines have not been written in the expected volumes. The reinsurance programme has scarcely mitigated loss activity. Although the managing agent is engaged in a process of re-underwriting the account, we are sceptical that the syndicate can achieve the improvements required on the numbers that are now emerging for the 2016 account. The syndicate is under review, with a decision as to our recommended support to be made on the prospects for the 2018 underwriting account when the business plan is available. Syndicate 218 was heavily impacted by the change to the Ogden discount rate for personal injury claims announced by the UK s Lord Chancellor on 27 February The 2014 result was in consequence well below expectations and the forecast for 2015 has been downgraded from a profit of 3% to a loss of 5%. We understand that the 2016 result will suffer a similar sized increase in loss costs and we have downgraded our forecasts for that year from a profit of 5% to break even. The 2017 year of account is therefore something of an anomaly; the reinsurance cost has not yet been adjusted for Ogden, but the syndicate has the opportunity to increase its rates ahead of the reinsurance cost going up. We were advised of the departure of the Active Underwriter of Syndicate 218, Mark Bacon, on 5 May and will be writing to members about this syndicate following the receipt of the first quarter numbers which we now anticipate will be worse than our forecasts overleaf.

13 Forecasts for 2015 Year of Account Managing Agent AIRL Q316 Q416 Q316 Q416 % % % % 33 Hiscox ERS TMK Beaufort QBE TMK TMK Atrium Beazley Meacock AmTrust Canopius Chaucer Argo Apollo Asta Charles Taylor R&Q Cathedral Pembroke Argenta Asta AmTrust MAP AmTrust MAP Hiscox Ark Beazley Catlin Argenta average

14 Forecasts 2016 and 2017 Years of Account Managing Agent AIRL AIRL Q416 Q316 Q416 Q316 Q416 % % % % % 33 Hiscox ERS TMK Beaufort QBE TMK TMK Atrium Beazley Meacock AmTrust Chaucer Argo Apollo Asta Charles Taylor R&Q Cathedral Pembroke Argenta Asta AmTrust MAP Canopius AmTrust Asta MAP Hiscox Beazley Catlin Argenta average

15 Caveats This Quarterly Review publication is issued for general information purposes only and should not be construed as an invitation or inducement to engage in underwriting activity, nor investment advice. The document has nevertheless been prepared in accordance with the general principles of the Financial Conduct Authority (FCA) financial promotion rules, in addition to those stipulated by the Code for Members Agents: Responsibilities to Members. Whilst all reasonable care has been taken to ensure that the information contained in this document is accurate at the time of publication, Argenta does not make any representations as to the accuracy or completeness of such information. Further, Argenta does not represent, warrant or promise (whether express or implied) that any information is or remains accurate, complete and up-to-date, or fit or suitable for any purpose. This document provides information about syndicates' past performance. Past performance is not a guarantee for future performance. The forward-looking statements (including, but not limited to, the AIRL forecasts) in this document are subject to uncertainties and inherent risks that could cause actual results to differ materially from those contained in any forward-looking statement. Whilst it intends to publish future Quarterly Reviews, Argenta undertakes no duty to update publicly any forward-looking statements contained herein, in light of new information. Unauthorised use, disclosure or copying of the document is strictly prohibited and may be unlawful. Argenta Private Capital Limited is authorised and regulated by the Financial Conduct Authority. Argenta Insurance Research Limited is a wholly owned subsidiary of Argenta Private Capital Limited.

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