Possible Effects of Solvency II and the new Baremo Indemnification Table for Spanish Auto Insurers
Over the last two decades, the so-called “Baremo” indemnification table for traffic victims in Spain has provided a legal framework and a stable basis for compensation. As a result of the Baremo, out-of-court settlements are the standard, even for severe bodily injury claims, thereby removing uncertainty from this important line of business. During this period, the Spanish insurance industry has enjoyed excellent results in the motor business, unheard of in most mature insurance markets. Profits have been holding up even during the last decade, despite increasing competition from direct insurance companies, online insurance price comparisons that fuel competition with aggressive advertising, not to mention the sharp decline in car sales, since the economic crisis hit the country in 2008.
How have Spain’s auto insurers and reinsurers managed to maintain such impressive numbers? Despite falling prices, loss ratios have been rather stable, mainly due to people with less money tending to use cheaper means of transport; in other words, they drive less. According to Spain’s oil stockholding agency CORES, petrol consumption fell by more than 20% over the last several years, which resulted in a significant decline of loss frequency. For example, liability loss frequency dropped below 9% by the end of 2014 from 12% in 2008, and road traffic mortality was down to 1,680 fatalities in 2013 compared to 3,823 in 2007, according to data from Spain’s traffic agency DGT. At the same time, more professional fraud detection systems and more efficient internal operations helped to curb the trend towards more fraudulent claims. It also helped that the insurance companies’ loss reserves were quite comfortable at the beginning of the crisis. Having said that, the sector’s motor loss reserves diminished by EUR 2 billion between 2009 and 2014.
Although the Spanish economy is recovering, the reality varies widely for different auto insurers. At 102% for retained business for the first quarter of 2015, the combined ratio for the motor market is similar to the previous year, with 40% of the companies at a technical loss1 and many relying on investment income, which remains surprisingly high at 7.8%, according to ICEA (Spain’s Association of Insurance Companies). That’s despite the low interest rate environment; Spanish 10-year treasury bonds were yielding just below 2% by the end of July 2015. Most Spanish insurers secured 5%+ yields for 10 years or longer, during the peak of the economic crisis when the Spanish government had trouble refinancing itself with 10-year treasury bonds, paying close to 6% from the third quarter of 2011 to the third quarter of 2012. Thus, many companies have at least another five years with above-average investment income to help them steer through the competitive motor insurance market.
Also, fewer cars have been sold since the crisis. As a result, there are now a larger number of older vehicles on the road. The average age of the Spanish car park is now 11 years compared to eight years in 2007, which means that 50% of all cars circulating on Spain’s roads are older than 10 years.2 So we could easily conclude that once vehicle-use levels rebound to their pre-crisis levels, the exposure will be clearly higher than it was in 2008. We can add to that the tighter budgets of municipalities, which led to worse road maintenance.
But maybe there’s light at the end of the tunnel. After 11 years of declining average premium per policy, two of Spain’s market leaders (Allianz and Mapfre) recently announced plans to increase their motor tariffs. Could this be the first sign that the premium trend is finally set to change? And what about the loss increases expected due to the Baremo modification?
This is where in-depth analysis of the new Baremo indemnification table would make sense, but would be beyond the boundaries of this article (check out therefore the soon to be released blog by our claims manager Frederico Maroto). Here are some general facts:
- According to the Ministry of Justice based on data from TIREA (Tecnologías de la Información y Redes para les Entidades Aseguradoras) in cooperation with the Spanish insurance association (UNESPA), the loss cost for motor third party liability losses with bodily injury victims will increase by 16.2% or as little as 15 percentage points, considering that the small number of Baremo points (1 to 2) for bodily injury losses compensation would be dramatically reduced. There may be a question mark regarding how much these mass losses will really diminish because that kind of “whiplash losses” is the main area of traffic accident frauds with bodily injury,3 but as fraud detection has already improved, the effect will probably be less for companies that have been more efficient in the management of these types of losses.
- There is much uncertainty because of the lack of data on concepts that until now haven’t played an important role in determining compensation amounts – for instance, loss of income and new claimants, such as close friends, who will now have the right to claim indemnification.
- Litigation is likely to increase noticeably during the initial phase of the new Baremo table, inevitably resulting in higher loss costs.
- A significant impact on reinsurance cost which eventually will be a multiple of the current excess of loss reinsurance treaty rates due to the increase in compensation for severe bodily injury victims being over-proportional in many cases, according to internal studies.
While the loss cost will undoubtedly increase, especially in the steep rise for severe bodily injury losses, every insurance entity will have to carry out its own study to analyze the effect on its portfolio, depending on the type of losses and the individual portfolio mix.
Even after companies have carried out internal studies, uncertainty will persist because the application of the new Baremo table will have to be tested in court, and it is rather likely that the initial estimates of the sector’s loss ratio will have to be raised, unless this phase comes with considerable rate hikes.
Let’s briefly reflect on how all this will fit in with the new Solvency II regime, which will also take effect in 2016.
The more prudent insurance entities will have already looked at the changes in the Baremo and its possible impact on business in their Own Risk and Solvency Assessment (ORSA). They will have considered how to confront its effects with the best possible strategies. But how will these qualitative aspects most likely be supported by the pure numerical application of Solvency II’s standard formula? Although we are unable to provide a full impact study of the new Solvency II regime on the Spanish motor business, we can reflect on potential scenarios and come to a conclusion as to whether or not they will best meet the intentions of Solvency II.
On the back of the recent negative technical results for a significant number of actors in Spain’s motor insurance business, a negative effect on the solvency ratio under Solvency II criteria would be expected. But let’s examine that assumption:
The reserve risk within the Underwriting Risk module will normally be the module for an auto insurer, which has the most impact on the solvency capital requirement (SCR). Auto insurers will generally find that, as a result of loss reserves having to be accounted for in the economic balance sheet as the “best estimate” (plus a risk margin), these obligations will often show a lower number than under current accounting rules. This would lead to higher own funds and probably to a better solvency margin, depending on the rest of the variables. In (simple) theory, the obligations should be reflected in the most realistic way, considering the payout time and adding a risk margin to that result. In practice, the discounting effect for long-tail motor business, combined with a “best estimate”, will normally result in lower provisions than today’s numbers and even over-compensate the effect of adding the risk margin, thus leading to a better solvency margin, possibly over-proportionally for entities that show a less positive balance sheet.
Since this is untested territory, one must wait to see how the insurance authorities will react when they detect such cases.
In any case, with the Baremo initially bringing a lot of uncertainty and most likely worse results for the most significant non-life line of business in Spain, we must wonder whether the robust reserve structures of the past won’t be weakened as a result of the Solvency II “best estimate”, leading to the opposite effect of what is supposedly the goal of implementing Solvency II: better risk management that takes into account all the risks of an insurance entity in the most realistic way while considering the threats and opportunities of the future. One might think that the market would rather need higher loss reserves than “discounted best estimates” to confront the threats of an initially uncertain future for the motor insurance market in Spain.
Maybe technology will save the day and the latest car safety improvements will lead to an enormous reduction in road traffic accidents in the near future, or it will have other implications, of which a new round of premium reductions may be the least of the threats to motor insurers. However, that is a completely different topic and for now we had better think of “self-drive vehicles” as science fiction.