Why brokers need to revisit risk differentiation

  • Lyndon Broad Operations Manager, FM Global

Brokers have been placing business into a falling market for the past five years. While that provided the opportunity to get clients insured more easily, we’ve seen that focus has drifted away from the quality of the underlying risk to the price of the insurance contract. 

This has had a significant impact on insurer profitability in particular segments of the commercial property insurance sector. Insurers now need to re-establish the discipline associated with pricing good quality risks from poor, with this forcing brokers to view their responsibilities a bit differently.

We’ve seen this before in the US. The year is 2005. Brokers are seeing clients getting caught up in a wave of commercial property insurance rate increases after catastrophic damage caused by Hurricanes Wilma, Katrina, Rita and others. Twenty, thirty, fifty per cent more. 

Brokers realised something had to be done before good risk went down with the bad. A concerted effort was made to turn the situation around by getting clients with good risk management practices in front of insurers to differentiate themselves from those with poor risk management. FM Global’s data shows that for those who had followed best practice, their losses during Katrina were 84 per cent lower. 

In 2018, Australian brokers have an opportunity to be proactive in the same way. The latest Australian Prudential Regulation Authority shows that combined ratios in Fire and Industrial Special Risk (ISR) have been unsustainable for the past four years – peaking at 134 per cent in 2015.

A competitive landscape

What’s happening? To some extent, we’ve been victims of our own success. Australia has a highly competitive commercial insurance market. FM Global data shows Australia has enjoyed some of the lowest rates in the world. They’ve fallen almost constantly since 2002 with this decline accelerating between 2013 and 2016. 

Most of the large global insurers are here, including recent entrants like Berkshire Hathaway Specialty Insurance. We’ve felt the impact of the increased balance sheet size and capacity of newly merged insurance groups such as XL Catlin and ACE/Chubb, with more to come through the acquisition of XL Catlin by AXA. 

Alternative capital has also played a role, with more fund managers now allocating a portion of their capital towards the reinsurance market. With a relatively low cost of funds and meagre returns from investing capital elsewhere, these funds have been prepared to accept lower returns from their reinsurance investment. This has caused further downward pressure on commercial property rates. 

But here’s the rub. With an abundance of insurance capacity and the ability to easily place business into the market, there’s been a growing trend of brokers having no need to differentiate risk. As a whole, it appears that brokers have taken an optimistic view of client risk and the insurers have been along for the ride. Partly as a consequence, commercial property insurers last year lost about 10 cents for every premium dollar collected. Those rate declines have now started to taper off. After last year’s series of hurricanes, rates are turning. Now, the recycling sector and unprotected EPS sandwich panels are facing increases of 300 per cent.

Unfortunately, even businesses that manage risks well will share some of the costs of the commercial insurance industry returning to a position of reasonable long-term profitability. Yet with adequate risk differentiation, we anticipate those increases will be modest. 

Well managed businesses shouldn’t be forced to subsidise poorly managed ones on an ongoing basis. Clients with good quality risk procedures deserve to pay lower premiums and rates. By rewarding companies with lower rates, we will also encourage better quality risk management practices. This will deliver a more sustainable outlook for insurance providers in the long term. Businesses that manage risk poorly should expect to pay a premium for their choices. After all, FM Global data shows that average fire-related loss amounts equate to US$3,200,000 for those companies with poor risk management, compared to US$724,000 for those with better practices. 

Proactive and partnering 

Clients will need proactive brokers if they’re going to level off their premiums. Fortunately, many brokers already acknowledge that there’s much more to properly differentiating complex risk than reading a brokers’ report. There’s a skills shortage in this area.

Luckily, there are partners out there who can fill the gap and help brokers reach a fair outcome for clients. Steps may include getting a specialist engineer in to review physical risk factors and consult on the quality of their risk management.  

Key areas to address in the Fire and IRS sectors specifically include the management of procedures involving people, such as hot work, maintenance, and operator training. At FM Global, we’ve seen many losses occur due to a lack of stringent oversight in this area. Having an automatic sprinkler system in place that’s well managed and serviced makes a huge difference if a fire does break out, reducing a loss that could otherwise reach into the hundreds of millions to something far more manageable.  

Sensor-based technologies provide us with enormous opportunities to further improve risk profiles, for example through preventative maintenance, while predictive analytics show the likelihood that a particular piece of equipment could fail. Besides allowing organisations to benefit from a reduction in losses and making disasters less common, such measures have a multiplier effect on a company’s total cost of risk, protecting business continuity, improving investor confidence and reducing distractions to management.

For those forward-thinking companies that are willing to go on the journey, there’s plenty of reason to believe they’ll be significantly rewarded for better managing risk quality. In turn, so too will the brokers that helped them get there.