Is your pricing based on analysis and not commercial speculation?

A New Zealand executive from Marsh, the giant insurance broker, gave an unscheduled talk at the NZCID conference today. (I didn’t get his name)

While the good news was that even after Christchurch international insurers have appetite for insuring NZ property, the bad news is of course that prices and terms have changed for the worse.

The two main findings for me were that average Marsh negoatiated premiums have increased 140% this year, and that the earthquake excess amounts (the bit the owners pays in the event of a claim) have not ony increased, but are now calculated as a percentate of the total value of the insured property rather than the claim. That represented, in the example he gave the room, a 10-fold increase in the excess amount.

However these changes are probably a fair reflection of the true risk, though perhaps they have deliberately over-shot to compensate for an appalling year for insurance.

His estimate was that 20-40% of the insurance claims are to the NZ companies, with the remainder being held by international re-insurers like General RE and Swiss RE. Those re-insurers take massive global risks and despite Japan are still OK for the year so far. To me that means we will get 60%-80% of the estimated $25 billion insurance losses coming into NZ for offshore, and that’s essentially one way traffic, not investment. While the earthquakes have been a tragedy in many senses of the word, these funds allocated to fixing Christchurch will result in a tremendous economic stimulus.

But let’s look at pricing of insurance.

In the past Marsh and insurers understood that Wellington was a risk, and so had a property by property approach to assessing the likelihood and magnitude of damage in a large quake. Now that approach is being rolled out to not just Christchurch, but also to other nearby regions, like Nelson and Manawatu. (Auckland and Hamilton were not mentioned.)  Wellington traditionally also had those much higher earthquake claim excess rates based on total insured value, and now Christchurch and other cities will take on those excess rates as well. For now @polarbeerfarm tells us that no new Christchurch (residential?) policies have been issued for the last six months.

But the most important change to me was a broad shift from “commercial pricing” to “risk based pricing”. Apparently, and I can back this up with what I saw in a brief consulting assignment with a Lloyds underwriter/broker, much of the commercial property insurance has been priced on getting a certain market share. Going forward in New Zealand the insurers will be wanting much more specific information about the property – starting with location (longitude and latitude), a recent building survey and so forth. One company is modelling location to within meters, and they’ll be able, if they have the technology, to model the effect of a large quake on their portfolio, and manage their risk accordingly. Thus insurers will be able to much more scientifically calculate an approximation of the risk and magnitude of loss, and then charge an appropriate insurance premium.

It sounds so obvious. It took Christchurch for the insurance industry, and those who pay premiums, to face the facts that the previous wisdom of crowds pricing  can only take us so far. Perhaps it will gradually regress over the years, but the lessons should be held, and with today’s technologies there really is no excuse for not bringing an analytical approach to insurance.

But the insurance industry is not alone,as a quick look at the financial markets or US politics will show. Neither are showing a reasonable amount of reason at the moment. The US market crash over the last week is relatively small, but disturbing.

Disturbing because despite the correction, we still have individual stocks with ludicrous valuations. Linked In is trading at US$75 per share, but had earnings per share of just 18 cents over the last 12 months. That’s about 0.2%. Imagine giving your bank $75 and having them say they’d give you 18 cents in interest a year later.

A week ago the Linked In share price was over $100, valuing the company at US$9- $10 billion, which implies at some stage investors expect the company to make say $700-$1,000 million per year in net profit available to shareholders. Last year Linked In made just $21 million – so they need to grow earnings 40 times to justify the price. Looking at the business itself I just cannot see where the required extra income would come from. Linked In is a once a week (say) site, and simply isn’t valuable enough for most people to pay for.

Meanwhile Amazon earned $1 billion, and was valued at 80 times that after last night’s drop, and significantly more last week. Amazon is an awesome company, but that price exposes an investor belief that even after the market correction, investors expect net earnings available to shareholders will increase by 7-10 times. That may happen, but let’s also remember that there is a major downturn happening in Europe and the USA, and that’s where the majority of Amazon’s high paying customers are.

I’m betting that both stocks will keep falling – I bought options last week to do so. I only purchased a tiny amount, and while I wish now that I’d bought a lot more, the simple fact of the matter is that the financial markets are currently pricing using ‘commercial’ rather than sound analytical reasons.

About Lance Wiggs

@lancewiggs
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