The commercial insurance landscape in Western Europe is changing. The good old days of capital-based competition will soon be gone. Instead, knowledge of the risk profiles and financing and service needs of individual corporate customers is fast becoming the only currency that counts.

The signs are already visible. Commercial carriers are increasingly diversifying into risk management and financing services, while reinsurers are consolidating and using their superior risk knowledge to approach corporate customers directly. Brokers are joining forces and offering a greater range of fee-based services, corporate customers are adopting more professional approaches to risk management, and even investment banks are entering the arena.

These developments are the outward manifestations of a Europe-wide transition from capital- to knowledge-based competition. In capital-based competition, capacity or the ability to absorb event risk is the most important factor. Knowledge-based competition, which has shaped the face of the US industry for more than 15 years, has already taken hold in the more advanced European markets such as the United Kingdom and Scandinavia. In knowledge-based competition, it is the detailed understanding of risk profiles, claim patterns, and corporate customers’ ability to finance risk that matters most. Coverage structuring or solution engineering is steadily overtaking simple capacity provision in importance. Meanwhile, capital has become a commodity.

In the new knowledge-based game, the key buying factors for corporate customers and the key success factors for insurance carriers will depend on the type of risk concerned:

• Bottom-layer risks are those where the frequency of occurrence is expected to be high and the severity of claims low, such as auto fleet insurance
• Middle-layer risks are those where the frequency and severity of claims are expected to be moderate, such as most commercial fire risks
• Top-layer risks are those with low expected frequency but catastrophic severity, such as product liability.

Thanks to their size and critical mass in many commercial lines, the larger European carriers are best placed to succeed in the new game. They enjoy more strategic freedom than smaller national carriers, and are able to make the huge investments in knowledge that are necessary to achieve a world-class position in every layer. In the end, however, they will succeed in maintaining their current position in the different lines only if they commit themselves to the following strategic actions:

• Running the activities in the three different risk layers as separate businesses, each focused on its own key buying and success factors
• Strengthening their knowledge base through internal growth, acquisitions and joint ventures, and alliances with specialist providers
• Building market share in the top risk layer
• Using professional account management to integrate the products and services offered for each layer of risk.

For the many national players with small and medium-sized commercial lines books and a strong domestic focus, pressure will mount to define their strategy in terms of three imperatives:

• Providing insurance solutions to smaller companies and independently run subsidiaries of large multinationals in an attempt to leverage knowledge of local markets and risk profiles. A strong local market position must, however, be strengthened by a specific segment and/or service focus to be sustainable in the long run
• Focusing on specific segments, such as particular customer industries or types of risk, and configuring skills and product or service offerings accordingly
• Making targeted investments to develop superior risk management, policy handling, and claims processing services for national customers in the bottom layer.

Many smaller European players will be forced to exit the commercial lines market by selling or "running off" their books, a practice by which the insurer closes a portfolio of similar risks and uses accumulated reserves to pay for future claims until all policies have expired. They will be unable to catch up with the sophisticated carriers that have already begun to spread knowledge-based competition across Europe, among them AIG, Swiss Re, and Zurich/Centre Re.

Shrinking profits

Today’s declining prices and dwindling volumes are not just the symptoms of another downcycle

In the past, competitive intensity in most European countries was fairly low. But today’s declining prices and dwindling volumes are not just the symptoms of another downcycle. Rather, the entire industry map is being redrawn.

The good old days

When commercial lines insurance was based on capital or capacity, customer preferences were relatively unsophisticated, products were more or less standardized, and relationships between corporate customers and insurers were fairly stable. The result: comfortable returns for the few large and many smaller players.

Most customers tended to choose carriers on the basis of their capital strength or ability to absorb risk, regardless of the layer of risk they were trying to protect. The internal insurance department rarely served a genuine risk management function; instead, it was primarily seen as an administrative office for buying and renewing insurance policies. In countries such as Germany, corporate insurance departments were (and often still are) typically set up as in-house brokerages whose primary aim was to generate commissions from risk transfers in order to cover their running costs. This meant they seldom had much incentive to reduce the level of risk transfer by increasing the level of self-insurance, however desirable that might have been from a corporate perspective.

Relatively simple, standardized single-line coverage such as fire or marine has prevailed until now, especially in markets with little broker penetration; so have bundled services such as policy administration and claims handling. Few European carriers have shown much appetite for devising coverage for difficult-to-price new risks with little statistical history, such as environmental liability and terrorist damage. Sales efforts are still largely focused on single-line, single-year policies that reflect traditional thinking on separate insurance lines. In some European countries including Germany, policy conditions continued to be developed by industry associations until recently—well beyond the 1987 European liberalization introducing free product and price competition in commercial insurance. These policy conditions seldom took account of industry-specific risk characteristics and differences in risk protection and management.

In Western Europe, the market has generally been parceled out at a national level according to long-standing ties among insurers and established relationships between corporate customers and carriers. Most in-house brokers or corporate insurance department managers tended to be recruited from the underwriting ranks of the companies’ insurers. Competitors have often been members of the same consortium, at most changing its leadership from time to time. Predictably, market shares have changed very little.

Reshuffling the cards

Under these circumstances, it is hardly surprising that overall profitability levels have been most attractive for the past decade, despite a downcycle in 1991-92. Average returns have exceeded the cost of capital for most insurance lines. However, the old game is becoming unsustainable. Price levels are continuing to fall and the trend toward self-insurance and unbundled services is gaining momentum in Europe. With the introduction of self-insurance, corporate customers are paying for the first portion of a claim themselves, while their insurance carriers pick up costs beyond the limit set for self-retention. Self-insurance can be financed either from corporate cashflows or from funds that have been built up in a special vehicle, such as a captive insurance company.

We can expect a reduction of as much as 50 percent in the volume of premiums by the year 2005

If we take the developments that have occurred in the United States over the past 15 years and extrapolate them in the more advanced European markets, we find we can expect a reduction of as much as 50 percent in the volume of premiums by the year 2005. This suggests that the cards could be reshuffled quickly.

The relentless fall in prices was evident in this season’s renewal results, with a 10 percent drop in certain areas, such as fire in Germany. We expect this trend to continue, for several reasons:

First, high profitability in the past, bolstered recently by sizable investment gains, has led to an oversupply of capital at the primary level. Cheap reinsurance capacity for traditional risks in Europe will open up even more room for price concessions at this level, adding to the pressure on rates. The fact that there have been so few catastrophic losses for corporate customers in Europe over the past five years is leading to rate reductions and further overcapacity. In Germany, for example, the frequency and average cost of large fire losses have been remarkably stable for the past decade.

Second, primary carriers are increasingly attempting to boost their market share by reinvesting some of their recent profits in price cuts. This trend is being reinforced by brokers, whose role is to structure insurance coverage and select carriers on behalf of corporate customers. Price reductions will be particularly pronounced in heavy broker markets such as the United Kingdom and Belgium. Here, brokers are responding to the pressure of declining overall prices and volumes (and hence declining commissions) by structuring new coverage, offering new services, and shifting more business to fewer carriers to generate compensatory volume and fee income.

Third, better on-site risk control by corporate clients is reducing the frequency and severity of claims on average. These improvements attest to the growing sophistication of the corporate risk manager, often fostered by the advice of brokers and risk management consultants.

Evidence is mounting that overall demand for insurance in Europe will continue falling, as it has for the past five years. The shift from manufacturing to service industries in Western European economies is eroding demand for traditional lines. The expanding service sector is providing much lower premiums per unit of revenue than the manufacturing sector, and the growth in demand for specialized coverage such as computer fraud or intellectual property protection is unlikely to make up for the loss of insurance volume from manufacturing industries. Where compensatory growth opportunities do exist, in Eastern European and other industrializing countries, they are relatively limited and difficult to exploit.

Some corporate customers are starting to realize that they have paid far too much for insurance coverage over the past decade

In addition, corporate customers are practising more risk prevention and renewing their efforts to cut the cost of risk through self-insurance and self-retention. The costs of insurance risk (excluding market, credit, and business risk) in some industries, such as health care, already account for over 1 percent of revenue, or nearly 50 percent of return on sales. As a result, many corporate customers are taking a closer look at their insurance policies. Some are starting to realize that with claims payments received from insurers over the past decade amounting to less than 40 percent of premium payments made, they have paid far too much for insurance coverage over the cycle.

Self-insurance heightens line managers’ sensitivity to risk management, since any losses will cut into their budgets

This is especially true of the bottom layer, where most corporate customers have borne the high costs of the insurance industry (and rising insurance taxes) in return for nothing more than simple coverage of predictable losses. When a company increases its self-insurance, it reduces the overall cost of risk, for two reasons. First, the administrative costs of running a self-insurance program are usually much lower than those loaded into regular insurance premiums. Second, self-insurance heightens the sensitivity of line managers to risk management issues, since any losses at this level will cut into their budgets.

Corporations’ greater balance sheet power and larger cashflows are also reducing the need for risk transfer. More important, chief financial officers have recently begun to assume responsibility for insurance, replacing managers who typically reported to the head of operations or purchasing. These CFOs are making the link between risk transfer and financing. They find they can easily finance certain exposures themselves, resorting to insurance-like arrangements primarily for balance sheet stability and tax reasons.

The speed at which price or volume reductions occur will ultimately depend on the relative cost of insurance. If rates continue to decline, the cost advantage of better risk prevention and control and increased self-insurance could shrink. Under such circumstances, these developments would take longer to unfold. But as soon as the next cycle of severe losses and rising rates hits, it will drive more volume out of the system. A deterioration in margins is unavoidable in any case, since the more attractive corporate customers—those with relatively low claims costs compared to the premiums they pay—are bound to exit the market first.

The new knowledge-based game

The new game will be predominantly knowledge-based, with a heavy emphasis on the compilation and analysis of detailed risk and claims profiles across entire layers for individual corporate customer accounts. Carriers will also have to take care not to pay out more than the terms of a policy require. The additional growth opportunities in bottom-layer services, middle-layer risk financing solutions, and new top-layer risks will not be big enough to compensate all players for the reduction in conventional premium volume. Competitive dynamics will reward those players that make targeted knowledge investments early. The nature of these investments will differ by layer of risk.

The bottom layer

Risks in the bottom layer are typically high in frequency and low in severity. Examples include auto fleet insurance, most marine coverage, and some types of property risk. Claims costs for this layer are often referred to as "burning costs," as the total sum is highly predictable for a single customer on an annual basis and is therefore effectively "burned" or incurred every year. Risk characteristics and key buying and success factors suggest that the bottom layer will evolve into a pure processing game.

Processing efficiency, speed, accuracy, and service quality will be the key buying factors for corporate customers. As claims costs are so predictable, these customers will have no incentive to transfer all their risk, which would effectively mean exchanging a pound for a pound. Instead, they will handle the risk themselves and select carrier services such as claims processing primarily on the basis of processing costs. In addition, multinational customers will require local policy handling and claims processing capabilities in those countries in which they operate.

Winning carriers in this layer will have to invest heavily in information technology and policy- and claims-handling skills to reach the necessary standards. As with credit-card and small-loans processing companies, they will have to run their operations like processing factories. They will have to find ways to compete with both large systems houses such as EDS and independent third-party administrators such as Crawford, the claims adjuster. Players like these have recently entered the European scene after years as fixtures in the United States.

Carriers will also need a clear understanding of how to structure self-insurance solutions, and a good knowledge of the relevant tax law and legal matters. However, global network capabilities will not necessarily require a local presence in every country. Instead, they can be achieved via joint ventures and alliances with other local service providers.

The middle layer

In the middle layer, where claims are moderate in frequency and severity, risk characteristics and competitive dynamics suggest an evolution toward what might be called a risk structuring and financing game. The cost of risk in this layer can be predicted only over a five- to ten-year horizon. Fire, liability, and engineering coverage typically fall into this category.

Corporate customers in the middle layer will focus not only on price but on a carrier’s ability to structure coverage and reputation for paying out claims. In the recent past, market demand has evolved toward line-spanning aggregates (aggregate levels of self-insurance or self-retention that are defined across all lines) and multiyear price guarantees. Such arrangements increasingly involve risk financing solutions, not only for future losses (prospective coverage) but also for past losses (retrospective coverage).

Successful insurance carriers will need world-class underwriting skills based on a detailed understanding of the risk profile and claims history of individual customers. They must learn to manage the tradeoff between self-insurance in the bottom layer and traditional coverage in the middle layer. To do this, they will have to identify a customer’s optimal threshold (above which the carrier will pay claims in full up to a certain limit) for each type of insurance, according to that customer’s risk appetite. They will also be required to blend in risk-financing elements as corporate customers discover the risk-bearing abilities of their cashflows and demand cover for risks that have traditionally been difficult to insure.

Carriers picking up middle-layer business will need a good sense of the claims-handling capabilities of those covering the bottom layer, since their economics depend largely on keeping actual claims costs from exceeding the limit that separates the bottom from the middle layer.

The top layer

Top-layer risks are hard to measure and predict, especially in liability. Typical exposures include product and environmental liability, catastrophic property damage, and business interruption exposure. Rising consumer activism, new technologies such as biotechnology and wireless telephony, mounting environmental legislation, increasing supplier concentration, and the growing interdependence among companies will create increased demand for top-layer protection in Europe. The top layer will evolve toward a capital access game.

Unlike the bottom and middle layers, the market for top-layer exposure will be a seller’s market. Corporate customers will choose carriers for their size, capital strength, corporate finance skills, and relevant risk knowhow. It is hardly surprising that reinsurers such as Swiss Re have decided to switch to direct distribution in this layer, as they are the industry’s principal providers of capital.

A critical precondition for every insurer in the top layer is access to capital. Given the nature of the risks involved, insurers also need a solid grounding in all categories of capital-market-based products such as catastrophe bonds and derivatives. The many insurers unfamiliar with these products may have to enter into alliances with investment banks.

Investment banks have themselves recently begun to devise catastrophe bonds and special-purpose vehicles, thus opening up the global capital market as a source of finance for catastrophe exposure. In France, Axa/UAP has announced a joint venture with Paribas to develop and promote capital-market-based products and risk-financing solutions. Several other large carriers have stated that securitized insurance risk has a bright future. Yet many capital-market-related products offered by investment banks satisfy only the need for financing, leaving ample room for insurers prepared to take risks.

Many corporations in Europe are not yet fully aware of the extent and breadth of their catastrophe exposure

As well as securing access to capital, carriers will have to develop demand. Many corporations in Europe are not yet fully aware of the extent and breadth of their catastrophe exposure. They are slowly beginning to face up to product, computer system, and contractual risks.

Different players, different strategies

National insurance carriers of every size will have to position themselves strategically to play the new game. Larger carriers will enjoy greater strategic freedom than their small and medium-sized rivals thanks to their critical mass and financial strength. They will be able to serve multinational corporate customers across the globe and across all layers and lines provided they are quick to make the necessary investments to close the knowledge gap in all three layers.

Small and medium-sized national players will face tougher strategic choices. To survive, they will need to penetrate their home base of small companies more deeply. They may choose to leverage their existing knowledge and focus on specific segments, such as industries or types of risk. Alternatively, they might build a national service business offering risk management, policy processing, and claims handling to domestic corporate customers.

No matter what their size, European commercial lines insurers will have to build world-class underwriting skills and streamline their individual cost positions. Carriers that lack the crucial underwriting skills of information collection, coverage structuring, risk assessment, pricing, and negotiating are bound to fail, especially if they are active in the middle and top layers.

Large carriers

Larger carriers enjoy a structural advantage in that they can easily make the investments needed to close their knowledge gaps and become world class in every layer. Ultimately, though, they will only succeed if they commit to certain actions.

Large carriers will have to run their activities in each layer as separate businesses. They will have to break up their current commercial lines divisions before they can properly reflect the differences in skills and challenges within each layer. In the bottom-layer unit, they will probably pool their transaction-intensive auto fleet and marine insurance business and their unbundled service business. The middle-layer unit would focus on property and liability coverage and risk financing solutions. The top-layer unit would concentrate on catastrophic exposure and reinsurance solutions.

Large carriers may also want to consider setting up a dedicated "run-off" unit rather like a bank’s credit workout unit to take over reserves and policy and claims payment commitments from smaller players seeking to exit the market.

Large carriers can become the providers of choice for corporate customers so long as they are willing to focus on the different buying and success factors in each layer. However, they must be aware of possible competition from brokers and be ready to adapt their distribution approach accordingly.

In the bottom layer, large carriers will encounter fierce competition both from brokers trying to promote their own services and from specialist third-party administrators. They must make sure they have efficient networks for this kind of service business, whether developed internally or obtained via acquisitions, joint ventures, or alliances.

In the medium and top layers, large carriers may become market makers. Since there is less transaction-intensive service business here, the interests of brokers and carriers tend to be better aligned, allowing the latter to rely on broker or consultant distribution to a larger extent. In the heavy broker markets, carriers will need to select and manage broker relationships carefully and invest in electronic trading platforms. Any player choosing to distribute direct will have to consider its entire broker book, since customers review their choice of carrier regularly and brokers may be quick to shift business away.

Carriers must strengthen their knowledge base in each layer, whether through internal growth, the acquisition of specialist providers, joint ventures, or alliances. Winterthur and Allianz have recently announced the establishment of alternative risk transfer units as a separate division in the first case and a fully funded insurance carrier in the second. These units will focus on new financial insurance solutions and capital-market-based products.

In top-layer business, gaining market share quickly is vital. Only a few exposures of comparable nature are available, and a carrier that enjoys a higher share will be able to offer better pricing.

Broadening the range of products and services and upgrading them regularly will be the name of the game, not a winning formula

Finally, broadening the range of products and services and upgrading them regularly will be the name of the game, not a winning formula. More may rest on the effectiveness and professionalism of account management—the integration and segment-specific delivery of different products and services at the customer interface. AIG is among the first to face up to this challenge by establishing a global risk unit that manages business with many of the world’s largest companies. Swiss Re and Zurich/Centre Re are following with similar approaches.

Small and medium-sized carriers

Smaller carriers face an even tougher situation. Lacking the necessary capital strength, they will have to exit the top-layer business. Moreover, unless they rigorously define their knowledge-based strategy in terms of three imperatives, they will be unable to survive.

First of all, these carriers should build on their local presence and exploit their knowledge of local markets and risk profiles to raise their market share among small companies. To earn adequate returns, they will have to standardize their products and reduce frictional costs either by opting for direct distribution or by aligning their business system with that of brokers. In heavy broker markets, small carriers will be able to compete against larger players only if they can deploy superior underwriting and a lean business system to offer lower prices and a better service to brokers. Even players with a strong local position may be threatened in these markets as brokers merge and form extensive international networks capable of providing small local customers with easy access to big foreign carriers.

Small to medium-sized carriers seeking to expand their business may choose to gain market share in specific segments (such as customer industries), types of risk, or a combination of the two. Prominent examples include medical malpractice insurance and warranty schemes for the motor trade. Whatever niche they choose, smaller players will need to establish a specialist reputation and create a marketing pull. Their position can be sustained only if they deepen their knowledge of their customers’ business systems and use it to improve their product design and inform their underwriting and pricing.

Smaller carriers might choose instead to build a national service business in their home market. Such an approach calls for a competitive cost position (which in turn requires a critical mass of transactions) coupled with state-of-the-art support technologies.

The transition from capital-based to knowledge-based competition is proceeding apace in Europe. It is already transforming commercial lines business in the insurance industry. Players that move quickly to invest in the knowledge they need to exploit new growth opportunities will be rewarded with attractive returns.